Animal Science Farm Management

ODA BULTUM UNIVERSITY

COLLEGE OF AGRICULTURE
DEPARTMENT OF ANIMAL SCIENCE

HANDOUT OF FARM MANAGMENT (AgEc422)

BY: MEFTU ABDI (MSc, Agricultural Economics)

MARCH 2024
CHIRO ETHIOPIA

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TABLE OF CONTENTS
1. INTRODUCTION TO FARM MANAGEMENT 3
1.1. Definitions and Basic Concepts of Farm Management 3
1.2. Objectives and Scope of Farm Management Studies 4
1.3. Nature and Characteristics of Farm Management Science 5
1.4. Farm management decision-making process 6
1.5. Characteristics of Farming as a Business 7
1.6. Farm Management Problems in Developing Countries 7
2. PRODUCTION RELATIONSHIPS 9
2.1. Definitions and Concepts of Basic Terms 9
2.2. Types of Production Relationships 11
2.2.1. Factor-Product Relationships 11
2.2.2. Factor-Factor Relationships 17
2.2.3. Product –Product Relationship 23
2.3. Production Resource Management 28
2.3.1. Farm Resources 28
2.3.2. Rewards for using farm resources 30
2.3.3. Farm Resources Valuation 30
3. FARM PLANNING AND BUDGETING 34
3.1. Farm Planning 34
3.1.1. Definition of Farm Planning 34
3.1.2. Objectives of Farm Planning 34
3.1.3. Importance of Farm Planning 35
3.1.4. Basic Steps in Farm Planning 36
3.1.5. Types of Farm planning 36
3.1.6. Characteristics of Good Farm Plan 36
3.2. Farm Budgeting 36
3.2.1. Advantages of Farm Budgeting 37
3.2.2. Types of Farm Budgeting 37
4. FARM RECORDS, ACCOUNTING AND ANALYSIS 41
4.1. Farm Records 41
4.1.1. Definition of Farm Records 41
4.1.2. Advantage of farm Record Keeping 41
4.1.3. Types of Farm Records 41
4.1.4. Characteristics of Good Farm Records 42
4.2. Farm Accounting 42
4.2.1. Advantages of Farm Accounts 43
4.2.2. Problems and Difficulties in Farm Records and Accounting 43
4.3. Farm Inventory and valuation method 43
4.4. Farm Financial Analysis 48
4.4.1. Balance Sheet and analysis 48
4.4.2. Income Statement and analysis 50
5. RISK AND UNCERTAINITY IN AGRICULTURE 58
5.1. Definition of Risk and Uncertainty 58
5.2. Types and Sources of Risk and Uncertainty in Agriculture 59
5.3. Decision making under risk 61
5.4. Methods of Reducing Risk and Uncertainty 64

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1. INTRODUCTION TO FARM MANAGEMENT

1.1. Definitions and Basic Concepts of Farm Management
There are various expressions towards farm management. Some of the preliminary concepts
can be described as follows:
Agriculture: The sum total of the practices of crop and livestock production on individual
farms. Hence, the agricultural production of country is the sum of contributions of the
individual farm units, and the development of agriculture means the sum of developments of
millions of farm units.
Farm: It is a piece of land devoted either to crop production or raising of livestock or both
managed by an individually or jointly and has a common management and demarcating line
or boundary. It is both a producing and a consuming unit. It also a socio economic unit which
not only provides income to a farmer but also a source of happiness to him and his family. It
is also a decision making unit where the farmer has many alternatives for his resources in the
production of crops and livestock enterprises and their disposal.
Family farm (family holding): It is the size of holding as being equivalent (according to
local or existing conditions of technology and techniques of farming) either to a plough unit
or to a work unit for a certain farming family size.
Farm Firm: It is an enterprise of production activities by organizing various inputs for profit
maximization. Hence, it is a business unit of control over factors of production. Farm is called
firm because production is organized for profit maximization. Besides, it is a household unit
demanding maximum satisfaction of the farm family.
Stock inputs: Those resources which are consumed during the production period, like seeds,
fertilizers, pesticides and the like. They can be stored, if not used currently, for future use.
Flow inputs: Recourses which cannot be stored and used as when they are available for use.
Such as like labor and management, if not used, cannot be stored for the next season.
Technical unit: is an exact single unit used in production (i.e., one hectare land, one cow, one
goat etc).
Economic unit: is the sum of resources for which costs, returns and net income can be
worked out. As such, a farm is an economic unit.
Agricultural holding: is total area of land owned by an individual or joint family whether
cultivated or rented out.
Operational holding: Actual area on which cultivation is carried on, this includes rented in
or out land.
Economic holding: The size of holding which could provide a reasonable standard of living
to farmer and full employment to a family of normal size.
Management of Farm vs. Farm Management: Generally speaking, management of farm
aims at maximizing production in the sphere of agronomy, whereas, farm management is
concerned with maximizing profit in the realm of agricultural economics.
 Towards the definitions of farm management there are many kinds of interpretation to
explain the concept of the subject matter. Farm Management comprises of two words i.e.
Farm and Management. Farm means a piece of land where crops and livestock enterprises are
taken up under common management and has specific boundaries. Management is the art of
getting work done out of others working in a group. Besides, it is the process of designing and
maintaining an environment in which individuals working together in groups accomplish
selected aims.

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1.The art of managing a farm successfully, as measured by the test of profitableness. (L.C.
Gray).
2. Farm management is defined as the science of organization and management of farm
enterprises for the purpose of securing the maximum continuous profits. (G.F. Warren).
3. Farm management may be defined as the science that deals with the organization and
operation of the farm in the context of efficiency and continuous profits. (Efferson).
4. Farm management is defined as the study of business phase of farming.
5. It is a branch of agricultural economics which deals with wealth earning and wealth
spending activities of a farmer, in relation to the organization and operation of the individual
farm unit for securing the maximum possible net income. (Bradford and Johnson)
Generally, farm management is a branch of agricultural economics that deals with the way
how a farmer attempts to accommodate scarcity to his/her needs. It is also a science that deals
with the proper combination and operation of production factors including land, labor and
capital and the choice of crop and livestock enterprises to bring about the maximum of
continuous returns to the most elementary operation units of farming. Moreover, it study
about the application of agricultural sciences, business and economic principles in farming in
view of an individual farmer. The principles may serve as a guideline for collecting and using
required information for rational decision making. They also provide a set of tools for the
preparation of farm budget and production programs.
1.2. Objectives and Scope of Farm Management Studies
Objectives of Farm Management
Looking at the farm structure as a whole, it is apparent that the objective has to do with two
aspects of the same farm as a producing unit and as a consuming unit along with the
harmonization of their behavior and goals. Broadly, the objectives of farm management are:
1. To study existing resources (land, labor, capital and management) and production patterns
on farm,
2. To perform strategic task of identifying the deviation of the resources from their optimum
utilization.
3. To explain means and procedures of moving from the existing combination of resources to
their optimum use for project maximization.
4. To outline conditions that would simultaneously obtain its objectives of profit
maximization and maximization of family satisfaction through optimum use of resources and
judicious income distribution.
5. To work out costs and returns on individual enterprises and on the farm as a whole.

Scope of Farm Management

Farm Management is generally considered to be microeconomics in its scope and primary
concern farm as a unit. It deals with the allocation of resources at individual farm level. It
deals with decisions that affect the profitability of farm business and seeks to help the farmer
in deciding the problems like what to produce, how to produce, and how much to produce. It
covers all aspects of farming which have bearing on the economic efficiency of farm. Farm
management deals with the business principles of farming from the point of view of an
individual farm. Its limited to the individual farm as a unit and it is interested in maximum
possible returns to the individual farmer. It applies the local knowledge as well as scientific
finding to the individual farm business. In short be called as a science of choice or decision
making. In this regard it includes:

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 The types of enterprises to be combined, the kinds of crops (livestock) and varieties to be
grown
 The amount of fertilizer to be applied, the way the farm functions are to be performed
 Investment decisions, farm planning and budgeting
 Farm prices, credit and profits
 Risk and uncertainty
Furthermore, the subject farm management includes farm management research, training and
extension.
 Farm management research– to find out solutions of economic problems faced by the
farmers, it is greatly facilitated through recording of data related to the farm and it has to be
analyzed in view of that enables to identify causes of inefficient functioning of the farm.
 Farm management extension – once the results of the study are known, they are to be
made available to the farmers. The farmers also have to be educated and trained in the
application or adoption of these results.
 Farm management teaching– It is essential for agricultural graduates to understand
farmers’ response to varying economic pressures and stimuli. It also help the farmers to take
the right decisions as to what to grow, how much to grow, how to grow and where to sell and
buy.
1.3. Nature and Characteristics of Farm Management Science
It is basically both an applied and pure science. It is a pure science (theory) because it deals
with the collection, analysis and explanation of factors and the discovery of principles. It is an
applied science (technology) because the ascertainments and solutions of farm management
problems are within scope. Furthermore, farm management science has many distinguishing
characteristics from other fields of agricultural economics.
1. Practical science: It is a practical science, because while dealing with the factors of other
physical and biological sciences, it aims at testing the applicability of those facts and findings
and showing how to put these results to use on a given farm situations. A farmer has to select
a method which is more practicable and economical to his particular farm situation taking into
consideration the volume of work and financial implications.
2. Profitability oriented: Farm management is interested in profitability (considers the costs
involved in producing each unit of output in relation to returns). Biological fields such as
agronomy and plant breeding concern themselves with distaining the maximum yield per unit
irrespective of the profitability of inputs used. It is interested in optimum yields which may
not necessarily coincide with the maximum production point. In brief, when other sciences
deal with physical efficiency, farm management deals with economic efficiency.
3. Integrating science (interdisciplinary science): The facts and findings of other sciences
are coordinated for the solution of various problems of individual farmers with the view of
achieving desired goals. It involves different disciplines to decision making. It considers the
findings of other sciences in reaching its own conclusions. Principles of farm management
integrate results by physical sciences under specific set of conditions.
4. Broader field: It uses more than one discipline to make decisions. It gathers knowledge
from many other sciences for making decision and farm management specialists have to know
the broad principles of all other concerned sciences in addition to specialization in the
business principles of farm management.
5. Micro-approach: In farm management, every farm unit is considered as unique in terms of
available resources, problems and potentialities. It recognizes that no two farms are exactly

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identical with respect to soil, other production resources, managerial ability. Each farm unit
has to be, therefore, studied, guided or planned individually.
6. Farm unit as a whole: In farm management analysis, a farm as a whole is considered to be
the unit for making decisions because the objective is to maximize the returns from the whole
farm instead of only improving the returns from a particular enterprise or practice. It considers
all possible aspects of crop and livestock enterprises of a given farm. The principles of farm
management, thus, help to get the optimum enterprise mix that would yield the highest
income to the farmer from the total farm organization.
1.4. Farm management decision-making process
This section elaborates how farm management is applied in deciding on allocation of scarce
resources in different alternative uses. Hence, farm management is concerned with the
allocation of limited resources among a number of alternative uses which require a manager
to make decisions. In farm business, goal attainment is confined with in some limits set by the
amount of land, labor and capital available. These resources may change overtime, but they
are never available in infinite amounts. The expertise of the manager may be another limiting
resource. If the limited resource could only be used one way to produce one agricultural
product, the manager’s job would be much easier. Therefore, farm management seeks to help
the farmer in deciding on economic problems like:
 What to produce? (selection of profitable enterprises)
 How much to produce? (optimum enterprise mix and resource use level)
 How to produce? (Selection of least cost production method)
The process of making a decision can be formalized into a logical and orderly series of steps.
Important steps in farm decision making process are:
 Identifying and defining the problem,
 Collect relevant data, facts and information,
 Identify and analyze alternative solutions,
 Make the decision – select the best alternative,
 Implement the decision and
 Observe the results and bear responsibility of the outcomes.
Hence, farm management may in short be called a science of decision-making or science of
choice. That is, managing a farm is a continuous process of decision-making. The principal
changes frequently encountered by the farmers are fluctuations in price, weather variations,
and inventions in farming methods, changes in socio-economic environment including
changes in government policy and social responses and values.

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1.5. Characteristics of Farming as a Business

Farming as a business has many distinguishing features from most other industries in its
management methods and practices. The major differences between farming and other
industries are:
a. Primary forces of production: Agriculture is primarily biological in nature. A slight
change in the environment may cause serious difficulties. One day of cold, for example, may
destroy the whole of a standing crop. Unforeseen changes in the environment such as plant or
animal diseases and storm can cause a considerable damage. Most of the other industries are
less likely to be affected by such circumstances.
b. Size of the production unit: Farming is a small-sized business as it gives little scope for
division of labor. In this business the farmer is both the laborer and the capitalist.
c. Heavy dependence upon climatic factors: Weather changes may involve readjustments.
As a result of dependence on climatic factors, management practices in farming must be much
more flexible than in other industries.
d. Frequency and speed of decisions: Farming requires many and speedy decisions on the
part of the farmer and the farm workers.
e. Changes in prices: Agricultural prices and production usually move in opposite
directions. Because of the effects of climate and biological factors, a relatively large
volume of production of a given farm commodity is usually followed by a decrease in
price, and a smaller volume results in increase in prices.
f. Fixed and variable costs: Of the total costs, portion of fixed costs is more in agriculture
than in other industries. This high proportion of fixed costs tends to make the
adjustments in production more difficult.
g. Inelastic demand for farm products: Agriculture deals with production of food and
raw materials. As standard of living improve and income increases, the demand for
agricultural products will increase less rapidly than that for industrial products. On the
one hand, if increased production comes from the decreased marginal returns phase,
costs will go high. Higher production may reduce prices so low that total returns might
not increase or even may decrease.
1.6. Farm Management Problems in Developing Countries
Farm management problems may vary from place to place depending on the degree of
agricultural development and the availability of resources. The following are some of the
most common problems:
1. Small size of the farm business: It is obviously in Ethiopia, the average land size or
holding is fragmented and too small. Thus, excessive pressure of population creates
unfavorable man-land ratio in most parts of the country. This combined with excessive family
labor, which depends upon agriculture, and that has weakened the financial position of the
farmers and limited the scope for business expansion.
2. Farm as a household: In most parts of the country family farms perpetuate the traditional
combinations of crops and methods of cultivations. Thus, the equation between agricultural
labor and household labor becomes an identity. This makes difficult for the farmer to
introduce business content and incorporate new management idea in his/her farm operations.
Home management thus heavily gets influenced by farm decisions.
3. Inadequate Capital: Capital shortage is usual feature of farming in developing countries.
Most often, peasant agriculture (i.e., mostly subsistent) is labor intensive and characterized by
serious deficiency of capital. Generally, small size of farms, problems of tenure ship and

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remunerative prices have set the farmer under perpetual poverty. New technologies demand
higher inputs such as more fertilizers, protection measures, irrigation and better seeds as well
as investment in power and machines. Therefore, small farm holders cannot meet the financial
requirements from their own funds. Hence, low cost, adequate and timely credit is their most
pressing need if they have to put their farms on growth paths.
4. Slow Adoption of Innovations: Small farmers usually conservative and sometime
skeptical of new technologies or methods. However, the rate of adoption depends on the
farmers’ willingness and ability to use the new information. Since established attitudes and
values do not change overnight, the extension take time to get the research results
commercially adopted and existed on the farms. It calls for training and substantial financial
requirements.
5. Inadequacy of Input Supplies: Farmers may be willing to introduce change yet they may
face the difficulty in obtaining the required inputs of desired quality, in sufficient quantity,
and on time to sustain the introduced changes. Moreover, shortage of foreign exchange in
developing countries seriously limits importation of needed supplies and materials. Domestic
industries generally lack adequate raw materials, skills, capital or a combination of these to
manufacture the needed farm supplies.
6. Managerial Skill: It is the most prominent and difficult problem of several small-scale
farmers for many years in developing countries. This is necessary for millions of farmers who
use the research results to develop progressive attitude and be responsive to the technological
changes through education.
7. Communication and Markets: These are also the other two important elements of
infrastructure necessary for introducing economic content in the farm organizations. Lack of
these elements set as a major bottleneck in the way of improving the management of farms on
business lines. Substantial investments, therefore, need to be made on roads, marketing and
other communication facilities.

