Costs in theory

We will first make some general, ‘theoretical’ points about costs. It is hard to say precisely just what all the costs of owning and operating a farm are. To some extent, costs are what you think they are. Like all other farm figures, some costs are obvious and easy to measure (such as cash out-of-pocket, expenses) whilst others are ‘hidden’ and can only be roughly guessed.

Hidden costs include non-cash costs like the cost involved if a farmer owns a piece of machinery which will last a number of years, but is slowly wearing out. It wears out a bit at a time with each crop it is used to help produce. So, with each crop there is a ‘wearing-out cost’ of capital equipment. It is called depreciation. The annual cost of owning and using a machine will depend in part on the length of its working life. A judgment (guess) has to be made about the length of working life which the machine is likely to have (see Chapter 13). ‘Opportunity cost', which is the revenue which could have been earned but is given up when a decision is made to use resources in an alternative way, is another hidden cost. So, whilst some costs are matters of fact, others depend on opinions and assumptions.

Fixed (overhead), variable and total costs

Actual costs of production are the sum of two components: (i) fixed (or overhead) costs which are not directly related to the amount of crop produced on the land resources (they have to be paid whether anything is produced or not and include land rent, land taxes, loan repayments, living expenses); (ii) variable costs, which are directly related to the amount of crop grown and so with the amount of variable inputs used (e.g. weeding, labour, seed, fertiliser). Adding total fixed costs and total variable costs gives the total cost of production.

As fixed costs have to be ‘paid’ whether production occurs or not, the fixed cost component of the total cost of producing 1 unit of output will be high compared to the fixed cost part of the total cost of producing IOunits of output. The more output is produced, the lower the amount of fixed cost involved in the making of each unit of output (fixed costs are spread over more output).