Classification of Inputs and Outputs

The budget of output revenues and input costs provides the organiza-tional framework for data collection and the construction of a PAM. A budget is constructed for each activity of the system. Data collection begins with compilation of an inventory of inputs and outputs for each activity. These items are categorized, quantified, and priced, first in private and then in social terms. The costs and returns of each activity

Box 8.1. Selecting Representative Wheat Production Systems in Portugal Portuguese wheat production occurs in three agroclimatic zones: the Alen-tejo, a hot, dry, rainfed area with large, mechanized farms; the Ribatejo, a neighboring region with a somewhat cooler climate, better-quality soils, exten-sive irrigation, and a high degree of mechanization; and the Tras-os-Montes, a region with a cooler climate than that of the Alentejo, limited irrigation, and a range of mechanized and animal-intensive production technologies. Prelimi-nary inspection of production systems in the various regions revealed a large number of potential representative systems. In the Alentejo, the most promi-nent differences in wheat production were those associated with the four soil qualities that are recognized in the soil type classification used in Portugal. In the Ribatejo, both rainfed and irrigated production technologies were present. Rainfed systems again differed by soil quality. Irrigated systems used either sprinkler irrigation or groundwater pumping into a furrow delivery system. In the Tras-os-Montes, production systems were primarily rainfed, differentiated by the use of animals versus tractors for land preparation and by soil quality. In total, twelve representative systems (four from each region) were considered as potential candidates for PAM analysis.

Only three systems actually were selected. How was this reduction achieved? In the Alentejo, the decision was made to model representative systems for high-quality (A-B) and low-quality (C-D) soils. In the Ribatejo, rainfed systems appeared very similar to the Alentejo systems; thus rainfed system models for the Ribatejo were judged redundant. Although irrigation technologies were different, preliminary analysis indicated that their effects on profitability were relatively minor. The decision was made to use the sprinkler irrigation technol-ogy as the representative irrigated-wheat system. The Tras-os-Montes tech-nologies and profitabilities were quite different from those of the other regions, but the region's production was only a small percentage of total national output. For this reason, the Tras-os-Montes systems were left out of the final evaluation, allowing increased attention to data collection for the other repre-sentative systems.

Portugal joined the European Community in January 1986. The policy issue for wheat analysis involved assessment of the impacts of the Common Agricul-tural Policy (CAP) prices on Portugal's wheat sector. This assessment provided the rationale for ignoring the less productive region. But different policy issues could have generated a much different set of representative systems. If the concern had been low-income farmers, for example, the Ribatejo and much of the Alentejo would have been excluded, and principal attention would have focused on the Tras-so-Montes and parts of the poor-soil Alentejo. If the policy issue had involved subsidies for irrigation water, attention would have focused largely on the Ribatejo. There, distinctions between irrigation technologies would have been crucial in the designation of representative systems.

Fixed Inputs

Budgets are made up of costs and returns on an annual (or single crop) basis. However, fixed inputs have a useful life of many years, and only a portion of fixed input costs should be attributed to a particular year's production. A simple approach is to divide the cost of the fixed input by the useful life of the input. But that calculation ignores the need for capital expenditures to earn a rate of return on the investment. For example, if a wheat farmer did not buy a tractor, the money could have been invested in some other on- or off-farm activity. If this potential investment could earn a positive rate of return, the tractor investment must earn at least an equal return.

The annual equivalent value for a fixed input is known as the capital recovery cost-the annual payment that will repay the cost of a fixed input over the useful life of the input and will provide an economic rate of return on the investment. The derivation of capital recovery cost can be illustrated in a few steps. A is defined as the annual payment sufficient to repay the cost, Z, of the fixed input, at the end of its useful life of _n years. If one puts amount A into an investment earning rate of return i, the total value of one's annual payments at the end of the fixed input's useful life will be

The term A(1+i)_n-1 is the value of the initial deposit at the end of _n years, the term A(1+i)_n-2 is the value of the second deposit at the end of n years, and so on until the end: the term A(l), which represents the value of the nth year payment. This formula calculates the amount of capital necessary to repay the cost of the fixed input.

