Adopting Alternatives

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Adopting Alternatives

• A methodology for
• improved economic decision-making
• in enterprise management

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• Situation
• Agronomic research considers various production
  methods and provides data and information about
  how effective these alternative methods are.
• Farm managers must decide, based on the
  information available to them and their personal
  preferences, whether or not to adopt a
  recommended alternative practice.
• Taking a rational, methodical approach to problem
  solving leads to better economic decisions and
  reduces the chance of an undesirable outcome.

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• The purpose of this presentation is to outline
  the eight step process that better farm managers
  use to make good economic decisions about whether
  or not to modify an existing production practice
  (the base plan) by adopting a proposed new
  practice (an alternative plan).
• This is an iterative process, comparing the base
  plan to one alternative at a time.

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• Step 1
• Monitor the base plan
• identify a problem

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Step 2 Consider all alternative solutions
(brain-storming)
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• Step 3
• Is the alternative compatible with this familys
  values this farms goals? 
• Farmers will have different goals objectives,
  even when their resources are similar, because
  they have different values and/or feel more or
  less strongly about each value.

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• Step 4
• Is a particular alternative technically
  feasible?
• Is the alternative practice or crop compatible
  with local agronomic, climatic and other
  physical growing conditions?
• Does the managerial capacity exist on the farm to
  implement the alternative?
• Is the necessary labor and/or machinery available
  to produce the product effectively?

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• Step 5
• Is the alternative economically feasible (more
  profitable )?
• For example, consider a farmer trying to decide
  between his current practice of hand weeding and
  the alternative of applying herbicide. His
  current practice results in average yields of
  2,000 kg/ha. However, researchers using
  herbicides in on-farm trials obtained an average
  yield of 2,400 kg/ha. Would it be more profitable
  to adopt herbicide weed control?
• To answer this question, we need a method to
  organize experimental data about the costs and
  benefits of various alternative treatments and to
  enable us to compare the net benefits.

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• A complete budget or enterprise budget
  calculates the profitability for a single
  enterprise, such as maize or coffee production.
• Unfortunately a complete budget requires that
  one know all of the production costs for an
  enterprise. Most farmers have never bothered to
  collect the data and figure out how profitable
  the enterprise actually is.
• Fortunately, in order to compare the relative
  profitability of two production practices, the
  current base plan and the proposed alternative
  plan, one need only compare those costs that
  actually vary between the two methods of
  production.

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• Marginal analysis
• A partial budget, as its name suggests, consists
  only of those parts of two enterprise budgets
  that are immediately relevant to the comparison
  of the current base plan and an alternative. It
  only considers
• 1. the marginal revenue (i.e., extra revenue
  any new revenue minus any revenue foregone)
  and/or
• 2. marginal costs (any new costs minus any
  costs saved.)
• The partial budget is therefore much easier to
  work with than two complete budgets, and for the
  purposes of evaluating a proposed alternative, a
  partial budget is all we need.

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• Calculation of costs that vary
• Price for herbicide (/l.) 250
• Application rate (l./ha) 2 liters
• Cost of herbicide (/ha) 500
• Labor wage rate (/day) 50/day
• Time to apply herbicide (days/ha) 2 days
• Cost of labor apply herbicide (/ha) 100
•  
• Labor wage rate (/day) 50/day
• Time for hand weeding 8 days
• Cost of labor for hand weeding 400
•  

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Example A - Partial budget
Alternative Base plan
Herbicide Hand weeding Ave.
test plot yield (kg/ha) 2,400 2,000 Field
yield adjusted down10 (kg/ha) 2,160
1,800 Field price (/kg) 2.25
2.25 Harvesting cost (/kg) 0.20
0.20 Other costs (/kg) 0.05 0.05
Gross revenue (/ha) 4,320 3,600 MR
720 Cost of herbicide (/ha) 500
0 Cost of labor to apply herbicide
(/ha) 100 0 Cost of labor for
hand weeding (/ha) 0 400
Total costs that vary 600 400 MC
200
Gross benefit of each practice 3,720 3,200
MB 520 MARGINAL BENEFIT of alternative
520 (3,720 - 3,200)  
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• The partial budget is the most basic farm
  management tool.
• The partial budget can be used for a wide
  variety of comparisons and should always be the
  first tool to use in any comparative analysis. If
  this tool is not up to the task at hand, one will
  have to go on to a more complex tool, such as the
  complete enterprise budget, or even to a
  whole-farm budget, to solve the problem.

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• Marginal analysis (continued)
• The marginal (or extra) benefit from herbicide
  use is clearly higher than for hand weeding.
  There is a positive economic benefit from the
  alternative, but it would be useful to have some
  way to measure the relative profitability of the
  alternative.
• We could consider the rate of return to the
  extra cash used to implement the alternative and
  compare this rate to that available from other
  uses of the money. We can calculate a marginal
  rate of return using the alternatives marginal
  cost (MC) and the resulting marginal benefit (MB).