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2. PRODUCTION RELATIONSHIPS
2.1. Definitions and Concepts of Basic Terms
In the production process, firms use inputs also called factors of production. Therefore, we
may conceive of firms as being sellers of goods and services and buyers of factors of
production. Firms buy factors of production and transform them into goods and services. This
process of transformation is called production. This process of transformation is influenced by
the time horizons involved. Production is more flexible in the long run than in the short run.
Output: The amount of a good or service produced by a firm. It is the result of combinations
of inputs or the transformation of inputs into a product. It is any good or service that comes
out of the production process.
Production: It is a process by which some goods and services called inputs are transformed
into other goods called output. Or it is a process of transformation of certain resources
(inputs) into products. Production relationships are also known as input-output combinations.
Transformation (production period): The time that required for a resource to be completely
transformed into a product. All resources are not completely transformed in a single year.
Long-lived resources such as buildings, tractors may not be transformed into product.
Inputs: Resources that are combined to produce finished goods. It also called productive
resources, and in economic termed as ‘factors of production’. They are usually grouped in to
four main categories such as land, labor, capital and management (entrepreneurship).
Factors of production: It is the resources that are used to produce a good. It could be fixed or
variable. The difference is relates to the time horizon involved. In economics, there are two
main horizons: the short run and the long run. Short run it is a relatively short period of time
in which the quantity of some factors of production such as equipment and buildings cannot
be varied. Such factors are called fixed factors. Factors of production whose quantity can be
varied in the short run are called variable factors. Long run, on the other hand, is a relatively
long period which allows the variation of all factors of production including plants and
equipment. Those resources whose uses vary with the level of production are known as
variable resources. Volume of output directly depends on these resources. Costs
corresponding to these resources are known as variable costs. It exist both in the short run and
in the long run. Eg. Seeds, Fertilizers, Plant protection chemicals, feeds, medicines etc. Fixed
resources are those resources whose use remains the same regardless of the level of production.
Volume of output does not directly depend up on these types of resources. Costs
corresponding to these resources are known as fixed costs. It exist only in the short run and in
the long run they are zero. Example: machinery, farm buildings, equipment, implements,
livestock, etc.
Production function: It is a technical and mathematical relationship describing the manner or
extent between factor inputs and output. It describes the amount of output expected from
different combination of input usage. It reflects the best technology available for a given level
of output in the production process. Simply, it is the relationship between physical inputs and
output of a farm or a firm. It can be categorized into continuous and discontinuous or
discrete.
Continuous Production function: It is obtained for those inputs which can be split up into
smaller units. It is obtained for those inputs which are measurable. Eg. Fertilizers, Seeds,
chemicals, Manures, Feeds etc.
Discontinuous ( discrete Production Function): It is obtained for resources or work units
which are used or done in whole numbers. In other words, production function is discrete,

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where inputs cannot be broken in to smaller units. It is obtained for those inputs which are
counted. Eg. Ploughing, Weeding, Irrigation, number of beef cattle and dairy cows owned.
Short Run Production Function: Production Function in which some inputs or resources
are fixed. Y= f (X1/X2, X 2… X n). Eg: Law of Diminishing returns or Law of variable
proportions.
Long Run Production Function: Production function which permits variation in all factors
of production. Y =f(X1, X2, X3,.., Xn). Eg: Returns to scale. Production functions can be
expressed in three forms such as in tabular, graphical and algebraic (equation) types.
a) Tabular form
Input (X) Output (Y)
0 0
10 50
20 110
30 180
40 250

b) Graphical Form
1500
Output (e.g

1000
Maize)

500

0
0 50 100 150
Input (e.g. fertilizer) 200 250
c) Algebraic Form: It can be expressed as:
 Y= f(X) - when only one input is involved in production function.
 Y=f(X1, X2, X3, X4.... Xn)-When more number of inputs is involved in the production
function.
 Y=f(X1|X2, X3 ….Xn)- In case of single variable production function, only one
variable is allowed to vary, keeping others constant, can be expressed as: The vertical bar is
used for separating the variable input from the fixed input. The equation denotes that the
output Y depends upon the variable input X 1 , with all other inputs held constant.
 Y=f(X1, X2| X3, X4…Xn)- If more than one variable input is varied & few others are
held constant.
Production function depends on the following factors:
1. Quantities of inputs used
2. Technical knowledge of the producer.
3. Production process
4. Size of the firm
5. Nature of firm’s organization
6. Relative prices of factors of production

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2.2. Types of Production Relationships

Major production relationships fall under three categories:
1. Factor - Product Relationship
2. Factor - Factor Relationship
3. Product - Product Relationship
2.2.1. Factor-Product Relationships
The Factor-Product Relations deal with the production efficiency of resources. It studied the
rate at which the factors are transformed in to products. The central goal of this relationship is
optimization of production. The relationship is known as input-output relationship by farm
management specialists and responsive curve by agronomists. It guides the producer in
making the decision on ‘how much to produce?’ It helps the producer to decide the optimum
input level to use and optimum output level to produce. The decision on the optimal levels of
input and output is made by using price ratio as the choice indicator. The factor-product
relationship or the amount of a resource that should be used and consequently the amount of
output that should be produced is directly related to the operation of law of diminishing
returns. This law explains how the amount of product obtained changes as the amount of one
of the resources is varied keeping other resources fixed. It is also known as law of variable
proportions or principle of added costs and added returns. Furthermore, the economic
principles as listed below help us in explaining the relationships between input and output,
input and input and output and output in making farm management decisions.
Table 2.1 Principles of economics along with production relations
Principle of economics Explaining Management decision
Principles of diminishing returns Factor-product How much to produce? (Use of
or increasing costs. relationship resources at optimum level)
Principles of substitution or least Factor-factor How to produce? (Least-cost
cost combination of resources. relationship method)
Principle of opportunity cost or Product-product What to produce? (Enterprise
equi-marginal returns. relationship selection.

Types of input-output relationship

There can be three types of input-output relationships in the production of a commodity where
one input is varied and the quantities of all other inputs are fixed. The rate at which the
changes in output due to varying amount of inputs that is used to explain the different laws of
production, popularly known as laws of returns. The nature of a single input and a single
output relationship can be either of the following types:
a. Law of Increasing returns (increasing marginal productivity)
b. Law of Constant returns (constant marginal productivity)
c. Law of decreasing returns (decreasing marginal productivity)
A) Law of Increasing returns (increasing marginal productivity)
In this case every additional unit of input adds more to the total product than the previous
unit, i.e. the addition of total product is improved at an increasing rate. Each successive unit
of variable input when applied to the fixed factor adds more and more to the total product than
the previous unit. The marginal physical product is increasing and hence known as law of
increasing returns. Increasing returns means lower costs per unit of output. Thus it signifies
that cost per unit of additional product falls as more and more output is produced. Hence law
of increasing returns also called law of decreasing costs.

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Table 2.2 Response of different input rates on wheat yield

X ∆X Y(TP) ∆Y MP (∆Y/∆X)
10 - 1000 - -
15 5 1025 25 25/5 = 5
20 5 1075 50 50/5 = 10
25 5 1150 75 75/5 = 15
30 5 1250 100 100/5 = 20
35 5 1375 125 125/5 = 25
The above Table (2.2) shows that in every production time as 5 units of fertilizer are added,
the marginal addition to the total output will goes on increasing. The relationship is also
indicated algebraically as: ∆Y1 < ∆Y2 < ∆Yn
∆X1 ∆X2 ∆Xn
When production function is graphed with output on vertical axis and input on horizontal axis, the
resulting curve is convex to the origin.
B) Law of Constant returns (constant marginal productivity)
In constant returns or linear relationships, each additional unit of the variable input applied to
the fixed factor(s), it will produce equal amount of additional product. That is, the amount of
product is increased by the same magnitude for each additional unit of input. Eg. The use of
one additional tractor with the driver will do the same amount of work as a previous tractor
and driver did.
Table 2.3 Constant relationship of wheat response function (hypothetical data)
X ∆X Y(TP) ∆Y MP (∆Y/∆X)
0 - 1000 - -
10 10 1350 50 50/10= 5
20 10 1400 50 50/10= 5
30 10 1450 50 50/10= 5
40 10 1500 50 50/10= 5
50 10 1550 50 50/10= 5
This Table 2.3 shows that with every increase in input there is equal or constant increase in
the level of output. It is known as constant marginal returns. Mathematically, the relationship
can be expressed as: ∆Y1 =∆Y2 = … = ∆Yn
∆X1 ∆X2 ∆Xn
The shape of the total product curve is linear. Linear production indicates constant returns.
This function denotes a straight line graph having the same slope throughout its entire range.
In a specific farm production activity, the constant returns production function can be
expressed as: Y = a+bX. Obviously, linear production function does not exist when input per
ha or per head of animal is intensified. Such a relationship only exists when the initial doses
applied per ha or per head is very small. Agronomists and soil scientists sometimes make
recommendations as if the production function is linear, which of course, never be true in
each practice. Before making any recommendation one should, therefore, carefully consider
the nature of returns and economic criterion.

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C) Law of decreasing returns (decreasing marginal productivity)

In this type of production function each additional unit of input adds less to the total product.
i.e., diminishing marginal returns exist. Eg. If the first input adds 20 units to the total output,
while the second add 15 units, the third adds 10 units, and so on. This function exists in
almost every practical situation in agriculture such as: the responses to fertilizers, insecticide,
seeds, irrigation, and all show diminishing returns. A production function of a single variable
nature showing diminishing returns throughout is given in table below.
Table 2.4. Application of fertilizers and output of wheat grain
X ∆X Y(TP) ∆Y MP (∆Y/∆X)
0 - 500 - -
10 10 1400 900 900/10 = 90
20 10 2100 700 700/10 = 70
30 10 2600 500 500/10 = 50
40 10 3000 400 400/10 = 40
50 10 3200 200 200/10 = 20
60 10 2950 150 150/10 = 15
This Table (2.4) shows that for every time 10 units of fertilizers are added, the marginal
addition to the total output goes on decreasing. The relationship is also indicated algebraically
as: ∆Y1 > ∆Y2 >.... ∆Yn
∆X1 ∆X2 ∆Xn
The production function which exhibits diminishing returns is concave to the origin. Law of
diminishing returns is very common in agriculture. Since ∆X1 = ∆X2 =..... = ∆Xn; the value of
∆Y/∆X goes on decreasing pattern as higher and higher input level is adopted. This is the law
of biological responses and is applicable in almost all practical situations of agricultural
production.
CONCEPTS OF PRODUCTION
For analysis of factor product relationship, the following concepts are essential to know:
Total product (TP): Amount of product obtained by applying various quantities of variable
input. Total product indicates the technical efficiency of fixed resources.
Average Product (AP): It is the ratio of total product to the quantity of input used in
producing that quantity of product. Average product indicates the technical efficiency of
variable input. AP= Y/X where Y is total product and X is total input.
Marginal product (MP): It is amount of output resulting from use an additional unit of input.
MP= Change in total product / Change in input level (ΔY/Δ X)
Total Physical Product (TPP): Total product expressed in terms of physical units like kgs,
quintals, and tons are termed as total physical product. Similarly if AP and MP are expressed
in terms of physical units, they are called Average Physical Product (APP) and Marginal
Physical Product (MPP) respectively.
Total Value Product (TVP): Expression of TPP in terms of monetary value is called Total
Value Product. TVP = TPP * Py or Y* Py
Average Value Product (AVP): It represents the expression of Average Physical Product in
money value. AVP = APP * Py
Marginal Value Product (MVP): When MPP is expressed in terms of money value, it is
called Marginal Value Product. MVP = MPP * Py or (ΔY/ΔX) * Py or ΔY* P y / Δ X
Relationship between Total Product (TP) and Marginal Product (MP)
When Total Product is increasing, the Marginal Product is positive.

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When Total Product remains constant, the Marginal Product is zero.

When Total Product decreases, Marginal Product is negative.
As long as MP increases, the TP increases at increasing rate.
When the Marginal Product remains constant, the Total Product increases at constant rate.
When the Marginal Product declines, the Total Product increases at decreasing rate
When Marginal Product is zero, the Total Product reaches maximum.
When marginal product is less than zero (negative), TPP declines at increasing rate.
Relationship between Marginal and Average Product
When Marginal Product is more than Average Product, Average Product increases.
When Marginal Product is equal with the Average Product, Average Product is Maximum.
When MP is less than Average Product, Average Product decreases.
Elasticity of production (EP): It is the percentage change in output due to one percent
change in the quantity of input. It is a measure of responsiveness of output to changes in input. The
elasticity of production refers to the proportionate change in output as compared to proportionate
change in input.

The elasticity of production is the ratio of MPP to Average Physical Product.

Ep = 1: Constant Returns. Ep is one when, MPP = APP i.e. at the end of 1st stage.
Ep > 1: Increasing Returns (1st Stage of Production)
Ep < 1: Diminishing returns (2nd Stage of Production)
Ep = 0: When MPP is zero or TPP is Maximum (At the end of 2nd stage)
Ep < 0: Negative Returns (3rd Stage of Production)

2.2.1.2. Law of Variable Proportion (Law of Diminishing Returns)

This law was developed by early economists to describe the r/s b/n output and a variable input
when other inputs are held constant in amount. The factor - product relationship or the amount
of a resource that should be used and consequently the amount of output that should be
produced is directly related to the operation of law of diminishing returns. This law explains
how the amount of product obtained changes as the amount of one of the resources is varied
while the amount of other resources is fixed. This law can be stated as: “If increasing amount
of one input are added to a production process while all other inputs are held constant, the
amount of output added per unit of variable input, will eventually decrease”. This law
suggests that there is some right amount of variable input to use in combination with fixed
inputs. This implies that: producers should use neither too much nor too little quantity of
variable inputs. This law requires that method of production does not change as changes are
made in the amount of variable input. It refers changing proportion b/n variable input and
fixed input and does not apply when all inputs are varied. This law can be explained with the
help of the following data:

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X Y ΔX ΔY MP (ΔY/ΔX) AP (Y/X) EP (MP/AP) MVP (MP*PY) MC

0 0 - - - - - - -
1 2 1 2 2 2 1 12 12
2 5 1 3 3 2.5 1.2 18 12
3 9 11 4 4 3 1.33 24 12
4 14 1 5 5 3.5 1.43 30 12
5 19 1 5 5 3.8 1.32 30 12
6 23 1 4 4 3.83 1.04 24 12
7 26 1 3 3 3.71 0.81 18 12
8 28 1 2 2 3.5 0.57 12 12
9 29 1 1 1 3.22 0.31 6 12
10 29 1 0 0 2.9 0 0 12
11 28 1 -1 -1 2.54 -0.39 6 12
12 26 1 -2 -2 2.16 -0.93 12 12
If price per unit of input and output are 12 and 6 birr respectively, determine optimum level of
input use?
Stage of Classical Production Function
The production function showing total, average and marginal product can be divided into
three regions or stages in such a manner that one can locate the zone of production function in
which the production decisions are rational. The study of these stages is important from view
point of determining most profitable level of input use i.e. the level at which profit would be
maximized. The three sages are shown in the following figure and discussed below the figure.

First Stage or I Region or Zone 1:

The first stage of production starts from the origin i.e. zero input level.
 In this zone, MPP is more than APP and hence APP increases throughout this zone.
 MPP is increasing up to the point of inflection and then declines.
 Since the MPP increases up to the point of inflection, the TPP increases at increasing rate.
 After the point of inflection, the Total Physical Product increases at decreasing rate.
 Elasticity of production is greater than 1 up to maximum APP
 Elasticity of production is one at the end of the zone (MPP = APP).
 In this zone fixed resources are in abundant quantity relative to variable resources.
 The TE of variable resource is increasing throughout this zone as indicated by APP.
 The TE of fixed resource is also increasing as reflected by the increasing TPP.
 Marginal Value Product is more than Marginal Factor Cost (MVP >MFC)
 Marginal revenue is more than marginal cost (MR > MC)

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 This is irrational or sub-optimal zone of production.

 This zone ends at the point where MPP=APP or where APP is Maximum.
Economic Decisions in Stage I: If the farmer is producing in stage I, he is using small
amount of variable input in relation to fixed resources. It is called irrational zone of
production. Any level of resource use falling in this region is uneconomical. The technical
efficiency of variable resource is increasing throughout the zone (APP is increasing).
Therefore, it is not reasonable to stop using an input when its efficiency is increasing.
Economic principle states that so long AP is increasing application of variable input should
also increases. Therefore, producer can use variable input at least up to the point of highest
AP (Under the situation of limited availability of variable input). Moreover, in stage I, the MP
also keeps on increasing indicating more scope of use of variable input and thereby increasing
income as well. In this zone, more products can be obtained from the same resource by
reorganizing the combination of fixed and variable inputs. For this reason, it is called
irrational zone of production.
Second Stage or II Region or Zone II:
 starts where the TE of variable resource is maximum i.e., APP is Maximum (MPP=APP)
 In this zone MPP is less than APP. Therefore, the APP decreases throughout this zone.
 Marginal Physical Product is decreasing throughout this zone.
 As the MPP declines, the Total Physical Product increases but at decreasing rate.
 Elasticity of production is less than one between maximum APP and maximum TPP.
 Elasticity of production is zero at the end of this zone.
 In this zone variable resource is more relative to fixed factors.
 The technical efficiency of variable resource is declining as indicated by declining APP.
 The technical efficiency of fixed resource is increasing as reflected by increasing TPP.
 Marginal Value Product is equal to Marginal Factor Cost (MVP=MFC).
 Marginal Revenue is equal to Marginal Cost (MR= MC)
 It is rational zone of production in which producer should operate to attain his objective of
profit maximization.
 This zone ends at the point where TPP is highest or Marginal Physical Product is zero.
Economic Decisions in Stage II: It is rational or economic zone of production. Within the
boundaries of this region is the area of economic relevance i.e. it is economic stage of using
variable input. The Optimum point of input use lies in this stage. The producer, who wants to
maximize profit, must operate in this stage. The optimum level of input use in this stage can
be determined by using the following criterion.

⟹ or =
i.e. Value added product = Value of added cost
If > , more quantity of variable input can be used
< , quantity of variable input needs to be reduced
= , optimum level of input use is attained.

Third Stage or III Region or Zone III:

 This zone starts from where the TE of fixed resource is maximum (TPP is Max).
 Average Physical Product is declining but remains positive.
 Marginal Physical Product becomes negative.
 Total Physical Product declines at faster rate since MPP is negative.

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 Elasticity of production is less than zero (Ep < 0)

 In this zone variable resource is in excess capacity.
 Technical efficiency of variable resource is decreasing as reflected by declining APP.
 Technical efficiency of fixed resource is also decreasing as indicated by declining TPP.
 Marginal Value Product is less than Marginal Factor Cost (MVP < MFC)
 Marginal Revenue is less than Marginal Cost (MR < MC)
 This zone is irrational or supra-optimal zone.
 Producer should never operate in this zone even if the resources are available at free of
cost.
Economic Decisions in Stage III: It is also an area of irrational or uneconomic region of
production as producer uses more quantities of variable resource in relation to fixed resources
as a result marginal product becomes negative and total products decreases at increasing rate.
Since the additional quantities of resource reduces the total output, it is not profitable zone
even if the additional quantities of resources are available at free of cost. By operating in this
stage, farmers incur double loss i.e. less output and unnecessary additional cost on variable
input.
2.2.2. Factor-Factor Relationships
This relationship deals with the resource combination and resource substitution. Cost
minimization is the goal of factor-factor relationship. Under this relationship, output is kept
constant while inputs are varied in quantity. It guides the producer for a decision on ‘how to
produce’. Such a relation is explained by the principle of factor substitution or principle of
substitution between inputs. It is concerned with the determination of least cost combination
of resources. The choice indicators are the physical substitution ratio and price ratio. It is
expressed algebraically as: Y = f(X1, X2, / X3, X4… Xn), where we consider two variable inputs
In the production process inputs are substitutable. For instance capital can be substituted for
labor and vice versa; grain can be substituted for fodder and vice versa. The producer has to
choose that input or inputs, practice or practices which produce a given output with minimum
cost. The producer aims at cost minimization through choice of inputs and their combinations.
The relevant production function is defined by a set of isoquants. Thus, the objective of this
analysis of factor - factor relationships is two fold:
1. Minimization of cost at a given level of output and
2. Optimization of output to the fixed factors through alternative resource use combinations.
Each combination of the two inputs produces a unique amount of output.
A. Isoquants: Definitions and Properties
The relationship between two factors and output cannot be presented with two dimensional
graph. This involves three variables and can be presented in three dimensional diagram giving
a production surface. An isoquant is a convenient method for compressing three dimensional
picture of production into two dimensions. Isoquant means - Iso means ‘the same’ and quant
means ‘product’ or ‘output’. An iso-quant is the locus of all technically efficient methods
(all combinations of factors of production) for producing a given level of output; i.e., it shows
the different combinations of two inputs that can be used to produce a given level of output.
An isoquant represents all possible combinations of two resources (X1 and X2) physically
capable of producing the same quantity of output. It also known as iso-product curves or
equal product curves or product indifference curves.