Because the fixed input is required also to earn a positive rate of return, the necessary value of the output produced by the fixed input is not just Z but Z(1 + i)_n. Therefore, the annual cost-equivalent calculation is expressed by

This expression can be altered by a rearrangement of the terms to

The above equation can be written as

The bracketed term on the right-hand side of equation 4 is the capital recovery factor. By applying this factor to the purchase price of the fixed input, the analyst can calculate the annual equivalent value for any fixed input.

Annual equivalent values also depend on initial capital cost (Z) and useful life (n). Replacement cost is used as the estimate of initial capital cost to maintain consistency with the long-run perspective of the PAM. Existing firms utilize many different vintages of capital equipment; as a result, fixed costs may vary substantially among firms. But capital stock must be replaced eventually, and current costs of fixed inputs become important to the continued operation of the firm. Useful lives of fixed inputs vary among firms as well, depending on intensity of use as well as owner maintenance practices. Equipment dealers and construction firms can be good sources of information about useful life. Rough rules of thumb can be used when no better information is available: build-ings, 30 to 40 years; machinery, 10 to 15 years; and small machines and tools, 5 years. Box 8.2 provides some examples of the calculation of annual equivalent values for wheat production inputs in Portugal.

Direct Labor

The second category of inputs, direct labor, covers all labor directly employed in the activity. Both hired and family labor resources are included. If the analyst wants to make a distinction between family and hired labor, these inputs can be entered as separate lines within the labor

Box 8.2. Calculating Annual Equivalent Values of Fixed Inputs

The calculations needed to determine the annual equivalent value of a fixed input are slightly more complicated than is indicated in the text. First, the fixed input may have some salvage value when its useful life is ended. Because salvage value is realized at the end of the useful life, estimates of salvage value are discounted to the present before the net total cost of the fixed input is deter-mined. These calculations are illustrated here for a tractor, tractor accessories, and a thresher in wheat production in Portugal. The rate of return used is 2 percent.

			Salvage	Present value of	Net initial
	Initial cost		value	salvage value	cost
	(thousands	Useful	(thousands	(thousands of	(thousands
	of escudos)	life	of escudos)	escudos)	of escudos)
Input	(a)	(years)	(b)	(c)	(a -c)
Tractor	1,366.70	10	268.00	219.85	1,146.85
Plow	122.50	15	24.78	18.41	104.09
Disk	217.30	15	43.56	32.36	184.94
Planter	397.30	15	82.00	60.93	336.37
Thresher	3,482.10	10	374.10	306.89	3,175.21

A second complication for the calculation of annual equivalent values arises when the fixed input serves a larger number of units of the activity than are covered in the budget. A farm-level budget, for example, may be expressed in terms of costs per hectare, whereas the fixed input serves much more than one hectare during each year of its useful life. Only a portion of the annual equiv-alent costs of the fixed input should be allocated to the per hectare budget. These allocations are determined here for the five fixed inputs used in wheat production.

	Hours per hectare	Hours per year	iPer hectare share of annual use
Input	(d)	(e)	(d/e)
Tractor	10.1	1,000	0.0101
Plow	3.0	250	0.0120
Disk	2.0	250	0.0080
Planter	1.0	125	0.0080
Thresher	2.0	400	0.0050

The annual capital cost per hectare is determined by the product of the net initial cost, the capital recovery factor, and the per hectare share of annual use, as is shown here.