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• In the weed control example the marginal revenue
  (MR) is 720, the marginal cost (MC) is 200/ha.
  (600 - 400) and the marginal benefit (MR-MC) is
  520/ha. So for a cost of 200, one will receive
  a marginal benefit of 520, or a net benefit of
  320 (520 - initial 200).
• A good way to assess the alternative is to
  calculate the marginal rate of return (MRR) by
  dividing the net benefit by the marginal cost, in
  this case 320/200 1.60 . For every 1
  invested the farmer will earn a 1.60 profit,
  that is, a MRR of 160.
• Farmers will not usually adopt a significant
  change unless the marginal rate of return is
  greater than 100. This rate of return must cover
  the cost of money (interest) and all the
  perceived risks of implementing the alternative.

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• Step 6
• Is the alternative financially feasible?
• Does this farmer have access to the extra cash
  required to implement the alternative plan?
• A cash flow budget is more useful than a partial
  budget to determine financial feasibility.
• Is the opportunity cost of the alternative too
  high for this farmer?

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• Is the opportunity cost of implementation
  personally too high for this farmer to adopt the
  recommendation?
• What is an opportunity cost?
• If you do one thing, you cannot do the other
  thing. An opportunity cost is simply the value
  of what one has to give up in order to adopt the
  better alternative.

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Example B - Opportunity cost All coffee is
produced on new growth. Pruning coffee will
double the yield of unpruned coffee. In the
first year after pruning, there will be no crop.
In year 2 there will be half a crop Coffee
growing on new shoots (the same as before the
pruning). In year 3 and thereafter the crop will
be at least twice as much as before pruning.
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So, should a farmer prune or not? It is clearly
economic to adopt pruning. However, most Timor
Leste farmers do not prune because their cash
flow will not allow them to go for a whole year
without coffee income. The opportunity cost of
pruning is the lost coffee income of the first
post-pruning year. Government policy and banks
can be especially useful in making an
economically feasible alternative financially
feasible. Growers could implement the pruning
recommendation over a longer period of time to
reduce the impact on their cash flow.
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• Step 7
• Is the perceived risk of the alternative
  acceptable to this farmer?
• Risk refers to a situation in which more than
  one possible outcome exists,
• some of which may be unfavorable.
• Risk is the possibility of adversity or loss
  risk refers to uncertainty that matters.

• Marginal analysis gave us some idea of the size
  of the cushion that is available to absorb the
  risk.
• Break-even analysis is another way to calculate
  the ability to absorb the inherent risk of the
  alternative.

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• To determine the break-even point
• 1.  Determine which one or two variables in the
  partial budget are most likely to vary and cause
  the plan to fail?
•  
•       2. For each of these variables calculate
  how much short of the projection the alternative
  can be and still have the farmer be no worse off
  than he was with his base plan. In short, how
  much extra benefit is necessary to cover the
  extra costs incurred by implementing the
  alternative.

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• In the earlier weed control example the
  increased yield from using an herbicide and the
  price for the crop may not turn out to be as high
  as the farmer had hoped. But one way or another
  the alternatives marginal cost (200) must be
  covered.
• Example C - Break-even yield
• The projected net market price of the product is
  2.00, so the farmer will need to obtain at least
  100 extra kg. (200/2) to cover his extra costs.
  The break-even extra yield is 100 kg. Therefore,
  the total break-even yield is 1900 kg. (1800
  100), assuming the projected 2 price proves to
  be correct.

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• Or lets assume the farmer does achieve the
  2,160 kg. yield he had hoped for, but the price
  drops. How far could it drop and still provide
  enough revenue to cover the extra costs, that is,
  what is his break-even price?
• Example D - Break-even price
• We know he needs to make at least 3,800 (3,600
  200) and we know his yield will be 2,160 kg.
  Therefore, the break-even price is 3,800 2,160
  kg. 1.76.
• This means that the price could drop from 2.00
  to 1.76 and the alternative would at least
  break-even. (However, if the alternative were not
  implemented and the net price dropped to 1.76,
  the farmer would be substantially worse off. And
  the alternative would then become that much more
  attractive.)

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Sensitivity analysis
A simple, interactive Excel spreadsheet offers a
more sophisticated means of assessing risk
dynamically. It involves selecting the two
variables of most concern (often price and
yield) as the vertical and horizontal axis of a
five by five matrix. In each cell the marginal
benefit is displayed for the higher and lower
values of the selected variables. It is easy to
see how sensitive the alternatives benefits are
to variations in price and yield (or which ever
variables are selected.)
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Example E - Sensitivity analysis (using the
earlier herbicide alternative)
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• Other considerations How sensitive would the
  success of this plan be to external variables not
  considered in the partial budget?
• E.g., drought or timing of rainfall, excess
  rain at planting causing need to replant

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• Step 8
• Implement the alternative
• and monitor performance
• (esp. in comparison to original base plan).