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Iso-quant Map or Iso-product Contour: If number of isoquants are drawn on one graph, it
is known as isoquant map. It indicates shape of production surface which in turn indicates the
output response to the inputs.
Y

Y3
X2 Y2= X2 Isoquant
Y1=
O X1 O X
Isoquant Map X
Isoquant
1
Characteristics of Isoquants
 They have negative slope
 They are convex to the origin.
 Isoquants cannot intersect each other or be tangent each other.
 Isoquants for higher level of output will normally lie above and to the right of isoquants for
lower level of output.
1. Marginal Rate of Technical Substitution (MRTS)
It refers to the amount by which one resource is reduced as another resource is increased by
one unit. It indicates the rate of exchange between some units of X1 and X2 which are equally
preferred.

i.e. Marginal Rate of Technical Substitution= Number of units of replaced resource

Number of units of added resource
The slope of Isoquant indicates MRTS.
2. Types of Resources Used as Substitute Inputs
Inputs are technical substitutes when an increase in one input allows a decrease in the other
input while maintaining the level of output: such resources compete with each other and the
marginal rate of technical substitution between such inputs is negative.
Substitutes: A range of input combinations which will produce a given level of output.
When one factor is reduced in quantity, a second factor must always be increased MRTS is
always less than zero.
Perfect Substitutes: When two resources are completely interchangeable, they are called
perfect substitutes. The isoquants for perfect substitutes is negatively sloped straight lines.
The MRTS is constant. Eg. Family labour and hired labour, Farm produced and purchased
seed etc,
Complements: Two resources which are used together are called complements. In the case
of complements reduction in one factor cannot be replaced by an increase in another factor i.e.
MRTS is zero.
Perfect Complements: Two resources which are used together in fixed proportion are
called perfect complements. It means that only one exact combination of inputs will produce a
particular level of output. The isoquant in this case is of a right angle. Eg. Tractor and driver,
Pair of bullocks and laborer

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3. Types of Factor Substitution

The shape of isoquant and production surface will depend up on the manner in which the
variable inputs are combined to produce a particular level of output. There can be three such
categories of input combinations. They are:
Fixed Proportion combination of inputs
Constant rate of input Substitution
Decreasing Rate of input substitution
a. Fixed Proportion Combination of Inputs
To produce a given level of output, inputs are combined together in fixed proportion.
Isoquants are ‘L’ shaped. It is difficult to find examples of inputs which combine only in fixed
proportions in agriculture. An approximation to this situation is provided by tractor and
driver combination. To operate another tractor, normally we need another driver.

b. Constant Rate of Substitution: For each one unit gain in one factor, a constant quantity of
another factor must be sacrificed. When factors substitute at constant rate, isoquants are
linear, negatively sloped.
X1 X2 Δ X1 Δ X2 MRTS X1X2 = Δ X2/Δ X1
0 50 -- -- --
5 40 5 10 10/5=2
10 30 5 10 10/5=2
15 20 5 10 10/5=2
20 10 5 10 10/5=2
25 0 5 10 10/5=2

The above table shows that the 6 combinations of resources X1 and X2 can be used in
producing a given level of output. As X1 input is increased from 0 to 5 units, 10 units of X2
are replaced. Similarly addition of another 5 units of X1 replaces another 10 units. The MRS
of X1 for X2 is 2. That means if we want to obtain one unit of X1, we have to forego 2 units of
X2. Eg. Family labour and hired labour. When inputs substitute at constant rate, it is
economical to use only one resource, and which one to use depends up on relative prices.

Algebraically, constant rate of factor substitution is expressed as: Δ1X2/Δ1X1 = Δ2X2/Δ 2X1
= ……. = Δ nX2/Δ nX1

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c. Decreasing Rate of Substitution: Every subsequent increase in the use of one factor
replaces less and less of other factor. In other words, each one unit increase in one factor
requires smaller and smaller sacrifice in another factor. Eg. Capital & labour, concentrates
and green fodder, organic and inorganic fertilizers etc.
X1 X2 Δ X1 Δ X2 MRTS X1X2 =ΔX2/ΔX1
1 18 -- -- --
2 13 1 5 5/1=5
3 9 1 4 4/1=4
4 6 1 3 3/1=3
5 4 1 2 2/1=2
The MRS of X1 for X2 becomes smaller and smaller as X1 replaces X2. Iso-quants are convex
to the origin when inputs substitute at decreasing rate.

Algebraically, decreasing rate of input substitution is expressed as: Δ1X2/Δ1X1>

Δ2X2/Δ2X1 > …… > ΔnX2/Δ nX1. Decreasing rate of factor substitution is more common in
agricultural production.
4. Isocost Line (Price Line, Budget Line, Iso Outlay Line, Factor Cost Line): is all
possible combinations of two resources (X1 and X2) which can be purchased with a given
outlay of funds. It can be represented graphically as:

Iso-cost line can also be represented by equation as follows: Where: C=

Total outlay of funds, X1= Quantity of resource X1, X2= Quantity of resource X2, PX1=
Price of resource X1, PX2= Price of resource X2. For given fund of outlay and price of
resources, the amount of any resources that can be purchased is computed as follows:

Characteristics of Iso-cost line:

1. As the total outlay increases, the iso-cost line moves farther away from the origin.
2. Iso-cost line is a straight line because input prices do not change with the quantity
purchased.
3. Slope of iso-cost line indicates the ratio of factor prices i.e. slope = PX1/PX2 or PX2/PX1

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Methods of Determining Least Cost Combination of Inputs

There are innumerable possible combinations of factors which can be used to produce a
particular level of output. The problem is to find out a combination of inputs which should
cost the least i.e. a cost minimization problem. There are three methods to find out the least
cost combination of inputs. They are:
i. Simple Arithmetical calculations
One possible way to determine the least cost combination is to compute the cost of all
possible combinations of inputs and then select one combination with minimum cost. This
method is suitable where only a few combinations produce a particular level of output.
X1 X2 X1@birr 3 X2@birr.2 Total Cost
10 3 30 6 36
7 4 21 8 29
5 6 15 12 27
3 8 9 16 25
2 12 6 24 30

The above table shows five combinations of inputs which can produce a given level of output.
Assume, the price per unit of X1 is birr 3 and of X 2 is birr 2. The total cost of each
combination of inputs is computed. Out of five combination, 3 units of X1 and 8 units of X2
is the least cost combination of inputs i.e., birr 25.
ii. Algebraic method
a) Compute Marginal Rate of technical substitution
MRS = Number of units of replaced resource / Number of units of added resource
MRS X1X2 = Δ X2/Δ X1 or MRSX2X1 = ΔX1 /Δ X2
b) Compute Price Ratio (PR)
PR=Price per unit of added resource/Price per unit of replaced resource
PR=PX1/PX2 if MRSX1 X2 Or PR= PX2/ PX1 if MRSX2X1
c) Workout least cost combination by equating MRS and PR
i.e., ΔX2/Δ X1= PX1/PX2 for MRSX1X2 and ΔX1/ΔX2= PX2/ PX1 for MRSX2X1
The same can be expressed as: ΔX2. PX2= PX1.Δ X1 or ΔX1.PX1 =Δ X2.PX2
⟹The least cost combination is obtained when Marginal Rate of substitution is equal to Price
Ratio.
iii. Graphical Method
Since the slope of isoquant indicates MRTS and the slope of iso-cost line indicates factor
price ratio, minimum cost for production of a given output will be indicated by the tangency
of these isoclines. For this purpose, isocost line and isoquant are drawn on the same graph for
different levels of production. The least cost combination will be at the point where iso-cost
line is tangent to the iso-quant i.e., slope of isoquant=slope of isocost line i.e., MRS=PR

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Iso-cline: There can be number of possible output levels and the least cost combination can
be found out for these various output levels. A line or curve connecting the least cost
combination of inputs for all output levels is called iso-cline. The isocline passes through all
the iso-quant at points where they have the same slope. Isoclines can be drawn at different
sets of price ratio. All isoclines of course converge at the point of maximum output. Though
all the points on isocline represent least cost combination, only one point represents the
maximum profit output.

Expansion Path (Scale Line): Of many isoclines, the isocline which is considered to be the
most appropriate over a production period is known as expansion path or scale line. At any
particular time, only one expansion path is possible. It is a line or curve that connects the
point of least cost combination of resources for different levels of outputs.

AB, A1B1, A2B2, A3B3 are iso- cost lines representing various outlay of funds. q1, q2, q3
and q4 are iso- quants. Points E1, E2, E3 and E4 are points of least cost combination of
resources X1 and X2 which lie in stage II of production function. The line joining these points
(E1, E2, E3, E4) is called the expansion path. Expansion path may be linear or curved. If
prices of resources remain constant, expansion path would be linear indicating that input
would combine in the same proportion for producing various given levels of output. If prices
of resources change in different proportion, the expansion path would be curved one
indicating that resources would combine in different proportion for producing various levels
of output.
Ridge Lines/Border/Boundary Lines: It represent the points of maximum output from each
input, given a fixed amount of another input. These are the lines which separate the zone of
complementarities from zone of substitution. Also they represent limits of substitution. Ridge
lines reflect the limits of economic relevance, the boundaries beyond which isoquant map
ceases to have economic meaning. The portions of isoquants which lie between the lines are
suited for economic production (Where MPP of both inputs are positive but decreasing and
isoquants are negatively sloped). Portions of isoquants outside the ridge lines are not suitable
for production in economic terms (outside the ridge lines, MPP of both factors are negative
and methods of production are inefficient).

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2.2.3. Product –Product Relationship

Product -Product relationship deals with resource allocation among competing enterprises.
The goal of Product-Product relationship is profit maximization. Under Product-Product
relationship, inputs are kept constant while products (outputs) are varied. This relationship
guides the producer in deciding ‘What to produce’. This relationship is explained by the
principle of product substitution and law of equi-marginal returns. This relationship is
concerned with the determination of optimum combination of products (enterprises). The
choice indicators are substitution ratio and price ratio. Algebraically it is expressed as: Y1 = f
(Y2, Y3… Yn)
Production Possibility Curve (PPC): It is a convenient device for depicting two production
functions on a single graph. It represents all possible combinations of two products that could
be produced with given amounts of inputs. It is known as Opportunity Curve because it
represents all production possibilities or opportunities available with limited resources. It is
called Iso-resource Curve or Iso-factor curve because each output combination on this curve
has the same resource requirement. It is also known as Transformation curve as it indicates
the rate of transformation of one product into another.
How to draw Production Possibility Curve
PPC can be drawn either directly from production function or from total cost curve. The
method of drawing PPC from Production Function is explained below: A farmer has five
hectare of land and wants to produce two products Teff (Y1) and Sorghum (Y2). Assume all
other inputs are fixed. Now the farmer has to decide how much of land input to use on each
product. The amount of land that can be used to produce Teff (Y1) depends upon the amount
of land used to produce Sorghum (Y2). Therefore Y1= f (Y2). The allocation of land resource
between the two products and the output from different doses of land input are presented
below

Allocation of land in hectares Output in quintals

Y1 Y2 Y1 Y2
0 5 0 60
1 4 8 48
2 3 15 36
3 2 21 24
4 1 26 12
5 0 30 0
As evident from the above data, if all 5 hectares of land are used in the production of Y2 we
obtain 60 quintals of Y2 and do not get any Y1. On the other hand, if all the five hectares of
land are used in the production of Y1 we can obtain 30 quintals of Y1 and do not get any Y2.
But these are the two extreme production possibilities. In between these two, there will be

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many other production possibilities. Plotting these two points on a graph, we get the
Production Possibility Curve.

Iso Revenue Line: It is a line, which represents all possible combinations of two products
which would give same revenue. In symbolic notion, it can be represented as: TR = Y1PY1 +
Y2 PY2; Where: TR = total revenue, Y1 = Product Y1, Y2 = Product Y2, PY1 = Price of
product Y1, PY2 = Price of product Y2

Types of Product-Product Relationships or Enterprise Relationship

Farm commodities bear several physical relationships to one another. These basic product
relationships can be:
1) Joint Products: These are produced through single production process. As a rule the two
are combined products. Production of one (main product) without other (by-product) is
impossible. The level of production of one decides the level of production of another. All
farm commodities are mostly joint products. Eg. Wheat and Straw, paddy and straw,
groundnut and helms , cotton seed and lint, cattle and manure, butter and buttermilk, beef and
hides, mutton and wool etc.

Graphically the quantities of Y1 and Y2 that can be produced at different levels of resources
will be shown as points AB in the figure.
2) Complementary enterprises: Complementarities between two enterprises exists when
with a change in the level of production of one, the other also changes in the same direction.
That is when increase in output of one product, with resources held constant, also results in an
increase in the output of the other product. The two enterprises do not compete for resources
but contribute to the mutual production by providing an element of production required by
each other. The marginal rate of product substitution is positive (> 0). Ex: Cereals and pulses,
crops and livestock enterprises.

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As shown in the figure, range of complementarities is from point A to point B when

production of Y1 expands beyond zero level. On the other end of the curve, the products
again are complementary as production of Y2 expands beyond zero. This means Y1 must be
produced up to B and Y2 up to point C, up to these points increase in one product increases
the production of other. ⟹All complementary relationships should be taken advantage by
producing both products up to the point where the products become competitive.
3) Supplementary Enterprises: It exists between enterprises when increase or decrease in
the output of one product does not affect the production level of the other product. They do
not compete for resources but make use of resources when they are not being utilized by one
enterprise. The marginal rate of product substitution is zero. For example, small poultry or
dairy or piggery enterprise is supplementary on the farm. All supplementary relationships
should be taken advantage by producing both products up to the point where the products
become competitive. Production of Y1 can be increased without affecting the production of
Y2 in the range AB. From C to D, production of Y2 can be increased without affecting the
production of Y1. The two products (Y1 and Y2) stay supplementary from A to B as shown in
the graph. After point B they become competitive enterprises.
B

A
Y2

Y1
4) Competitive enterprises: it exists when increase or decrease in the production of one
product affect the production of other product inversely. That is when increase in output of
one product, with resources held constant, results in the decrease of output of other product.
Competitive enterprises compete for the same resources. Two enterprises are competitive in
the use of given resources if output of one can be increased only through sacrifice in the
production of another. The marginal rate of product substitution is negative (<0)

5) Antagonistic products: Two products may be detrimental to each other because of disease
or similar factors. When this is true, only one of the products should be produced. Eg: Aqua
culture and paddy cultivation, Poultry and Bee in the same area.
Marginal Rate of Product Substitution (MRPS): it has the same meaning under the
product-product relationship as under the factor -factor relationship. Marginal rate of the
product substitution refers to the absolute change in one product associated with a change of
one unit in competing product. The quantity of one product to be sacrificed to gain another
product by one unit is called MRPS. MRPS = Number of units of replaced product / Number
of units of added product.
MRPSY1Y2 = ΔY2/ΔY1 and MRPSY2Y1 = ΔY1/Δ Y2

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Types of Product Substitution: When two products are competitive, they substitute either at
constant rate or increasing rate or at decreasing rate.
1) Constant Rate of Substitution: For each one unit increase or gain in one product, a
constant quantity of another product must be decreased or sacrificed. When products
substitute at constant rate, the PPC is linear negatively sloped. Constant rate of substitution
occurs when:
a) One of the production function has an elasticity greater than one (increasing returns), the
other has an elasticity of less than one (decreasing returns) or
b) Both the production functions have stages of increasing and decreasing returns.