		Capital	Share of
	Net initial cost	recovery factor	annual use	Annual capital cost
Input	(f)	(g)	(h = d/e)	(f g h)
Tractor	1,146.85	0.111327	0.0101	1.290
Plow	104.09	0.077825	0.0120	0.097
Disk	184.94	0.077825	0.0080	0.115
Planter	336.37	0.077825	0.0080	0.209
Thresher	3,175.21	0.111327	0.0050	1.767

category. Similar distinctions may be made between male and female laborers and laborers of different ages and skill levels. Again, separate line entries within the direct labor category provide a way to maintain an advantageous organization of the data.

The category does not include all the labor used by the system, because some labor will be indirectly employed as a consequence of the use of intermediate inputs by the activity. If a farm activity uses im-ported fertilizer, for example, the labor used to handle and transport the fertilizer to the farm gate is an indirect employment effect of the farm activity. Keeping separate the direct labor inputs facilitates the analysis of employment effects of the system; this topic is often of interest in policy debates about particular commodity systems.

Intermediate Inputs

The third category of inputs, intermediate (variable) inputs, are char-acterized by a useful life of less than one year, viewed from the perspective of the representative firm. Examples of items included in this category are seeds, fertilizer, pesticides, fuels, and lubricants. But also relevant are the rentals of capital equipment services, such as custom plowing, custom harvesting, pesticide application, and transportation services. Ultimately, many of these costs will be categorized as capital costs, but the valuation and analysis of these costs will often be different from those used in the evaluation of fixed inputs owned by the activity.

Commodities in Process

The final category of input is commodities in process. This category covers the commodity of interest for the PAM and is included only as an accounting convenience. Because profitability is calculated for each of the activities, the principal output of the commodity system appears several times in the budgets of the system. In a wheat flour system, for example, wheat is the principal output of the farm activity. Wheat is the commodity in process for the farm-to-processor activity and the processing activity. Wheat flour is the commodity in process for the processor-to-market activity. Inclusion of the wheat cost within each activity is necessary for calculation of activity profits. In the transport of wheat from farm to processor, for example, the purchase price for wheat at the farm gate and the sales price for wheat at the processor's mill are observed (or imputed). Similar calculations follow for evaluation of the processing activity (buying wheat and selling wheat flour)

and the processor-to-wholesale-market activity (buying wheat flour from the mill and selling wheat flour at the wholesale market point). In evaluation of the system costs and revenues, however, only the incremental costs of production from the postfarm activities are counted. Wheat flour production costs are the farm-level costs of wheat production; the transportation, handling, and storage costs of the farm-to-processor activity; the processing costs net of wheat for the processing activity; and the transport, handling, and storage costs of the processor-to-wholesale-market activity. If the analyst were to include the wheat costs in the aggregation of postfarm activity costs, the system costs would include two units of wheat and one unit of wheat flour, whereas system revenues would show one unit of wheat flour. Such calculations are clearly erroneous. When a separate category in each postfarm activity is kept for commodities in process, the relevant costs are easily aggregated to the system-level evaluation.

The input categorization process described here is not intended to be rigid. Alternative categorizations of inputs may be better suited to particular evaluation problems. Whether the input is included in the direct labor category or in the intermediate input category makes no difference to the final result. The critical aspect of the evaluation process and the construction of PAM is that all inputs should be included somewhere in the budgets. Without a comprehensive account of inputs, production costs are underestimated, biasing the results in favor of more positive private and social profitabilities.

Outputs

Revenues, the final category of the activity budget, cover all outputs of the activity. The commodity of interest is designated the primary output and is listed first in the category list. All other outputs are called secondary outputs and are entered on subsequent lines of the list. These designations are entirely arbitrary; secondary products can be as important as or more important than the primary product as sources of revenue for the activity.

The categorization reflects the particular focus of the research project. Whether or not the outputs are marketed makes no difference to the budget calculation. The distinction for a valuable output is that it has some productive value to the activity. This value can be gained through sale or use elsewhere in the activity. Meat production systems, for example, often generate manure that is used to fertilize crops. The budget for meat production must impute a value to the manure, so that total revenues properly reflect the value of meat (and manure) production to the farm.