Using breakeven analysis for farm based decision making

August, 2012
Kenneth A. Johnson Jr., University of Florida, DeSoto County Extension Director and Livestock Agent

Whether you are in the cattle business or manufacturing sophisticated electronic equipment it is always important to know the point where you cover your cost of doing business (the breakeven point) when making business decisions. If you can accurately understand your costs and sale price then finding the breakeven point is rather simple math.  The breakeven point is an important measure as it is the lower limit of operational profit and where you begin to determine profit margin.  Understanding how this can help a farm and ranch operation begins with understanding how to define and calculate costs. 

 Costs:
There are several types of costs to calculate when using breakeven analysis. 

  • Fixed costs: business expenses that are constant for a company no matter what the production level is, e.g. land payments, insurance, depreciation, interest
  • Variable costs (operating and marketing costs): a cost that varies with a change in the volume of output while remaining uniform on a per-unit basis, e.g. fertilizer, lime, hay, veterinary service, maintenance, etc. 

Pricing:
The next critical function of using breakeven analysis is forecasting your sale price.  You must know your sale price in order to be able to calculate revenues per unit (calf, tree, fruit).  Unit price refers to the amount you plan to charge customers to buy a single unit of your product.  This can be hard to predict in a volatile commodities market but is however essential when figuring breakeven point.   As with costs there are several methods of calculating price that you should be aware of when doing breakeven analysis.

  • Cost-plus pricing - Set the price at your production cost, including both cost of goods and fixed costs at your current volume, plus a certain profit margin.
  • Target return pricing - Set your price to achieve a target return-on-investment (ROI).
  • Value-based pricing - Price your product based on the value it creates for the customer.
  • Psychological pricing - Ultimately, you must take into consideration the consumer's perception of your price, figuring things like:  Positioning, popular price points, fair pricing

For the cow calf producer setting a price point for accomplishing a break even analysis can be a very volatile decision.  As markets go from bull to bear and sale prices vary $200/cwt from calving to time of sale producers may elect to use various price mitigation measures such as futures, options, and LRP insurances.  Futures allow the producer to establish a price prior to delivery by using the Chicago Mercantile Exchange feeder cattle futures.  Producers sell calves early in the season under contract and then by out that contract at the time of actual sale.  If the price of cattle declines between that time period the producer makes a positive return and vice versa.  Producers can also buy a put option of feeder cattle futures in order to establish a minimum price and have the ability to take advantage of higher prices but not fall below a set point.  This however does come at a premium that is paid to hold a price.  Also producers have been using the USDA-LRP insurance which works similarly to buying a put of feeder cattle futures with setting an insured price point subject to payout if the market falls below that level.  These are some of the options cattle producers have to establish pricing when attempting to calculate breakeven point.

Calculating the Breakeven Point
Now that we have established the basis for calculating the breakeven point, to conduct your breakeven analysis, take your fixed costs, divided by your price, minus your variable costs. As an equation, this is defined as:

Breakeven Point = Fixed Costs / (Unit Selling Price - Variable Costs)
This calculation will let you know how many units of a product you'll need to sell to break even. At this point any additional units you sell become profit.  Once you reach the breakeven point you can calculate the additional profit contribution of additional units by using the following equation:

Unit Contribution Margin = Sales Price - Variable Costs
It is imperative when doing breakeven analysis that what the analysis is telling you is understood.  For instance if the calculation shows that 50 is your breakeven point, then when you sell your 50th unit (calf, vegetable, etc) then your costs are covered.  When you come to this analysis you must ask yourself a series of questions:

  • Is it feasible to produce that number of units
  • Can you exceed that number in order to make a profit?
  • At what level (number of units) would profit be satisfactory for your business endeavors? 
  • Can you lower your breakeven point by adjusting your cost structure?  This requires flexibility in your variable costs of production either through deferment of expenses or seeking better prices of for goods and services.
  • Can your sale price can be adjusted upward to again lower your breakeven point.  In commodities markets this can be done through a number of means either: hedging, futures, direct contracts or taking advantage of inherent market fluctuations. 

This is where the rubber meets the road for making production decisions.  At the price the market will bear and at my costs can I afford to make this decision (do I fertilize this year, do I early wean, how far I push the limits) and make a reasonable profit for my efforts.  We all make these production decisions on a daily basis in our operations.  With sound business planning and good operating practices, the use of breakeven analysis should help us make better more informed decisions 

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