The PPC is linear when products substitute at constant rate. When two products substitute at
constant rate, only one of the two products will be economical to produce depending on their
relative prices. This is to say that specialization is the general pattern of production under
constant rate of product substitution.
Y1 Y2 Δ Y1 Δ Y2 MRS
0 40 -- -- --
10 30 10 10 10/10=1
20 20 10 10 10/10=1
30 10 10 10 10/10=1
40 0 10 10 10/10=1
This relationship can be expressed as: Δ1Y2/Δ1Y1 = Δ2Y2/Δ2Y1 = ……. = Δ nY2/Δ nY1
2) Increasing Rate of Product Substitution: Each unit increase in the output of one product
is accompanied by larger and larger sacrifice (decrease) in the level of production of other
product. Increasing rates of substitution holds true when the production for each independent
commodity is one of decreasing resource productivity (decreasing returns) and non-
homogeneity in quality of limited resource. The PPC is concave to the origin when product
substitutes at the increasing rate. Increasing rate of the product substitution is common in
agricultural production. The general pattern of production is diversification i.e., profits are
maximized by producing both the products. The relationship can be expressed algebraically as
follows: Δ1Y2/Δ1Y1 <Δ2Y2/Δ2Y1 < ……. < ΔnY2/ΔnY1 or graphically as follows:

The above can also expressed in tabular form as indicated hereunder:

Y1 Y2 ΔY1 Δ Y2 MRSY1Y2
0 60 -- -- --
8 48 8 12 1.50
15 36 7 12 1.71
21 24 6 12 2.00
26 12 5 12 2.40
30 0 4 12 3.00

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3) Decreasing Rate of Product Substitution: Each unit increase in the output of one product
is accompanied lesser and lesser decrease in the production of another product. This type of
product substitution holds good under conditions of increasing returns. PPC is convex to the
origin when products substitute at decreasing rate. It is economical to produce only one of the
products depending on the relative prices, when products substitute at constant rate i.e.,
specialization is the general pattern of production. This relationship can be expressed in
tabular, algebraically or graphically as indicated hereunder.
Y1 Y2 Δ Y1 ΔY2 MRPSY1Y2
1 18 -- -- --
2 13 1 5 5
3 9 1 4 4
4 6 1 3 3
5 4 1 2 2

This relationship can be expressed algebraically as follows: Δ1Y2/Δ1Y1 >Δ2Y2/Δ2Y1 >

……. >ΔnY2/ΔnY1

Determination of Optimum Product Combination

To get the revenue maximizing combinations of two products, two relevant questions need to
be answered viz., what combinations should be produced and how that combination can be
determined. To answer these questions, the following methods need to be examined
Tabular method
Given the output combinations and prices, the total revenue of each output combination is
computed as presented in the following table. Then the output combination with the
maximum profit is selected as optimum combination.
Y1 in quintal Y2 (quintals) PY1@ birr 1100/Q PY2@birr500/Q Total income (birr)
0 75 0 37500 37500
8 60 8800 30000 38800
16 44 17600 22000 39600
24 26 26400 13000 39400
32 0 35200 0 35400

Algebraic Method
Step 1. Compute marginal rate of product substitution

MRPS = =
Here, Y1 is added product and Y2 is replaced product
Step 2. Compute product price ratio (PR)

=
Step 3. Find out the optimum combination of products by equating MRPS with PPR.

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⟹ If , Produce more of Y1 and less of Y2 to maximize profit

⟹ If , Produce more of Y2 and less of Y1 to maximize profit

Graphical Method
Since the MRPS can be represented by the slope of the PPC and the product price ratio can be
represented by slope of iso-revenue line the optimum combination level of products can be
represented by drawing both curves on the same graph. Then the point of tangency of PPC
and iso-revenue line is the profit maximizing level of combination of the two products.

2.3. Production Resource Management

2.3.1. Farm Resources
Productive resource is any good (commodity) or service used in the production process to
create another good (commodity) or service. In the production process, firms use factors
(inputs or agents of production) which are often classified into four categories: land, labor,
capital and entrepreneurship. Factors of production could be fixed or variable. The difference
between fixed and variable factors relates to the time horizon involved. In economics, there
are two main horizons: the short run and the long run. Short run is a relatively short period of
time in which the quantity of some factors of production such as equipments and buildings
cannot be varied. Such factors are called fixed factors. Factors of production whose quantity
can be varied in short run are variable factors. Long run is a relatively long period which
allows the variation of all factors of production including plants and equipments.
Variable resources:
a. The resources whose uses vary with the level of production
b. Volume of output directly depends on these resources.
c. Costs corresponding to these resources are known as variable costs.
d. Variable resources exist both in the short run and in the long run.
Seeds, Fertilizers, Plant protection chemicals, feeds, medicines etc., are examples of variable
resources
Fixed resources:
a. Resources whose use remains the same regardless of the level of production
b. Volume of output does not directly depend up on these types of resources.
c. Costs corresponding to these resources are known as fixed costs

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d. Fixed resources exist only in the short run and in the long run they are zero Example:
machinery, farm buildings, equipment, implements, livestock, etc.

Land: It consists of those gifts of nature which are not the result of human effort and it
includes land, water, sunshine, natural forests, minerals, wild animals and local climate. It is
often made productive as a result of human effort. Land is the basic resource which supports
the production of all agricultural commodities with unique characteristics compared to other
resources. The specific characteristics of land include:
1. Land doesn’t depreciate or wear out provided that soil fertility is maintained and
appropriate conservation means are used.
2. Area space and location of land are immobile: that is land cannot be moved or shifted to
be combined with other resources such as machines, seed, fertilizer or water, rather the latter
have to move to the land in the production of crops or livestock.
3. Each farm or specific parcel of land is unique: each parcel of land contains one or more
distinct feature such as soil types, topography, climatic factors and the existence of natural
hazards such as flooding, wind, etc.
4. Land is said to be fixed and limited in quantity (Supply): this is to say that the area of
land at country level cannot be increased or decreased (supply of land is fixed) but for an
individual farmer, land can be increased or decreased.
Therefore a farm manger should use these unique qualities of land for proper decision making
to make the farm enterprise perform well.
Labor: is the effort of human beings that include hired labor, family labor and farmers' labor.
Labor is needed for every type of production. It can be more productive as a result of time and
effort devoted to training.
The amount of labor (the labor input) used over a particular farm or plot of land depends on
the number of individuals employed and the number of hours worked. Mostly labor is
measured in man-day, where one man-day is equal to 8 hrs of work for an average man with
average strength, skill and experience. The most important characteristics of labor useful for
managerial decisions include:
1. Labor is flow resource that it cannot be stored like seed or labor is available for specified
time.
2. It is the service that is hired or purchased not the labor unlike land and capital items, i.e the
worker sells his/her work or services.
3. Labor is a lumpy or indivisible input. This is to say that it is not possible to employ half
a man (but possible to divide seed or fertilizer).
4. In agricultural sector, the operators and other members of the family provide all or largest
part of labor in a farm. This labor (family or community labor) doesn’t generally receive
direct cash payment unlike manufacturing sector, so its costs and values can be easily
overlooked or ignored.
5. The human factor is another characteristics distinguishing labor from other resources. That
is if an individual employee is treated as inanimate object, productivity and efficiency suffers.
Therefore, the hope, fears, ambitions, likes and dislikes, worries and personnel problems of
the owner/operator and the employees must be considered in any labor management plan.

Capital: It presents all resources which are the result of past human effort. Which means it
consists of all manmade goods which are used in the production of other goods. The capital

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category includes a wide variety of items ranging from durable items such as building, dams,
roads, and machinery to stock of materials like seed and fertilizer which may be used in a
single production season. Capital should not be confused with money since money itself is not
a productive resource. It only becomes productive when it is used to buy physical items or
hires services.
Management (Entrepreneurship): Entrepreneurship involves organizing and coordinating
the different farm resources (land, labor and capital) so as to get the maximum output and
profit. Management function is primarily a mental process, each choice and action whose
results are conditioned by the attitudes, values and goals of the manager. The manager’s goals
and value systems unconsciously determine what he will observe, what variables he will
consider, what information he will gather, and which alternatives he will choose. Thus, the
formulation of these goals is essential in effective management because they give direction to
the whole managerial process.
2.3.2. Rewards for using farm resources
The reward for using land is rent. Rent can be paid in cash or in kind by using farm produce.
Rent can be paid annually, seasonally, etc. based on the terms of agreement.
The reward for using labor is either salary or wage. It is salary for those who are on the
payroll receiving monthly salaries and wage for the casual laborer.
The reward for using capital is interest (cost of using money). The rate of interest charged
depends on the source of the capital. For instances private money lenders charge higher rates
as compared to formal financial institutions.
The reward for using management/entrepreneur is profit. This is so because the ultimate aim
of any producer is to maximize profit. Here the principle of “carrot and stick” holds. If a
manager performs well, he is given a carrot in the form of a pat on the back for a job well
done or promotion or an award. On the contrary, if he fails by recording a loss or poor
performance, he is given a “Stick” in form of query, dismissal, warning or demotion.
2.3.3. Farm Resources Valuation
Valuation is the practice of attaching prices to a given asset like buildings, vehicles, growing
crops, and stored products at the end of an accounting period or at the time of sale for a
particular farm organization. The price shows what farm assets worth at a particular time.
Valuation process involves getting a realistic measure of the current value of the assets of the
farm business. The first step in asset valuation is to list the resources available in physical
terms and the second step is placing values on the assets. The five methods of valuation
include are briefly explained below
Valuation at cost: This method involves entering the actual amount invested on the asset
when it was originally acquired. A major set-back of this procedure is that after the business
has been in operation for some time, the original cost is not of much value since the
conditions might have changed at the time of valuation.
Valuation at market price: The market price of an asset at the time of consideration can be
taken as its value. Example grains, feeder, livestock and land. This method may, however,
over or under-estimate the value depending on the states of affairs in the economy. For
instance the market price for the land may be based on the price of a similar piece of land or
what the owner is willing to sell it for. Yet, it’s common phenomenon that land appreciates in
value over time.

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Valuation at net selling price (PNS): Some costs such as cost of advertisement and
transportation may incur at a time of selling an asset. In this valuation method, whatever price
that can be obtained in the market for the asset, that is, market price (Pm) less the cost of
selling (CS) is taken as a price of asset at a particular point in time. Mathematically it can be
shown as: PNS = Pm – CS.
Valuation by reproductive value: An asset can be valued at what it would cost to produce it
at present prices and under present methods of production. This method is more useful for
long-term assets and has little or no application for short-lived assets.
Cost less accumulated depreciation: This method is appropriate only for depreciable assets
like machinery and buildings. Value of the asset is set equal to the ‘book value’. Book value is
computed as the difference between the initial cost and the accumulated depreciation of the
asset from acquisition to the time of valuation.
Depreciation
Depreciation is the loss in value of capital asset overtime due to age, obsolescence and wear
and tear. Depreciation, therefore, is a function of time and use, and it involves prorating the
original cost of an asset over its useful life. An important but difficult consideration is the rate
at which depreciation should take place. Some managers assume 10%, 20%, etc. but the best
choice depends on the depreciation rate that is closest to the actual rate of loss in value for the
period under consideration. Different assets loss values at different rates; hence different
methods of depreciation have been developed. These methods of depreciation are discussed as
follows:
Annual Revaluation Method
The annual revaluation method is based on the resale value of the asset in the market. In this
approach Depreciation (D) = Original Price – Resale Price of the asset to date
If the original price of an asset was Birr 2,000 in 2009 and Birr 1,800 in 2010 the depreciation
is 200 (i.e., 2,000 – 1,800 = 200). The problem with this method is that it may not be easy to
find a comparable product being sold in a market at a time of estimating depreciation. Or in
an economy with run-away inflation, a recent experience of rising world price, appreciation
rather than depreciation of assets might be apparent. For instance an asset purchased in 1975
for Birr 2,100 was sold for Birr 2,500 in 1983 because the new price of virtually the same
asset has gone up to Birr 6,000.
Straight Line Depreciation Method
The straight-line depreciation method assumes that an asset depreciates at a constant rate over
its economic life. The method is, therefore, useful for assets that loss value constantly over
their entire life. Depreciation (D) by this method is the difference between the purchase price
(P) and the salvage value1 (SV) divided by useful life of asset in years (n).Mathematically:

Example, An asset costing Birr 4,000 initially has a salvage value of Birr 400 and expected
life of 10 years. For this asset the yearly depreciation is given by [(4000 – 400)/10 = 360].The
depreciation schedule over years appears as shown in the table below.

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Table 1: Straight line depreciation for an asset initial cost Birr 4000 and SV Birr 400 and n=10 years
Year Depreciation Remaining value at the end of the year
1 360 3640
2 360 3280
3 360 2920
4 360 2560
5 360 2200
6 360 1840
7 360 1480
8 360 1120
9 360 760
10 360 400

Declining Balance Method

The declining balance method assumes a fixed rate of depreciation every year. Since the value
of the asset is greater at the beginning, if the rate is applied the amount of depreciation is also
greater at the beginning and less at the end. The salvage value is not subtracted from the
initial cost. Yet, the rate is applied to each successive remaining balance till the salvage value
of an asset is reached. This method is, therefore, useful for asset which loss value fast at the
beginning of its economic life. Considering rate of depreciation to be 20% annually, schedule
of depreciation using the declining balance method is shown in the table below.

Table 2: Depreciation of an asset using declining balance method (Cost Birr 4000, SV Birr 400 & n=10 years)
Year Depreciation Remaining value at the end of the year
1 20% of 4000 = 800 3,200
2 20% of 3200 = 640 2,560
3 20% of 2560 = 512 2,048
4 20% of 2048 = 409.60 1,638.40
5 20% of 1638.4 = 327.68 1,310.72
6 20% of 1310.72 = 262.14 1,048.58
7 20% of 1048.58 = 209.72 838.86
8 20% of 838.86 = 167.77 671.09
9 20% of 671.09 = 134.22 536.87
10 20% of 536.86 = 107.37 429.50
Sum-Of-Years Digit Method (SOYD)
Annual depreciation is given by multiplying cost less salvage value (i.e., salvage value is the
estimated residual value of a depreciable asset or property at the end of its useful life) by the
fraction of remaining useful life (RL) to sum-of-years digit (SOYD).

The sum-of-years-digit (SOYD) is obtained by summing up the digits 1 to n for an asset with
a useful life of n years. For example, if the useful life of an asset is 10 years the sum of the
digits is given as 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55. Or use simple formula below to
find SOYD.

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The sum forms the denominator for the fraction while the numerator is the remaining useful
years of life of the asset at the beginning of the accounting period. Thus the fraction for the
first year of the asset is 10/55. For the second and third years the fractions are 9/55 and 8/55,
respectively. The depreciation schedule for the asset costing Birr 4,000 and salvage value of
Birr 400 is shown in the table below. In this method the asset losses values at a fairly constant
rate.
Table 3: Depreciation of an asset using the sum-of-years-digits method (Cost Birr 4000, SV Birr 400 & n=10 years)
Year Annual Depreciation Remaining balance
1 10/55 (4000-400) = 654.55 3345.45
2 9/55 (4000-400) = 589.09 2756.36
3 8/55 (4000-400) = 523.64 2232.73
4 7/55 (4000-400) = 458.18 1774.55
5 6/55 (4000-400) = 392.73 1381.82
6 5/55 (4000-400) = 327.27 1054.55
7 4/55 (4000-400) = 261.82 792.73
8 3/55 (4000-400) = 196.36 596.36
9 2/55 (4000-400) = 130.91 465.45
10 1/55 (4000-400) = 65.45 400.00

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3. FARM PLANNING AND BUDGETING

3.1. Farm Planning
3.1.1. Definition of Farm Planning
Farm planning can be defined in different ways:
1. it is an integrated, coordinated and advance program of actions, which seek to present an
opportunity to cultivators to improve his level of income.
2. it is a basic management function that involves selecting a particular strategy or course of
action among alternative courses of action with the objective of obtaining the greatest
satisfaction of the firm`s goals.
3. It is a process to allocate scarce resources of the farm and to organize the farm production
in such a way that to increase the resource use efficiency, the production and the income of
the farmer.
4. it the preparation of an operational program for a farm which will ensure the conservation
of land and other resources.
5. It is an approach which introduces desirable changes in farm organization and operation
and makes farm a viable unit.
Farm planning is an integrated, coordinated and advance program of actions, which seek to
present an opportunity to cultivators to improve his level of income. It is a basic management
function that involves selecting particular strategy or course of action among alternative
courses of action with objective of satisfying firm`s goals. In other word, it is the preparation
of operational program for farm which will ensure conservation of resources. It is an approach
which introduces desirable changes in farm organization and operation and makes farm a
viable unit. Thus, farm planning is the process of making decisions regarding organization
and operation of a farm business so that it results in a continuous maximization of net
returns of a farm business. It is a programmed of total farm activity of a farmer drawn up in
advance. It show the enterprises to be taken up on the farm; the practices to be followed in
their production, use of labor and other resources, investments to be made and similar other
details. Planning is also organizing, as a plan represents a particular way of combining or
organizing resources to produce some combination and quantity of agricultural products. A
farm plan contains the usual adage of “what, how much, when, where, who, and how” of a
situation. A successful farm business is not a result of chance factor. Good weather and good
prices help but a profitable and growing business is the product of good planning. With recent
technological developments in agriculture, farming has become more complex business and
requires careful planning for successful farm business. It’s important for the efficient use of
production factors thereby increase the net income and farmer satisfaction. Farm plans are
particularly required when there are limiting factors such as land, labor and capital. This
necessitates efforts to maximize returns to the limiting factors. A farmer makes plans before
starting production. Thus, farm planning may be deemed as an educational tool to bring about
desirable organizational changes on the farm to increase the farm income of the farming
family.
3.1.2. Objectives of Farm Planning
On the majority of our farms, there is underutilization as well as over utilization of the
existing farm resources. Due to this, usually farm organizations fail to get maximum net gain.
This indicates the need for reorganize the farm structure for proper allocation of resources to
obtain optimum production and net income. This calls for proper planning activity. Farmers
may have some personal preferences and motivations that must be taken care of in practical

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planning, which may includes maximizing security, minimizing risk, etc. However, the main
objective of farm planning is the
 Improvement in standard of living of the farmer and its immediate goal is to get the
greatest return in terms of cash and food, for his effort both in the short run and long run.
 it enables to achieve his objectives (e.g. Profit maximization or cost minimization) in a
more organized manner.
 It helps in analysis of existing resources and their allocation for achieving higher resource
use efficiency, farm income and farm family welfare.

