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Why do we run the farming business? Is it because the investment in the dairy is a way to maximise the return on capital or is it a way of life we want? In traditional economics, the company owner/manager is a .profit maximiser, but the situation for a farmer is very often different. It is not unusual that social aspects and traditions affect the goals. But even so, knowledge about the economic principles behind the milk production and a business-like approach to farming is important if you want to remain competitive in the long run. High costs and poor profitability will make it difficult to expand or even to survive.
Margin refers to an added unit, or the last unit, either of output or input. This margin can be measured in physical or financial terms. When the marginal cost (MC) is lower than the marginal revenue (MR), it is worth increasing the production through increased cost. If the marginal cost is higher than the marginal revenue, you are losing money. You will find the optimal production when the marginal cost equals the marginal revenue. This means that minimising operating costs is not, in general, the way to make the most profit.
Marginal Cost = Marginal Revenue = Max. Profit
To better understand this principle, let us look at an example. You are growing grass for silage making. With your experience, you know that the yield response is positive when adding extra nitrogen. With this knowledge, you will add nitrogen (marginal cost) as long as the extra growth is worth more (marginal revenue) than the extra cost for nitrogen. However, what we have to be aware of is that this increase in production does not last forever (see below). If you add too much nitrogen, the value of the extra growth will not cover the added cost.
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Constant or linear production responses to inputs are rare in agricultural production. As mentioned above, the yield response to nitrogen will, at a point, start to decline, which is illustrated in the diagram below. Between points A and B, the relationship between inputs and production is linear or constant. At point B, the response starts to diminish and between C and D, it falls. This means that when we reach point C, it is not worth adding more nitrogen because the yield response is then negative.
Max. Yield ≠ Max. Profit
The maximum yield is at point C, but the maximum profit is somewhere between B and C. In other words, maximum yield is not the same as maximum profit, because the marginal cost might be higher than the marginal revenue when the yield is at its maximum.
The principle of diminishing marginal.
The opportunity cost of not using a resource in a given way is the value forgone by not using it in the most profitable alternative way. Assume you have one hectare (or 2.5 acres) of land. The most profitable crop to grow on this land is wheat, but you are thinking about growing grass instead. What is the cost for growing this grass?
First of all, you will lose the whole gross margin from growing wheat (£500). This is in fact the opportunity cost. You will then have costs for growing the grass (fertiliser, seeds etc.) of £100. The .real. cost for growing one hectare of grass will be the sum of these two: 500 + 100 = £600.
Another example is your working time. The actual time spent on a specific operation, e.g. milking, can always be used in an alternative way, e.g. contracting operations. If the time spent on contracting is more profitable than on milking, it is worth trying to limit the time in the parlour and use the time for the contracting operation.
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The size of a dairy business has an impact on the profitability, but it is not always an advantage to be large. However, in many cases, we find economies of scale which is the same as decreasing costs when production increases.
Sources to this include the ability to spread fixed costs over greater supplies of milk and the purchase of inputs and services in volume at discounted rates. To illustrate this, we have to look at the figure below.
The impact on total cost when total production increases.
A farmer producing between A and B will increase net income by increasing production (Economies of Scale). B to C represents a constant production cost. The farmer producing at level B has the same production cost as the farmer producing at level C. The reason behind this is today’s production technology that allows moderate size dairy farms to be competitive with larger farms.
Between C and D, we find increasing costs which may be caused by, for example, the increasing difficulties to control, overview and manage a ‘too’ large dairy operation (Diseconomies of Size). If this occurs, it is often a good solution to split the business into two ‘independent’ operations.
The conclusion is that the optimal production level is somewhere between B and C, but exactly where depends on for example: market situation, available technology, taxes, complexity of the enterprise etc. However, over time, dairy farms have always increased in size.
The earlier you invest in a technology that improves efficiency, and therefore decreases the production cost, the more you will gain from that investment. How can this be true?
If you look at the figure below, you will find three different lines: milk price, average production cost and early adopter.s production cost. As you can see, the average production cost strictly follows the milk price. Assume now that a new technology, e.g. computerised management system, becomes available on the market.
If you as dairy farmer adopt this technology early (year one), it will lower your production cost and you will initially (year one to five) make a higher profit than the average dairy farmer.
Example of producttion cost fo milk vs. milk price.
Due to the fact that the technology has improved your efficiency, more and more farmers will invest in the technology. The increasing output of .cheaper. milk will force the milk price to fall over time and eventually the early adopter.s production cost will equal the average production cost. This is when the technology becomes a standard.
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