3.1.3. Importance of Farm Planning

Without planning, farm business decision would become random choices. Some of the
advantages of farm planning are:-
 Income improvement-It primarily concerned with making choices and decisions:
selecting the most profitable alternative from all possible alternatives and seek to present an
opportunity to cultivators to improve his level of income. It is the opportunity of income
maximization that induces farmers to adopt desirable changes. Such income maximization
could be achieved from a given bundle of resources by reorganizing present type of
production as well as introducing changes in technology.
 It helps manager to focus on organization`s goals and activities. This makes it easier to
apply and coordinate the resources of the farm more effectively. The whole organization is
forced to embrace identical goals and participate in achieving them. It also enables the farm
manager to outline in advance an orderly sequence of steps for the realization of
organization`s goals and to avoid a needless overlapping of activities.
 Educational tool/process- It bring about a change in the outlook of the cultivators and
extension workers. Knowledge of technological advances in agriculture is a prerequisite for
better farm planning; so farmers of farm managers keep their information up-to-date through
this forced action situation of farm planning process. This acts as self-educating tool for the
farmers. The farmers or farm managers can closely study their own business and see more
clearly their opportunities and limitations, thus, improving their managerial ability.
 Desirable organizational change- It helps to introduce desirable changes in farm
organizations and operations and also it makes the farm a viable unit. In its broad sense, it
may mean any contemplated change in the method or practices followed on the farm. The
advantage of farm planning lies in its treating the farm as an operational unit and tailoring
the recommendation to fit into the individual farmer`s opportunities, limitations, problems
and resource position.
 It allows managers and organizations to minimize risk and uncertainty by providing a more
rational and fact based procedure for making decision.
 Facilitates control-in planning, the farm manager gets goals and develops plan to
accomplish these goals. These goals and plans then become standards or benchmarks against
which performance can be measured. The function of control is to ensure that the activities
confirm to the plans. Thus, control can be exercised only if there are plans.
 It helps to identify problems faced by all farmers or managers.
 It forces farmers to define specific objectives.
 It helps to examine carefully his existing resource situation and past experiences as a basis
for deciding which of the new alternative enterprises and methods fit his situation the best.
 It forces farmers to think forward systematically.

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 It defines responsibility :( defines who does what).

 Effective communication :( between workers)
 Within the new farm work new ideas and opportunities and own resources position, it helps
him to make rational decision on what to do.
 It helps him to identify clearly the various supply needs for alternative improved plan.
 It helps to find out the credit needs, any of the new plans.
 It gives him an idea of the expected income after paying off his loans, etc.
3.1.4. Basic Steps in Farm Planning
1.Inventory of farm resources
2. Analysis of existing farm plan
3. Identifying weakness of present plan
4.Identification of risks,
5. Forecasting of the future
6. Establish objectives
7. Preparation of alternative plans
8. Analysis and selection of final plan
3.1.5. Types of Farm planning
Types of Farm planning: Farm plans are categorized into two sub-groups viz., simple farm
plan and complete farm plan. Simple farm plan implies. Complete farm planning. They are
explained below.
Simple farm planning: planning for minor changes or for a particular enterprise. It is
adopted either for a part of land or for one enterprise or to substitute one resource to another.
This is very simple and easy to implement. The process of change should always begin with
these simple plans.
Complete/whole farm planning: envisages when major changes are contemplated in the
existing organization of farm business. It is adopted for farm as a whole.
3.1.6. Characteristics of Good Farm Plan
1. It is should be written & flexible.
2. It should provide for efficient use of resources.
3. It should balanced combination of enterprises.
4. Avoid excessive risks.
5. Utilize farmer’s knowledge and experience and take account of his likes and dislikes.
6. Provide for efficient marketing.
7. Provision for borrowing, using and repayment of credit.
8. Provide for use of latest technology.
3.2. Farm Budgeting
Farm Budgeting can be defined as:
 Expression of farm plan in monetary terms by estimating expected income, expenses and
profit for a farm business.
 Detailed physical and financial plan for farm operation and prepared for specified period of
time or season.
 Method of examining the profitability of alternative farm plans.
Budgeting involves two steps. Preparation of description and specification of proposed plans
and estimation of expected cost and returns.

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3.2.1. Advantages of Farm Budgeting

 It evaluates old plan and guides farmer to adopt new farm plan with advantage.
 It makes the farmer conscious of leakage or waste in farm business.
 It gives comparative study of receipts, expenses and net income on d/f farms in the same
locality and in d/f localities for formulating national agricultural policies.
 It guides and encourages the most efficient and economical use of resources.
 It serves as a valuable basis for improvement in the management practices of farm.
 To compare how profitable different kinds of enterprises and their combinations.
3.2.2. Types of Farm Budgeting
There are different types of budgeting, each of which is adapted to a particular size, purpose
and type of planning problems. The three basic types are partial budgeting, enterprise
budgeting and whole farm (complete) budgeting. Whole farm budgeting involves profitability
for the entire farm business while partial budgeting and enterprise budgeting are used to
analyze only a part of the whole farm.
Partial Budgeting: It is used to calculate the expected change in profit for a proposed change
in the farm business. Partial budget is best adopted to analyzing relatively small change in the
whole farm plan. It considers only those items of income and expenses which are affected
(changed) by the proposed adjustment in the plan. Those income and expenses that are
unaffected by the proposed change are excluded from the calculation. Changes in the farm
plan or organization adopted to analysis by use of partial budget are of three types.
 Enterprise substitution: This includes a complete or partial substitution of one enterprise for
another. Eg. Substitution of sunflower for groundnut.
 Input substitution: Machinery for labour, changing livestock rations, owning a machine
instead of hiring, increasing or decreasing fertilizers or chemicals.
 Size or scale of operation: This includes changing in total size of the farm business or in the
size of the single enterprise, buying or renting of additional land, expanding or decreasing an
enterprise. A partial budget usually prepared to ascertain the effect on the net benefit of the
farm due to small change in the farm plan such as:
Partial budget format

 Additional costs: A proposed change cause additional costs because of a new expanded
enterprise requiring the purchase of additional inputs.
 Reduced income: Income may be reduced if the proposed change would eliminate an
enterprise, reduce the size of an enterprise or cause a reduction in yield.
 Additional income: A proposed change may cause an increase in total farm income if a
new enterprise is being added, if an enterprise is being expanded or if the change will cause
yield levels to increase.

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 Reduced costs: Costs may be reduced if change results in elimination of an enterprise, or

reduction in size of enterprise o r some change in technology that decreases the need for
variable resources. If the difference is positive the proposed plan is more profitable than the
base plan. If the difference is negative the base plan is more profitable than proposed plan.
Differences of partial budgeting from other techniques
In partial budgeting one or more enterprises might be considered while enterprise budget is
prepared for a single enterprise. It is used to examine the profitability of possible adjustment
in the farm plan while the whole farm budget estimates the profitability of the entire farm
plan. Partial budgeting is not suitable for preparing a plan for the whole farm; there,
intermediate in scope between enterprises and whole farm budgeting. In partial budgeting,
contains only those items of income and expenses that will change and ignored that not
change but in the enterprise and complete budgeting the total values are included. Only the
changes in income are included and not total values. It is relatively simple and more
applicable. The final result is an estimate of the increase or decrease in profit.

Enterprise Budgeting: An enterprise is a single crop or livestock type produced on a farm.

An enterprise budget lists all income and costs of a specific enterprise to provide an estimate of
its profit. Each enterprise budget is developed on a single common unit, such as hectares for
crops or head for livestock. It allows comparison of profitability among different enterprises on
the same farm. Each is developed on the basis of small common unit such as one hectare
for crops or one head for livestock. This permits easier comparison of the profit for alternative
and competing enterprises. Enterprise budget can be organized and presented in three
sections: income, variable costs and fixed costs. The first step in developing an enterprise is
to estimate the total production and expected output price. The estimated yield should be
an average yield expected under normal weather conditions given the soil type and input
levels to be used. The output price should be the manager’s best estimate of the average
price expected during the next year or next several years. Variable costs are estimated by
knowing the quantities of inputs to be used (such as seed, fertilizer, labour, manures) and
their prices. The fixed costs in a crop enterprise budget are depreciation on machinery,
equipment, implements, livestock, farm building etc., rental value of land, land revenue,
interest on fixed capital.

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Enterprise Budget Format: Eg. Enterprise budget for teff production (one hectare)

I) INCOME
48 quintals @ birr. 600 per quintal 28,800
II) VARIABLE COSTS
1 Human labour 9,000
a Owned 3,000
b Hired 6,000
2. Bullock labour 300
a Owned 100
b Hired 200
3. Tractor power 4,000
a Owned 1,000
b Hired 3,000
4. Seeds 1,200
5. FYM 1,800
6. Green leaf manures 700
7. Fertilizers 3,000
8. Plant protection chemicals 500
9. Irrigation charges 500
10. Interest on working capital 1,700
Total variable costs 22,700
III) FIXED COSTS
1 Land revenue 12
2 Depreciation 900
3 Rent on owned land 3500
4 Interest on fixed capital 450
Total fixed costs 4862
Total costs 27562
Gross margin (TR - TVC) 6100
Profit (TR-TC) 1238

An enterprise budget can be used to perform a break even analysis for either price or yield or
both. Break even analysis is needed when, there is a great uncertainty about the level of yield
to be expected from a crop to be produced which has no previously been grown. In this case,
the ordinary partial budgeting can not be used, rather break budgeting can be employed to
estimate the yield required to provide an exact balance of changes in cost and revenue, so that
the farmer is neither better nor worse off.
Break-even yield- It is the yield which is necessary to just cover all costs at a given output
price. Break-even yield= .
Break-even price- It is the price necessary to cover all costs at a given yield level. Break-
even price = . Eg. an enterprise budget for sorghum production shows a yield of
20 quintal hectare , a selling price of 5 birr per kg and total cost of birr 5000 per hectare.

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Break-even yield= =10 qt/ha

Break-even price = =250 birr/q
Complete/whole farm Budgeting is a summary of the expected income, expenses and profit
for a given farm. It considers the cost and returns of all the crop and livestock enterprises in
order to derive the net return of the whole farm. It is just the horizontal sum of enterprise
budgets. It is generally made when major changes are to be done in view of technological
development and economic opportunities created in the area or due to personal problems
coming in the way of running the farms in efficient manner. Eg. A farmer may shift from crop
production to dairy farming or fattening or to production of some specialized crops.
Steps in complete budgeting
i. Preparing a plan that includes the area of each crop, the number of each class of livestock
and the production methods. The proposed plan is based on subjective judgment, experience
and intuition coupled with technical considerations. Eg. An agronomist may have suggested a
new crop rotation or a livestock specialist may have suggested the introduction of a goat
enterprise. Thus, several alternative plans may be prepared.
ii. Budgeting the expected costs, including common costs, and returns to financially evaluate
each plan, and find the best in terms of expected net farm income.

Complete budgeting Format

No. Items/Descriptions Total values
1. Income / revenue
Wheat -------------------------- x
Milk ---------------------------- x
Cotton-------------------------- x
Total income ----------------- xx
2. Variable costs
Seed/feed---------------------- x
Fertilizer/chemical----------- x
Fuel, oil, repair---------------- x
Labor ------------------------- x
Others costs ----------------- x
Total variable expenses---- xx
Gross margin(1-2)------------ xx
3. Fixed expenses
Property taxes & insurance----- x
Interest on debt------------------- x
Depreciation costs--------------- x
Others ---------------------------- x
Total fixed expenses ----------- xx
4. Total expense (2+3)------------ xx
5. Net farm income (1-4)--------- xx
\

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4. FARM RECORDS, ACCOUNTING AND ANALYSIS

In the application of Business principles of farming, a farm manager must be acquainted with
cost accounts because chief aim of a farmer is to get the highest possible net profit from his
farm business. The farm business generally consists of more than one enterprise. It is not only
the return from any one enterprise that determines the success or failure of a farm but total
return from all enterprises that measures the efficiency of farm. It is not possible to determine
the financial status of a farm by casual observations; the farm recorders are the best guides to
indicate the profit or loss on a farm as a unit. If properly maintained, they will prove helpful
in making farm management decisions.
4.1. Farm Records
4.1.1. Definition of Farm Records
Farm record is an account of the various activities carried out on the farm on a regular basis.
Such activities include farm purchases, utilization of farm inputs, number of livestock kept
and equipment procured. It also includes crop cultivated, seed planted, cultural activities
carried out, quantity harvested, etc.
4.1.2. Advantage of farm Record Keeping
Records provide information for proper farm planning, useful for sourcing credit, monitoring
farm performance, provide basis for conducting research, useful for decision making, etc.
The Main Functions of Farm Records are;
1.To indicate costs, returns and net profit on each enterprise and on the farm as a whole and
suggest ways for increasing profit and preventing losses.
2.To determine the cost of production of individual enterprises for knowing the sources of
greater profit.
3.To serve as a valuable guide for future
4. It throws light on income generating capacity of farm and there by indicates credit
worthiness of the farmer
5. Provide useful data for preparing farm plan.
6. Helps in knowing strengths and weaknesses of the farm business.
4.1.3. Types of Farm Records
Because of the diversity of the farm situations, not all records will be of equal use on all
farms. The kinds of records to keep will depend upon what information one wishes to have.
There are three parts of farm record system: Physical farm records, financial farm records and
Supplementary farm records.
Physical farm records: It related to the physical aspects of the operation of a farm business.
It simply records the physical efficiency or performance of the farm. To implement the
financial records and the financial decisions, the physical data recording concerning the farm
and its performance are essential. The main use of physical farm records is:
 To check performance of enterprises,
 For controlling business,
 To detect weaknesses and strengths to guide future decisions,
 To provide planning and budgeting data
Physical farm records normally include the following: farm map, contour map, land
utilization records; crop production and disposal records; livestock production and disposal
records, labor records, daily work diary, machine use records, feed records etc.
Financial records: are mainly related to the financial aspects of the operations of a farm
business. They are required to provide information regarding the profitability of the whole

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farm business over a given period. It enable financial analysis to be carried out to reveal the
economic strengths and weaknesses of the farming system, and to provide data to help in the
preparation of revised plans and budgets. The financial record may include farm cash records,
capital assets, cash and credit sale register, purchase register, wage register, fund borrowed
and repayment registers, farm expenses paid in kind register and non-farm income register.
Supplementary records: Examples; Sanction register, rainfall register, stationary register,
auction register and hire register.

4.1.4. Characteristics of Good Farm Records

 simple and easy to understand
 suitable forms for recording the type of information the farmer wants to record;
 have provision for an itemization and classification of all entries;
 have adequate space for itemizing all entries ,and the lines and spaces sufficiently wide for
writing without crowding
 have adequate instructions for recording and analysis of the recorded data.
4.2. Farm Accounting
Account: A summary of business transactions is an account which is divided in to two parts.
The benefits received are recorded on the left hand side and the benefits given are recorded on
the right hand side.
Accounting: It is the art of recording, classifying and summarizing the business transactions.
Recording refers to writing in journals; Classifying stands for writing in ledgers and
Summarizing relates to preparation of trading account, profit and loss account and balance
sheet.
Accountancy: is act of keeping books of accounts in a regular and systematic manner.
There are two types or methods of accounting entry: Single entry system and double entry
system. In single entry system, all types of transactions are recorded together. This system is
inaccurate. In double entry system, each transaction is recorded at two places and fundamental
rule is “debit the account which receives the benefit and credit the account which gives the
benefit.”
Journal: is related with recording of all daily business transactions in a book called Journal.
Journal is also called as book of original entry.
Ledger: is chief book of accounts. Or it is a book which contains various accounts related to
entries made in a journal.
Journal gives information in the form of entries whereas ledger contains information in the
form of accounts.
Cash book: is a book on which transactions relating only cash are recorded in at one.
The principle is that “cash coming in is recorded on debit side and cash going out is recorded
on the credit side.”
Trial balance: The accountant prepares a list of all ledger accounts with their closing
balances indicating the details of debit or credit, such a list of balances is known as trial
balance.
Farm Accounting: Commercial farming involves many transactions and book keeping.
Books of account are records of business transactions. Accounting systems should be
designed to provide information efficiently and quickly at least cost as well as capable of
offering protection to the business by exposing theft or fraud.

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4.2.1. Advantages of Farm Accounts

1. It is a means to higher income.
Keeping records and accounts would enable farmer to:
 Know farm financial status at a point in time;
 Know magnitude and sources of gains or losses over time;
 Identify better sources of income and items of costs;
 Keep a check on unproductive expenditures
 Examine comparative profitability & costs involved for different enterprises; etc.
2. It is a basis for diagnosis and planning
3. It is a way to improve managerial ability
4. It is a basis for credit acquisition and management
5. It guides to a better management and future decisions
6. It is a basis for research
7. It is a basis for policy formulation
4.2.2. Problems and Difficulties in Farm Records and Accounting
Most of the Ethiopian farmers do not know how to maintain farm accounts due to lack of
education, business orientation and time required to do this job. Some specific difficulties
include:
 Subsistence nature of farming: The subsistence nature of farming does not produce enough
incentive for keeping the records.
 Farming is a laborious work
 Triple role of farmers: Ethiopian farmers play a triple role in running their farm business
that of a manager, a financer and a laborer.
 Illiteracy and lack of business awareness
 Complicated nature of agribusiness
 Inadequate extension service
 Lack of standardized farm record books
 Fear of taxation
4.3.Farm Inventory and valuation method
Farm inventory is a list of all properties of a business along with their values at a specified
date. In other words, it is the complete list of farmer`s assets. It is the first step in farm
accounting. It consists of cash assets, depreciable assets and non-depreciable assets. The
purposes of preparing farm inventory are too serves as a basis for preparation of income
statement, balance sheet, measures of farm income. Besides, it serves as a basis for farm
business analysis. A complete farm inventory, taken at the beginning of each season, will give
a list of all the assets with their values. The loss in the value of asset due to depreciation can
be computed from farm inventory. The preparation of farm inventory involves physical
verification and valuation of the assets. Physical verification of items does not pose problem
for farmer, problem arises in evaluation of assets as improper evaluation leads to erroneous
farm decision.
Methods of Valuation of Farm Inventory
The most commonly used methods used in valuation of farm inventory include:
 Valuation at net selling price
 Valuation at cost less depreciation
 Valuation at market price
 Valuation at cost

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 Valuation at reproductive value or replacement cost

 Income capitalization method
Consistency in choosing same method of valuation is required as the method affects the profit
or loss derived on a given farm.
I. Net Selling Price Method
This method is used in determining the value of assets that held primarily for sale i.e. for all
assets available on the farm that the farmer wants to sell in the market. It provides a realistic
measure of the current value of the asset. It is used to value assets that could be sold in a
relatively short period of time. Eg. Livestock for sale, all farm products meant for sell are
evaluated by this method. Current value of asset = Market price of asset – Selling cost
II. Cost Less Depreciation Method
It is a useful method to value those assets that loss their value over time. The loss in value
(depreciation allowance) will be deducted in subsequent years from its book value (remaining
value). Commonly used for valuing working assets such as machineries and breeding
livestock. It enables the financial position well stated and the income figure not distorted by
market fluctuation.
amount of depreciation up to valuation
Present value of asset = Purchase price of assets –
period

III. Market Price Method

This method is appropriate for valuation of purchased farm supplies like: seeds, fertilizers,
Pesticides, fuels, feed for animals, veterinary medicines etc. In this case we need to value the
asset in its current market price and its cost and take whichever is lower.

IV. Valuation at Cost Method

This method is appropriate for valuation of farm produced inputs like: seeds, FYM, standing
crops in the field etc. For standing crops, expenses incurred in raising crops till date of taking
inventory are taken in to account.
V. Reproductive Value or Replacement Cost Method
This method is useful for valuation of very old farm buildings. Replacement cost represents
the cost of constructing same type of building at present prices. It is used to value long-term
assets such as buildings which are constructed a long time ago. However, farm buildings that
have been constructed only a short time ago may be valued at cost less depreciation. This
method will guard against undervaluation of the assets but will not insure against over
valuation.
Construction cost at
Current value of assets = - Depreciation up to valuation time
present prices

VI. Income Capitalization Method: The value of land and any other assets on its current
income in relation to the prevailing rate of interest is called capitalized value. Assets which
yield income over long period of time are evaluated by using this method. It used to value
long term assets (e.g. land) whose contribution to total income of business can be measured/
known. Example land. The formula for this method is: If time period is short
V=
If the time period is infinitely large: V= where v=the value of the asset per year

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I=annual income over the useful life of the asset

r=interest rate
Example: the contribution of the asset for three years is birr 2000 and the ongoing interest rate
is 10%. The value of the asset per year will be:
V= + + =4973.7 birr
However, in practice neither the annual income nor the interest rate can be known accurately.
Therefore, this method is often used in combination with other methods such as the market
price when land is valued.

Where: CI stands for capitalized value of asset; NI represents net income per year from per
unit of asset and r stands for rate of interest prevalent at long fixed deposit. This formula is
good when incomes are constant through time. However, the farm income increases decreases
with the rise or fall in prices and also due to change in the fertility status of soil. Hence, some
correction factor is needed to arrive at capitalized value of land. When such variability is
available use:

Where: I = Increase or decrease in net income per year.

Depreciation and Method of Computation
Depreciation involves the spreading of the cost of an asset over its useful life. It is considered
an annual expense and as such is regarded as a variable cost. Cost less depreciation is an
important factor in valuation. It is defined as the annual loss in value of durable assets due to
use, wear, tear, age, and obsolescence i.e. a business expense that reduces annual profit.
Hence, it is reduction in the value of an asset. Assets that may be depreciated include: assets
that have a useful life of more than one year and a determinable useful life but not an
unlimited life. Eg. Vehicles, machinery, equipment, building, fences, purchased breeding
livestock, wells. Land is not depreciable, but some improvements to land (e.g. drains) are
depreciable.
Depreciation is the financial estimate of the annual loss of value of capital equipment due to
wear and tear over its useful life. The original cost /purchase price of the asset is a prepaid
expense.
Cost: the price paid for the asset
Useful life: It is the number of years that asset is expected to be used in business.
Salvage value: It is the expected market value of the asset at the end of its useful life. It is
known as terminal value, scrap value or junk value. Salvage value will be zero, if the
asset/item is owned until completely worn out. Salvage value will be positive, if the asset/item
is sold before completely worn out.
Book value: the asset’s original cost less accumulated depreciation
Methods of Computing Depreciation
• Straight Line or Fixed installment method
• Sum-of-the-Year’s Digits (SOYD)
• Declining Balance

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A. Straight Line or Fixed installment Method

This method considers that all assets depreciated by some constant amount throughout its
useful life or an asset depreciates at a constant rate over its economic life. The method is,
therefore, useful for assets that loss value constantly over their entire life.
Annual Depreciation = Cost – Salvage Value/Useful Life or (Cost – Salvage Value) x R
Where: R is found by dividing 100% by useful life
B. Sum-of-the-Year’s Digits Method
Annual depreciation is given by multiplying cost less salvage value (i.e., salvage value is the
estimated residual value of a depreciable asset or property at the end of its useful life) by the
fraction of remaining useful life (RL) to sum-of-years digit (SOYD).

Where: RL = remaining years of useful life

SOYD = is obtained by summing up the digits 1 to n for an asset with a useful life of n years.
Or sum of all the numbers from 1 through the estimated useful life. E.g. for 5 year life, SOYD
= 1+2+3+4+5 = 15. Or use simple formula below to find SOYD.

C. Declining Balance Method

Its value depends on useful life and the type of declining balance chosen. It is a multiple of
the straight line rate. In this case, a fixed rate of depreciation (R’) is used for every year and
applied to the value of the asset at the beginning of the year (book value). The original cost of
the asset is divided by its estimated life to knock-off a fixed percentage. This percentage is
deducted every year from the diminishing balance till the asset reached the salvage value and
no further depreciation is possible. There are several ways to determine a fixed rate (R’) of
depreciation. It is most commonly estimated using a depreciation rate that double the straight
line rate(R).
Annual Depreciation (AD) = (Book value at beginning of the year).R`
Where R`=two times straight line percentage rate =2R
Where: R is a constant percentage rate. The percentage rate remains constant each year, but is
multiplied by the book value ,which declines each year by an amount equal to the previous
year`s depreciation.
Examples: Calculate depreciation for a machine with a cost of birr 4,000, a salvage value
(SV) of birr 400 and a useful life (n) of 10 years by using straight line method, SOYD and
Declining balance method.
a. Using Straight Line Method
For this asset the yearly depreciation is given by [(4000 – 400)/10 = 360birr/year]. Annual
depreciation will be the same every year under this method. The depreciation schedule over
years appears as shown in the table below.

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Table 4: Straight line depreciation for an asset initial cost Birr 4000 and SV Birr 400 and
n=10 years
Year Depreciation Remaining value at the end of the year
1 360 3640
2 360 3280
3 360 2920
4 360 2560
5 360 2200
6 360 1840
7 360 1480
8 360 1120
9 360 760
10 360 400

b. Using Sum of Years Digit Method

SOYD = 1+2+3+4+5+6+7+8+9+10 = 55. The sum forms the denominator for the fraction
while the numerator is the remaining useful years of life of the asset at the beginning of the
accounting period. Thus the fraction for the first year of the asset is 10/55. For the second and
third years the fractions are 9/55 and 8/55, respectively. The depreciation schedule for the
asset costing Birr 4,000 and salvage value of Birr 400 is shown in the table below. In this
method the asset losses values at a fairly constant rate.
Year Annual Depreciation Remaining balance
1 10/55 (4000-400) = 654.55 3345.45
2 9/55 (4000-400) = 589.09 2756.36
3 8/55 (4000-400) = 523.64 2232.73
4 7/55 (4000-400) = 458.18 1774.55
5 6/55 (4000-400) = 392.73 1381.82
6 5/55 (4000-400) = 327.27 1054.55
7 4/55 (4000-400) = 261.82 792.73
8 3/55 (4000-400) = 196.36 596.36
9 2/55 (4000-400) = 130.91 465.45
10 1/55 (4000-400) = 65.45 400.00

c. Using Declining Balance Method

Considering rate of depreciation to be 20% (double declining balance) annually, schedule of
depreciation using the declining balance method is shown in the table below. Note: 20% = 2 x
100% /10(useful life)

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Year Depreciation Remaining value at the end of the year

1 20% of 4000 = 800 3,200
2 20% of 3200 = 640 2,560
3 20% of 2560 = 512 2,048
4 20% of 2048 = 409.60 1,638.40
5 20% of 1638.4 = 327.68 1,310.72
6 20% of 1310.72 = 262.14 1,048.58
7 20% of 1048.58 = 209.72 838.86
8 20% of 838.86 = 167.77 671.09
9 20% of 671.09 = 134.22 536.87
10 20% of 536.86 = 107.37 429.50

When Using Declining Balance

If there is a salvage value greater than zero, declining balance methods can result in the
salvage value being reached before the end of the useful life. Depreciation must stop when
book value = salvage value. If salvage value is zero, it is necessary to switch from declining
balance to straight line (on the remaining value and remaining life) at some point to get all the
depreciation allowed.
Partial Year Depreciation: If an asset is purchased during the year, rather than at the
beginning of the year, depreciation must be prorated. A tractor purchased April 1 would be
eligible for 9/12 of a full year’s depreciation the first year.

4.4. Farm Financial Analysis

Farm financial analysis is a statement that shows the financial conditions of the business at a
particular point of time. It involves maintaining and using records and other information
needed to measure the financial performance of a business. The main objectives of farm
business analysis are to answer such questions as: a). How does the business perform at a
certain time?; b).Where are the weaknesses?, c). What Improvements are possible?. To
provide background information for farm policies and for getting credit facilities. The three
major steps or stages of farm business analysis are: Keeping proper recording of accounts and
activities, analysis and interpretation of the results, presentation of results.
The most widely used financial statements are: farm inventory, balance sheet/ net worth
statement, income statement, cash flow budget, break even analysis and physical efficiency.
4.4.1. Balance Sheet and analysis
Balance sheet is a summary of the assets and liabilities of the business, together with a
statement of the owner`s equity or net worth at a given point in time. It is a systematic
organization of everything ``owned`` and ``owed`` by a business or individual at a given point
in time. It also shows the net worth or owner`s equity which is the difference between total
assets and total liabilities. It can be computed any time during the year, but the usual time is at
the end of the accounting period (generally, December 31). The primary use is to measure the
financial strength and position of the business. Its primary function is to measure risk bearing
ability or financial solvency; i.e it shows the margin by which debt obligations would be
covered if the business was terminated and all assets sold. It is also called the net worth
statement. It shows the value of farm assets that would remain if the farm business is
liquidated. It indicates the financial solvency of farm business. Anything of value owned by a

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business or individual is an asset. Any obligation or debt owed to someone else is called
liability. Asset=liabilities+ owner’s equity.
Solvency refers to ability of farm business to meet its debt or obligation. More specifically,
balance sheet of farm is a statement of financial position of farm business at a particular time
showing its assets, liabilities and net worth or equity. It is the total asset minus total liability
(Net worth and net deficit). Balance sheet of a farm can be prepared only if farmers maintain
farm records. If net worth of a farm increases over time, it indicates efficient performance of
farm business. Balance sheet can be prepared with the help of total assets and total liabilities
of the farm.
a) Farm Assets: Anything of value owned by the farm business. It comprises of current
(liquid), working (intermediate) and fixed (long term) assets. The classification of assets
facilitates the analogies of liquidity position of farm business.
i. Current assets: They are very liquid or short term assets that can be converted in to cash
within a short time usually one year. Eg. Agricultural produces ready for sale such as stocks of
maize, sorghum, wheat, chat, etc.
ii. Intermediate or working assets: These assets take 2-3 years to convert in to cash such as
calf of cow, machineries, equipment etc.
iii. Long term or fixed assets: An asset that is permanent or will be used continuously for
several years is called a long term asset. It takes long time to convert in to cash due to time
involved in legal transaction and verification of records etc. Eg. Farm land, farm building etc.
b) Farm Liability: It refers to legitimate claims that can be made against the business i.e. all
debts which are owed to others by the farmers and others have legal claims on the assets of the
farmers. It is classified into current, intermediate and long-term liabilities.
i. Current liabilities: It refers to the debt which has to be paid by farmer in short run usually
within 6 –18 months. Eg. Crop loan.
ii. Intermediate Liabilities: It represents the liabilities or loans that are to be discharged or
paid by farmer within 3–5 years. Eg. Loan taken for purchase of oxen, small equipment, etc.
iii. Long term Liabilities: These loans or liabilities that are to be paid within 5 or more years
are categorized under this. Eg. Tractor loans, orchard loans, land development loans, loan for
establishment of dairy farm, poultry farm, etc.
c) Net worth: It reflects the absolute equity or the amount by which assets in the business
exceed its outstanding liabilities.
Using balance sheet
1. Current Ratio (CR): It indicates the capacity of the farmer to meet immediate financial
obligation (liquidity). If the value of the ratio is > 1, financial position of the farm is
comfortable. CR = value of current assets / value of current liability
2.Intermediate Ratio (IR): indicates liquidity position of farm business over intermediate
period. The value of this ratio should also exceed one to run the farm in sound manner. IR =
(Current asset+ Intermediate asset)/(Current liability + Intermediate liabilities)
3.Net capital ratio (NCR): It indicates long term liquidity position of the farm. If it is > 1,
funds of institutional agencies are safe. NCR = total assets / total liabilities
4.Current Liability Ratio (CLR): It is calculated as: current liabilities / net worth
If CLR > 1, farm financial position is uncertain, If CLR < 1, farm financial position is healthy
5. Debt–Equity Ratio (Leverage ratio) (LR): It shows the extent of indebtedness in farm
business. It is calculated as: LR = Total Debt / owner’s equity

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6. Equity Value Ratio (EVR): This ratio shows the productivity realized by the farmers in
relation to assets possessed by him/her. EVR = owner’s equity / value of assets
Sample Balance Sheet of a hypothetical Farm
Bilise Crop and Cattle Farm PLC
Balance Sheet
December 31, 2017
ASSETS VALUE(Br) LIABILITIES VALUE (Br)
Current Assets Current Liabilities
Cash on hand 2500 Crop L to be paid to instill age’s 4000
Saving in Bank 2000 Other loans due for imbed crypt 3000
Value of grain ready for sale 10000 Cost of maintenance of cattle 2000
Livestock products 15000 Costs of poultry enterprise 5000
Fruits, vegetables, fodder &
feed ready for sale 2000 Sub Total 14000
Value of bonds, share to be
realized in the same year 1000 Intermediate Liabilities
Sub total 32500 Livestock loans 5000
Intermediate Assets Machinery Loans 35000
Dairy cattle 4000 Sub Total 40000
Oxen 5500 Long Term Liabilities (Loan)
Poultry birds 4500 Tractor loan 40000
Machinery and tractor 84000 Orchard loan 5000
Sub Total 98000 Sub Total 45000
Long Term Assets TOTAL LIABILITIES 99000
Land(Book Value*) 150000 Owners’ Equity=total assets –
Farm building 25000 total liabilities 206,500
Sub Total 175000 TOTAL LIABILITIES AND
TOTAL ASSET 305500 OWNERS EQUITY 305,500

4.4.2. Income Statement and analysis

Income statement (Profit and Loss Statement) is a summary of income/receipts and expenses
over a given time period and shows the financial performance of a business. It is called as
operating statement or profit and loss statement. Its primary purpose is to compute profit for a
given time period. Some income statements may also include non-farm income and therefore
show the total annual net income for the farm family. It provides a measure of return from the
business or the ability to meet financial obligations such as debt payment, rent, payroll and
other expenses. It also reveals the success or failure of a farm business over time. It prepared
for entire farm for one agricultural year. In income statement, monetary values are assigned to
inputs and outputs. It basically consists of three items: Receipts, Expenses and net income.
Receipts-are derived from sale of products and miscellaneous sources. Any farm products
used in the home should be valued and included in the receipts. For the purpose of financial
analysis, receipts from the sale of assets such as real estate or machinery are generally not
considered as income since such income is not really produced or earned during the year.
Expenses-all expenses or costs involved in the operation of the business during the period
covered. All variable /operating and fixed expenses are entered. Capital expenditures like
purchase of fixed and working assets such as real estate, machinery and breeding livestock are

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excluded since such items usually are used in the business for several years. The depreciation
that occurs on these items during the period covered by the income statement is an expense
and should be included.
Net income-the net income or loss figures are useful in the analysis of the business which can
be divided into net cash income, net operating income and net farm income.
Net cash income-cash receipts less cash expenses during the year covered by the income
statement excluding purchases and sales of capital assets. It provides an indication of the
annual net cash flow of the business. It is useful in preparing the income tax return when it is
made on the cash basis.
Net operating income- is gross income less operating expenses. It facilitates the comparison
of farms with various fixed-cost structures such as different mortgage debt and depreciation
schedules. It facilitates comparing operating income on the same farm over a period of years.
Net farm income-net operating income less fixed costs.it represents an income accruing to
operating and family labor, management and equity capital. Of the three measures of income,
it is perhaps the most useful.
Sample Income Statement of a Hypothetical Farm
Dhaba, Saba and Bonsa Agricultural Production SC
Income statement
For the Year Ended December, 2017
PARTICULARS AMOUNT (ETB)
1. RECEIPTS
Returns from sale of crop outputs 52,000
Returns from milk and milk products 5,000
Returns from poultry enterprises 12,000
Gifts 2,000
Gross Cash Income 7,000
Appreciation on the value of assets 3000
GROSS INCOME 81,000
2. EXPENSES
i. Operating Expenses
Hired human labour 10,500
Bullock labour 900
Machine hours 1,500
Seeds 1,100
Feeds 5,000
Manures and fertilizers 3,000
Plant protection measures 1,550
Veterinary expenses 500
Irrigation charges 250
Interest on working capital 2,100
SUB TOTAL 28,400
ii. Fixed Costs or Fixed Expenses
Depreciation 3,000
Land revenue paid to government 200
Interest on fixed capital investment 3,200
Rental value of owned land 10,000

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TOTAL FIXED EXPENSE 16,400

Net Cash Income (NCI): 78,000 – 28,400 = 49,600
Net Operating Income (NOI): 81,000 – 28,400 = 52,600
Net Farm Income (NFI): 52,600 – 16,400 = 36,200

Financial analysis of farm business using income statement can also be used with the help of
costs and returns. These ratios are:
Expenses Income Ratios Investment Income Ratio
Operating ratio Capital turnover ratio and
Fixed ratio and Gross ratio Rate of return on investment
A) Expenses Income Ratios
i. Operating Ratio (OR): This ratio shows the amount of operating expenses required to
generate one birr of gross income. OR = Total operating expenses / Gross farm income
ii. Fixed Ratio (FR): This shows the amount of fixed expenses incurred to secure a birr of
gross income. It is calculated as: FR = fixed expenses / Gross farm income
iii. Gross Ratio (GR): This is also called as input-output ratio. It is calculated as: GR = Total
expenses (fixed+ operating expenses) / Gross Farm Income
NOTE: The above three ratios must be < 1 to run the farm in profit
B) Investment Income Ratios
1. Capital Turnover Ratio (CTR): This ratio gives the gross income obtained for each birr
of capital invested over the year. This ratio is calculated as: CTR=Gross farm income
/Average capital investment. (Average capital investment is calculated by adding the value of
assets at the beginning of agricultural year and at the end of agricultural year and then average
of the two values is taken)
2. Rate of Return on Investment (RROI): This ratio gives net return on capital for every
birr of average capital invested. It is calculated as: RROI = Net return to capital / Average
capital investment
Net Return to capital = Net farm income + interest paid on borrowed funds + interest paid on
crop loan - (value of unpaid family labour for the farm as a whole including live stocks
operation and management)
Gross Margin Analysis
Gross margin is the difference between the gross farm income and total variable cost. That is:
TR - TVC where: TR= Total revenue and TVC = Total variable cost. It involves evaluating
the efficiency of an individual enterprise in order to make comparison between enterprises
and different farm plans. It is applicable in situations where fixed capital is a negligible
portion of the farming enterprise, e.g. in subsistence agriculture. It is useful as a budgeting
tool to compare the profitability of one enterprise with another.
5.4. Farm Efficiency Measures (Physical and Financial Measures)
Farmers make several decisions in the use of resources. It is necessary to evaluate how
efficiently farm resources are being used. In order to know whether organization of farm
business is profitable, we need to measure the efficiency of farm. The measures of farm
efficiency can be made in two ways:
A. Physical Efficiency Measures
B. Financial Efficiency Measures
A. Physical Efficiency Measures of Farm

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Three types of major physical inputs vis Land, Labour and Capital are used on a farm. Every
farmer aims at efficient utilization of these resources. For measuring efficiency some criteria
or indicators are needed.
i. Measurement of Land Efficiency
Productivity, Cropping intensity and Crop yield index are the most frequently used indicator
of land efficiency.
a) Productivity of land
The production efficiency with respect to a particular crop is expected as the ratio between
actual yield of a crop on the farm and average yield of same crop in the locality.
Example: Suppose: yield of sorghum on a farm is 40 Q/ha and average yield of sorghum in
the locality is 30 Q/ha.
Then, production efficiency of farm is

= 40/30 * 100 = 133.33%

Therefor, efficiency of sorghum yield on farm is 133.33 – 100 = 33.33 % higher compared to
locality.
b) Cropping Intensity (C.I.)
It measures the extent of land use for the production of crops during an agricultural year.

Example: If a farmer is raising three crops in a year in his 5 hectares of irrigated land, then
C.I. = (15 /5) * 100 = 300%
Thus, it refers to the number of crops grown on a farm during the year with land as a fixed
resource.
c) Crop Yield Index
It shows the percentage yield of the crops on a farm to the average yield of the same crops in
the locality. It is a good measure of Index to compare the yield of all crops grown on the farm
with that of the average yields of the same crops grown in that locality.
Example:
Crops Average yield (Q/ha) Area under crop Production Production
In the On selected on farm (ha) efficiency efficiency *
locality farm on farm area under crop
Sorghum 30 35 0.5 116.67 58.33
Maize 20 22 0.5 110.0 55
Sugarcane 400 450 0.5 112.50 56.25
Wheat 40 45 1 112.50 112.5
Potato 250 300 0.5 120.00 60
total 3 342.08
Crop Yield Index = (342.08/3) * 100 = 114.02
Thus, selected farm is more efficient in realizing 14.02 % higher yield compared to yield of
locality.
ii. Measure of Labour Efficiency
On a farm, male, female and child labors are employed. Labour is measured in terms of man
days. A man day is the productive work completed by a worker in 8 hours of day assuming

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average efficiency. All the adult male, female and child labors employed are converted in to
man equivalent days using the following factors:
1 adult male = 1 man day
3 adult female = 2 male labour equivalent
2 child labour = 1 male labour equivalent
Man equivalent year = man days / 365
After calculating man equivalent year, the labour efficiency is measured by using the
following indicators:
Crop acreage per Man Equivalent Year
Live stocks Maintained per Man
Gross Income per Man
Productive Man Work Units per man Equivalent Year
Average and Marginal Productivity of Labour
Labour Efficiency Index

Measures of Financial Success and Capital Position

Components of the net-worth statement and the net income statements of the farm business
can be used to indicate the strengths and weakness of the farm business in financial terms. An
important function of management is to make use of these indicators in developing new plan
and learn for better performance of the farm business.
The net income defined as the gross farm income less gross farm cost. The net farm income
could be improved by increasing the gross farm income or decreasing the farm costs or both.
If the net farm income, however, is low the manager should examine the gross farm income
which is directly related to the yield.
For some factors might be over or under utilized by the farm firm, input factors used in the
production of the output need to be re-examined. The farmer being a price taker needs to
improve the efficiency of use of the resources (factor inputs) at his disposal. If low gross farm
income is due to low output price the demand elasticity of the product will be instrumental in
determining the revenue position of the farm. Logically, the farmer might explore all possible
ways of bargaining for better prices for his output through co-operatives, government
legislation, etc. However, attaining higher product price does not necessarily guarantee higher
gross income, for a product with inelastic demand will result in low gross income.
Also a low net farm income might be due to high cost. Examine such cost items as feeds,
labour, machinery and other supplies might reveal areas of possible wastage that need to be
avoided to cut down on input costs. However, if waste is minimal a different set of input
package might have to be considered.
The net farm income might be misleading because it may not be a good reflection of the
amount of capital, labour and management involved in the production process. It is, therefore,
necessary to examine other measures of financial success such as return to labour,
management, land and capital and three ratios (gross, operating and fixed) which are also
obtained from the net income statement.
Measures of Financial Success
The Gross Ratio
The gross ratio (GR) is the total farm expense (TFE) divided by the gross income (GI), that is:

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The total farm expenses figure is obtained by summing the operating and fixed costs. In the
case of farm given above, farm total operating cost is Birr 520 and the total fixed cost is Birr
420 and Birr 2,970 is gross income. Gross ratio (GR) = 940/2,970 = 0.32. This ratio shows
that the total farm cost was about 32% of the gross income. A less than 1 ratio is desirable for
any farm business. The lower the ratio, the higher the return per dollar invested. A higher but
less than 1 ratio might be tolerated for a large farm involving heavy capital investment. A
greater than 1 ratio is disastrous for a farm business and might indicate over utilization of
certain resources. If this happens management should consider ways of reducing costs and
increasing gross income. The gross ratio measures the overall financial success of a farm. It is
a long run planning tool for determining the performance of the entire farm business.
Operating Ratio
The operating ratio (OR) is the total operating cost (TOC) divided by the gross income, that
is, OR = TOC/GI. For the typical farm with data given in Error! Reference source not
found. the operating ratio calculated as: OR = 520/2,970 = 0.17. The operating ratio shows
the proportion of the gross income that goes to pay for the operating costs. The operating cost
is directly related to the farm’s variable input usage. An operating ratio of 1 means the gross
income barely covers the expenses on the variable inputs used on the farm. In other words,
such a business could survive only in the very short run and could fold up if correct
adjustments are not made to improve the usage of variable resources in terms of reducing
costs and / or increasing gross income. A thorough investigation into the details of such
component part will definitely help in identifying the necessary adjustments needed to correct
the situation.
The Fixed Ratio
The fixed ratio (FR) is the total fixed cost (TFC) divided by the gross income (GI), that is:

Fixed ratio for the stated farm is calculated as FR = 420/2970 = 0.14. The ratio shows that the
fixed expense is 14% of the gross income. If the fixed ratio is close to 1, some of the fixed
resources are either left idle or underutilized. However, in the event that these resources are
fully utilized the high fixed ratio might be due to the farmer’s over estimation of the expected
gross returns in his choice of enterprise or due to unpredicted biological conditions militating
against yield. Among the aforementioned ratios measuring the financial success of a farm
business, the gross and the operating ratios are the most import. The gross ratio measures the
ultimate solvency and success of the farm business. The decision of whether to liquidate the
farm or not depends on the gross ratio figure. A greater than 1 gross ratio means that an
alternative and more profitable enterprise should be considered. The operating ratio which is
directly related to the variable resources is the decision making tool with regards to factor
adjustments during a production period. The fixed ratio which is an indication of the
percentage of the gross income accruing to the fixed resources is an exante decision tool, that
is, an important decision parameter before and not during the production period. In the
traditional farm setting, the operating ratio is more important than the fixed ratio for most of
the resources used are variable while fixed items are almost negligible.
Measures of Capital Position
While the measures of financial success are based solely on the income statement, the
measures of capital position are based on data presented in the net-worth statement. The ratios

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which indicate how solvent the business is over different time periods are the current ratio,
working capital ratio, net capital ratio, asset-to-debt ratio and debt-to-net worth ratio.
Current Ratio
The current ratio (CR) is defined as the current asset (CA) divided by the current liabilities
(CL). Mathematically:

Based on the balance sheet statement given in Error! Reference source not found.the
current assets worth Birr 56,400, and the current liabilities amount to Birr 54,900, hence the
current ratio is 56,400/54,900 = 1.03. The current ratio generally shows the ability of the
business to meet financial obligations or its solvency. A current ratio of greater than 1 implies
that the current assets is more than the amount the farm need to pay for the current liabilities.
A narrow current ratio shows that problems exist especially if bills fall due for payment at the
wrong time. The current ratio is often called the acid test because it is a test that can be
performed quickly.
Net Capital Ratio
The net capital ratio (NCR) is defined as the total asset (TA) divided by the difference
between the liabilities (TL) and the proprietor’s equity (PE).

This ratio shows the overall solvency of the business, and indicates changes that are possible
in the future. It shows the degree of safety of the entire farm business and determines the
possibility of borrowing more capital. If the proprietor’s equity of the farm is Birr 100,000,
the NCR is given by the total asset (TA) divided by the difference between total liabilities and
the proprietor’s equity (TL-PE). Which means 534,400/(227,900-100,000) = 4.18. Total asset
and Total liabilities figure are taken from Error! Reference source not found.. This ratio
shows at a glance by how much the assets on the farm have to decline to be exceeded by the
liabilities other than the proprietor’s equity. A high ratio is desirable for a risky firm business.
Yet, a safe ratio depends on the type of farm and the degree of uncertainty and risks involved.
Asset-to-Debt Ratio
The asset to debt ratio (ADR) is the total asset (TA) divided by the total liability (TL), that is:

The asset to debt ratio is a close approximation of the net capital ratio if the proprietor’s
equity is negligible. The asset-debt ratio is, however, not as useful as the net capital ratio
because it may give a distorted position of the business. Using data from balance sheet
statement in Error! Reference source not found. the ADR is calculated as:
ADR = 534,400/227,900 = 2.34
The asset to debt ratio of 2.34, which is lower than the 4.18 calculated for the net capital ratio,
indicates a less solvent capital position of the business. The larger the proprietor’s equity the
less useful is the asset to debt ratio for measuring the capital position of the farm business.
Debt-to-Net Worth Ratio
The debt to net worth ratio (DNR) is defined as the total liabilities (TL) divided by the net
worth (NW), that is:

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This ratio indicates the ease with which the proprietor can meet financial debts internally
when, and if the creditors demand. A less than 1 ratio is preferred to enable the proprietor
meet his financial obligations internally. The total liabilities (current, intermediate and long-
term) given in Error! Reference source not found. are summed up to Birr 227,900 and the
net worth was Birr 306,500. Therefore, debt-to-worth ratio is equal to 227,900/306,500 =
0.74. This ratio of 0.74 indicates that the total liabilities were less than the value of the net
worth. Hence the proprietor can meet its debts internally.

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5. RISK AND UNCERTAINITY IN AGRICULTURE

Farmers must make decisions on crops to be planted, seeding rates, fertilizer levels and other
input levels early in the cropping season. The crop yield obtained as a result of these decisions
will not be known with certainty for several months or even several years in the case of
perennial crops. Changes in weather, prices and other factors between the time the decision is
made and the outcome is known can make previously good decision very bad. Because of
time lag in agricultural production and our inability to predict the future accurately, there are
varying amounts of risk and uncertainty in all farm management decisions. If everything was
known with certainty, decision would be relatively easy. However, in the real world more
successful managers are the ones with the ability to make the best possible decisions, and
courage to make them when surrounded by risk and uncertainty. Biological nature of farm
enterprise entails some uncertainties in their production and prices in addition to uncertainties
related to availability of inputs. Some of them are measurable in their parameters of
probability, yet others are more or less random phenomena that cannot be estimated with any
acceptable degree of accuracy. The first category uncertainties lead to the business risks that
can be, to a considerable extent, provided for either through adjustments in the production
programs and resource use planning or through hedging, forward contracts, insurances, etc.
The latter category cannot be treated as calculable risks and are not amenable to programs of
production or resource use adjustments. How these risks and uncertainties are accounted for
in the production programs of the farmers is the central objective of this chapter. Discussion
here center around i) how do the farmers in their normative production programs account for
estimable uncertainties (risks) of price fluctuations and yield (production) variability of farm
products, and ii) how do they provide for uncertainties on the availability of factor inputs.
5.1. Definition of Risk and Uncertainty
Risk is a situation where all possible outcomes are known for a given management decision
and the probability associated with each possible outcome is also known. It refers to
variability or outcomes which are measurable in an empirical or quantitative manner. Risk is
insurable. It is uncertainty that affects an individual’s welfare, and is often associated with
adversity and loss. Risk is uncertainty that “matters,” and may involve the probability of
losing money, possible harm to human health, repercussions that affect resources (irrigation,
credit), and other types of events that affect a person’s welfare. It is a situation where the
decision maker, for a given management decision, knows both the alternative outcomes and
the probability associated with each outcome. A simple example would be tossing a coin. In
this case, all possible outcomes and the probability of appearing head or tail for each possible
outcome are known by the decision maker before tossing the coin. Consider a farmer in risky
situation with respect to crop yield for alternative fertilizer level. In this case, the farmer
would know the probability distribution of the random variable, i.e. crop yield, for each
fertilizer level that could be applied. E.g., farmer in risky situation would know that the
probability of wheat yields between 20 and 25qt per hectare range is 0.5, that yield in the 26
to 30qt/ha range is 0.2, and so on for other yield levels. In risky situation, probabilities are
assigned to alternative outcomes. However, these assigned probabilities are subjective
probabilities which are based on the judgment and experience of an individual. In many
situations, it is believed that the true or actual probability can’t be determined. Therefore,
subjective probabilities are the only ones available, and they may vary from individual to
individual.

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Uncertainty is a situation in which the decision maker, for a given management decision, has
less information about the alternative outcomes and their probabilities of occurrence. It exists
when one or both of two situations exist for a management decision. Either, all possible
outcomes are unknown, or the probability of the outcomes is unknown or neither the
outcomes nor the probabilities are known. It refers to future events where the parameters of
probability distribution (mean yield or price, the variance, range or dispersion and the skew
and kurtosis) cannot be determined empirically. Uncertainty is not insurable. Uncertainty is a
situation in which a person does not know for sure what will happen and is necessary for risk
to occur, but uncertainty need not lead to a risky situation.

The difference between risk and uncertainty indicates that most agricultural decisions would
be classified as involving uncertainty. That means, even if all possible outcomes, for a given
production activities, could be listed, the associated probabilities can seldom be accurately
determined. Therefore, the best that can be done is to assign subjective probabilities. These
probabilities are decision maker’s best estimate of the true probabilities based on the limited
information available and past experience with the same or similar events and decisions.
Because of uncertain situation, two farmers or managers who faced the same problem under
the same conditions may make two different decisions. Most of the time, it is very difficult to
have a definitional distinction different risk and uncertainty.
5.2. Types and Sources of Risk and Uncertainty in Agriculture
Types of risks and uncertainty
There are two types of risks: Speculative risk and pure risk
Speculative risk is the one whose consequences may be either favorable or unfavorable.
Most risks of this nature are unfavorable only to some individuals and not necessarily to the
society as a whole. Thus, the loss of one person from sell of house is the gain of another; the
decline in price of wheat enriches some persons at the expense of others; the decline of on
business establishment may mean larger profits to others. The other feature of these risks is
that they are often immeasurable, that is, we lack the information about their occurrence that
would permit reliable estimation of their probable frequency and severity. The protection
against these risks is available or utilized only to a limited extent and in isolated insurances
because 1) elimination of unfavorable consequences may cost too much relative to the
potential gain or eliminate the possibility of gain. 2) Many persons prefer to accept such risks.
3) There is little information upon which to base an insurance payment and 4) Insurance
against these consequences involves too much moral risk.
Pure risks is the one whose consequences always entails serious and harmful consequences.
Eg Fire that destroys property; breakage of window; loss of employment. All of these
consequences are unfortunate, not only for the individual suffer but for the society as a whole.
There is no possibility of gain. Consequently, it is extremely important that the person seeks
ways to compensate these risks. Many of pure risks are measurable.
Sources of Risk and Uncertainty in agriculture
Some risks are unique to agriculture, such as the risk of bad weather significantly reducing
yields within a given year. Other risks, such as the price or institutional risks discussed below,
while common to all businesses, reflect an added economic cost to producer. If the farmer’s
benefit-cost tradeoff favors mitigation, then he/she will attempt to lower the possibility of
adverse effects. These risks include the following:

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Production and technical risk: In manufacturing firms /activities production (input and
output) can be known with certainty. This is not the case with most agricultural production
activities. Because of its nature, crop and livestock performance depends upon biological
processes, which are affected by weather, soil weeds, pest and diseases, infertile breeding
livestock and other factors which make the yield not to be accurately predicted and cause
yield variability. These processes cannot be predicted accurately. Inputs such as seed and
fertilizer must be applied before the weather is known and regardless of input level selected,
weather will affect the output level. This creates uncertainty about the output which will be
received for any input level as well as uncertainty about what input level to use. Technical
risk also contributes to the problem of determining the proper input level. This creates
uncertainty about input level and corresponding output levels even in the absence of other
uncertain yield influencing factors such as weather. Another source of production risk is new
technology. Will the new technology perform as expected? Will it actually reduce costs and
increase yields? These questions must be answered before adopting new technology.
Marketing or price risk: A major source of risk in agriculture is price variability. That
means, the prices of agricultural commodities vary seasonally within a year as well as
changing from year to year. Many forces cause price to fluctuate. E.g., the supply o inputs and
outputs are affected by a combination of production decision made by many farmers and the
resulting weather, which result price variability. Demand for a product is also affected by the
level of income that consumers have, the exchange rate and other prices, the strength of the
general economy and the supply of competing products, which result in price variability. In
general, all of the factors leading to unpredictable shift to supply and demand of input and
outputs are sources of price uncertainty. Because of the time lag in agricultural production the
price received for the output may be greatly different from the price at the time the production
decisions were made.
Financial risk: It occurs when money is borrowed to finance the operation of the firm. That
means it is the risk of losing equity due to decline in income as borrowing and the debt/equity
ratio increases. Yield and price uncertainty combine to generate financial risk or uncertainty
about the firm’s ability to repay debt. In other words, a combination of lower than expected
prices and yields can make debt repayment difficult, put a strain on the firm’s cash flow and
possibly reduce equity. A series of such events can result in bankruptcy. Furthermore, this
risk, also caused by uncertainty about future interest rates, a lender’s willingness to continue
lending, and the ability of the farm to generate the cash flows necessary for debt payments.

Institutional risk: It refers to irregularities in the provision of services such as the supply of
credit, purchased inputs and information, from both traditional and modern institutions. Part
of institutional risk is the uncertainty of government policy, programs, rule and regulations
that are subject to change creating another source of uncertainty for farmers.
Technological Risk: It arises from the development and adoption of new techniques or
methods of production. In fact, new crop varieties, chemicals, feed combinations, models of
machines, and the like, are continually being developed by research workers and business
concerns. While these new developments are usually based on approved experimental
procedures, the result realized may be different on a given farm from those expected.

Casual Risk: It is associated with property loss due to fire, flood, windstorm, theft, etc, which
result losses in agriculture. Casually losses can generally be covered by insurance. However,

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income may still be reduced by the interruption of normal business activity that often follows
a major loss.
Human or personal risks: Farmers are also subject to the human or personal risks that are
common to all business operators. Disruptive changes may result from such events as death,
divorce, injury, or the poor health of a principal in the firm. In addition, the changing
objectives of individuals involved in the farming enterprise may have significant effects on
the long run performance of the operation. Asset risk is also common to all businesses and
involves theft, fire, or other loss or damage to equipment, buildings, and livestock. A type of
risk that appears to be of growing importance is contracting risk, which involves
opportunistic behavior and the reliability of contracting partners.
5.3. Decision making under risk
Probability and Expectations
To make decision in a risky world, a manager needs to understand how to form expected
value, how to use probability (chances of occurrence), and how to analyze the variability
associated with the potential outcome.
Forming expected values: The major methods used to form expected values are:
 Average (simple and weighted average)
 Most likely method
 Mathematical expectation
Average (simple average)
Consider the following price over years for maize
Table 5: Annual maize price variation
Year Average of annual price
4 years ago 2.50
3 years ago 3.05
2 years ago 2.00
Last year 4.50
Summation 12.05
Average (expected value) = 12.05/4 = 3.01
Weighted average
This method usually weights the more recent values heavier than the older using some
predetermined weighing system on the basis of the decision maker’s experience, judgment
and performance. Example, using weighted averages to form expected value:
Table 6: Annual maize price variation with weight
Year Average annual price Weight price Result price times weight
4 years ago 2.50 1 2.50
3 years ago 3.05 2 6.10
2 years ago 2.00 3 6.00
Last year 4.50 4 18.00
Total 10 32.60
Weighted average 32.60/10 = 3.26
Most likely method
By this method, an expectation is formed by choosing the value most likely to occur (this is
the value that is relatively sure to occur). This procedure requires knowledge of the
probability associated with each possible outcome. The outcome with the highest probability
would be selected on the likely to occur.

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Table 7: Possible maize yield with probability

Year Possible maize yield (qt/ha) over 4 years Probability
Year 1 15 0.1
Year 2 18 0.3
Year 3 25 0.4
Year 4 30 0.2
Total 1.00
Four possible maize yields are shown along with probability of obtaining each yield. Using
the most likely method to from an expectation, a yield of 25 quintal per ha will be selected as
this yield has the highest probability and is therefore the most likely to occur. However, there
is no assurance that this yield will occur in any given year but it will occur 40% of the time
over a long period.
Mathematical expectation
When either the true or subjective probability of the expected outcome is available it is
possible to calculate the mathematical expectation of yield, price, cost, income or profit. It is
given as:
E(Y) = ∑(Y1P1 + Y2P2 + Y3P3 + ….+ YnPn)
Where E(Y) is the expected yield
Y1, Y2,…, Yn are yield under the various states of nature (wet, dry and normal years)
P1, P2, P3,…, Pn are the respective probability of the state of nature.
Example: Let’s assume that there are three states of nature based on past experience viz., wet,
dry and normal. The probabilities of occurrence of these conditions are 0.2, 0.3 and 0.5,
respectively. Consider maize and sorghum yield in the three states of nature as in the
following table:
Table 8: Expected maize yield with varying state of nature
State of Nature Expected yield
Crop Wet years Normal years Dry years
Maize 35 25 15 24
Sorghum 15 25 20 22

The expected yield for maize is:

E(Y) = (0.2*35) + (0.5*25) + (0.5*15) = 24
The expected yield for sorghum is:
E(Y) = (0.2*20) + (0.5*30) + (0.3*30) = 22
Finally the values 24 and 22 quintals are used for planning purpose.
There are several elements or components to any decision involving risk. Here three of them
are considered.
There are alternative decisions or strategies available to the decision maker;
There are possible events that can occur, such as variation in weather and variation in price
and these factors create the risk because the actual outcome is not known at the time the
decision must be made; and
The consequences or result of each strategy (decision) for each possible outcome (event) may
be expressed as yield, net returns or some appropriate value.
Example: Consider a fattening program or plan
Assume that a farmer plants alfalfa feed in a given hectare of land in the winter
Oxen are purchased in winter and graze on the alfalfa and sold in the spring
All oxen must be purchased and sold after fattening

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Now the farmer’s problem is on deciding how many oxen to purchase. That is:
If too few oxen are purchased and the weather is good there will be excess grazing available
and opportunity for additional profit is given up.
If too many oxen are purchased and the weather is poor, there will be insufficient forage, so
that feed may have to be purchased and profit is reduced or a loss is incurred.
Let’s further assume that the farmer has decided on three choices: purchase 30, 40 or 50 oxen.
These choices are the decision strategies and the weather can be good, average and poor with
probability of 0.2, 0.5 and 0.3, respectively.
The same three weather outcomes are possible for each of the possible strategies. This creates
nine potential consequences or results to be considered and it is helpful to organize this
information with decision tree or with pay off-matrix.
Decision tree (a diagram that traces out all possible strategies/acts), potential outcome (events
and possibility) and their consequences; and is illustrated as follow:
Table 9: Decision strategies with varying state of nature for oxen fattening program
Strategy Weather outcome Probability Net returns Expected Value
Good 0.2 6000
Buy 30 Average 0.5 4000 3800
Poor 0.3 2000
Good 0.2 5800
Buy 40 Average 0.5 5600 4160
Poor 0.3 0
Good 0.2 8000
Buy 50 Average 0.5 6000 4000
Poor 0.3 2000

The expected values are the summation of the net return weighted by their probability
(example, for the buy 30, the expected value is (0.2*600) + (0.5*400) + (0.3*200) = 3800
birr).
Pay-off matrix: This contains the same information as the decision tree but is organized in
the form of table and is illustrated below.
Table 10: Pay off matrix for oxen fattening program
Weather outcome Probability Purchase strategy
Buy 30 Buy 40 Buy 50
Good 0.2 6000 6800 800
Average 0.5 4000 5600 6000
Poor 0.3 2000 0 -2000
Minimum Value 2000 0 -2000
Maximum Value 6000 6800 8000
Expected value 3,800 4160 4000
Simple average 4,000 4133 4000

The Decision Rule

The decision rule includes the following: maximin, maximax, maximize expected value and
most likely outcome.
Maximin rule: This rule concentrates on the best possible outcome for each strategy. This
rule says that nature will always do the worst (pessimistic approach). Therefore, the strategy

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with the best of the worst possible result is selected, that is, the one with the maximum of the
minimum value is selected. From the above table this rule select “buy 30” strategies as its
minimum on sequence of birr 2000 is higher than the minimum for the “buy 40 and 50”
strategy with the minimum consequence of birr 0 and 2000, respectively.
Maximax rule: This rule is just the opposite of maximum rule. That is, this rule selects the
strategy with the highest maximum value or the maximum of the maximum value. This rule
says nature will always do its best (optimistic approach). According to this rule “buy 50”
strategy will be selected since its maximum value is greater than the maximum value of the
other two strategies.
Maximize expected value: In this rule the decision is made by selecting strategy with the
highest expected value. Accordingly, this rule selects the “buy 40” strategy since it has the
highest expected value.
Most likely outcome rule: By this rule, the outcome that is most likely to occur (one with
highest probability) and then the strategy with the highest consequences for that outcome will
be chosen. Accordingly, the highest probability (0.5) and the corresponding highest
consequence (6000 birr) occur in the “buy 50 strategy”. Therefore, this rule selects “buy 50”
strategy.
The use of the different rules depends on the types of the decision maker’s attitude towards
risk and the existing financial condition of the business. There are 3 types of persons with
regard to their attitude towards risk.
Risk-averse person: Risk avoider person. Usually risk-averse person perform the one that is
sure to get with the highest probability even if the result is low. This person usually prefers to
use maximin rule for making decision. A person/business with weak financial position mostly
prefers to use this rule.
Risk taker (prefer): This is a person who tries to achieve the maximum output under risk
condition. This person prefers to use maximax rule for decision making. A person/business
with strong financial position mostly prefers to use this rule.
Risk indifferent person: A person who doesn’t care whether risk occur or not. This person
prefers the last two decision rule to make his/her decision.
5.4. Methods of Reducing Risk and Uncertainty
The various methods which can be used to reduce risk are discussed hereunder.
1. Diversification: Production of two or more commodities with negative correlation in their
performance parameters may reduce income variability if all prices and yields vary.
Diversification is mainly a method of preventing large losses.
2. Selection of stable enterprises: Irrigation will provide more stable crop yields than dry
land farming. Production risk can be reduced by careful selection of the enterprises with low
yield variability. This is particularly important in areas of low rainfall and unstable climate.
3. Crop and livestock insurance: For phenomena, which can be insured, possible magnitude
of loss is lessened through converting the chance of large loss into certain cost through
insurance arrangement.
4. Flexibility: It is a method of preventing the sacrifice of large gains. It allows for changing
plans as time passes, additional information is obtained and ability to predict the future
improves.
5. Spreading sales: Instead of selling the entire crop output at one time, farmers prefer to sell
part of the output at several times during the year. Spreading sales avoids selling all the crop
output at the lowest price of the year but also prevents selling at the highest price.

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6. Hedging: It is a technical procedure that involves trading in commodity future contracts

through a commodity broker.
7. Contract sales: A contract of this type removes the price risk at planting time.
8. Minimum support price: The government purchases the farm commodity from the
farmers if the market price falls below the support price.
9. Net worth: It is the net worth of the business that provides the solvency, liquidity and
much of the available credit.

There are 3 types of persons with regard to their attitude towards risk.
Risk taker (prefer): This is a person who tries to achieve the maximum output under risk
condition. This person prefers to use maximax rule for decision making. A person/business
with strong financial position mostly prefers to use this rule.
Risk indifferent person: A person who doesn’t care whether risk occur or not. This person
prefers the maximize expected value and most likely outcome rule for decision making.
Risk-averse person: Risk avoider person. Usually risk-averse person perform the one that is
sure to get with the highest probability even if the result is low. This person usually prefers to
use maximin rule for making decision. A person/business with weak financial position
mostly prefers to use this rule. There are three general and perhaps related reasons why a risk
averse manager would be interested in taking steps to reduce risk and uncertainty.
 To reduce the variability of income over time. This allows more accurate planning for items
such as debt repayment, family living expenses, and business growth.
 There may be a need to assure some minimum income level to meet family living expenses
and other fixed expenses.
 Business survival. Several consecutive years of low income may threaten business survival
or result in bankruptcy. Many managers would be willing to accept a lower expected
income if it reduces income variability and hence the risk of business failure.
Management of risk is not something different from management of other aspects of a farm,
as every farm management decision has risk implications. Risk management strategies consist
of many responses, which may reduce the chance of a ``bad`` event occurring and/or reduce
the effect of the ``bad`` event if it occurs. Risk responses are commonly grouped into
production, marketing and financial (money) responses.
1. Production responses
a) Choosing low risk enterprises:-most farmers have experience with enterprises that seem
to be more stable than others.
b) Growing many things (diversification):- this strategy insures that farmers avoid having
their income totally dependent on the production and price of a single enterprise. If one
enterprise fails the income from the other enterprise is expected to be sufficient to keep going.
The farmer avoids putting “all his eggs into one basket”. Diversification is mainly a method
of preventing large losses.
c) Growing crops on different plots:-growing crops in different locations on the farm
reduces the impact of localized disease and micro-climatic factor.
d) Selecting and changing production practices.
e) Maintaining flexibility: - flexibility of the farming system allows the farmer to shift
resources from one enterprise to another smoothly and easily, without having a negative effect
on farm profitability. When the profitability of one enterprise becomes too low, the farm plan
can be easily changed to include another enterprises(s) which is now relatively more

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profitable. Flexibility is a method of preventing the sacrifice of large gains. Flexibility allows
for changing plans as time passes, additional information is obtained and ability to predict the
future improves.
2. Market- related responses
a) Obtaining market information: better information on seasonal variations in prices and
changes in prices over the years can be used to plan when produce should be marketed. A
farmer can reduce risk by collecting information about market price, and cost and return of
the alternatives open to them.
b) Spreading sales: diversification in marketing (making several sales of a product during a
year) used as risk reducing strategy. This can be accomplished by selling part of the annual
production at several times during the marketing year.
c) Contract farming: price uncertainty could be eliminated entirely if the farmer could make
advance contacts with the buyer of the produce and with the seller of agricultural inputs.
Some farmers make contacts with suppliers so that inputs are provided at specified prices.
This avoids the risk of price increases and the unavailability of key inputs at critical times.
Farmers, similarly, contact production sales at a given prices agreed upon by both parties.
Farmers make an agreement with a buyer who agrees to pay a set of prices for a certain
quantity and quality of a commodity to be delivered at a later date. In both cases, a legal cash
contact is binding on both parties regardless of price changes between signing the contact and
delivery date for the commodity. Contact farming may result in the farmer getting a lower
price than they would have if they had sold on the “day”. However, the ability to generate the
price the farmer receives allows them to plan.
d) Minimum price contact: provide farmers with the opportunity to secure insurance.
However, this contract will not always be able to guarantee a profit. This marketing technique
provides producers with greater flexibility and more risk management alternatives.
Insurance: There are different types of insurance that farmers could use as an alternative
way of dealing with risk and uncertainties. A manager can provide insurance for a business in
one of two ways.
1) Formal insurance: It can be obtained through an insurance company to cover many types
of risks which, if they occur, could have serious impact on business equity and survival.
2) Own insurance (self-insured): some type of readily available or liquid financial reserves
must be available in case a loss does occur. Without these financial reserves, a crop failure,
major windstorm, or fire may be such a financial set back that the business will fail. A manger
may choose a combination of formal and self- insurance. Attitude towards risk and the
financial condition of the business will determine the combination selected. Many types of
risks are insurable. Some types of insurances.
A) Property insurance: protects against the loss of buildings, machinery, livestock, and
stored grain from fire and lightning.
a) Liability insurance: protect the insured against lawsuits by third parties for personal
injury and property damage for which the insured and/or employees may be liable. For
example, the liability coverage on an automobile insurance, the policy pays for injuries and
damages to third parties when the insured driver is at fault. Liability claim on a farm may
occur, for example, when livestock wander on to a road and cause an accident or when a
third party is injured on the property. Most people find liability insurance an inexpensive
b) method to provide some ‘peace of mind’ and protection against the possible loss of the
business equity.

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B) Crop insurance: - two types of crop insurance are available.

 Crop hail insurance: protects the insured crop only against lose caused by hail storms.
 All risk insurance: protects against crop losses caused by everything except, neglect, poor
management practices and theft.
C) Life insurance: protects against losses that might result from the untimely death of the
farm owner/manager or a member of the family. Can be used to meet family living expenses,
pay off existing debts, and meet other expenses related to transferring management and
ownership of the business. It have two types:
c) Term insurance: provides only protection at relatively low cost, but has no saving or cash
value features. It provides protection for a specified period of time such as 5 or 10 years and
makes payment if the insured dies within that period.
d) Permanent insurance: It have some contribution of protection, saving, and cash value
build up. Most feature level periodic premiums for a specified period such as 20 years, until
age 65 or for life, and remain in force until the death of the insured. The Cash value some
permanent types of life insurance provides collateral for borrowing from insurance company
to meet future financial emergencies. Because of the cash value and other features of
permanent insurance, premiums will be higher than term insurance.

THE END
GOOD LUCKS!

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