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Chapter 3. Private Profitability Analysis: The PAM’s First Row
. The chapters are, for the most part, entered into separate worksheets whose names show up as tabs along the status bar at the bottom of the Excel page. This procedure helps keep track of the various components of the PAM computations and facilitates sensitivity analysis. The tabs also provide a visual reminder of the logic of the calculation sequence.
Single Commodity Private Price Budgets
The commodity budget used in this initial example is based on rice. Production and price data are used to calculate the returns to high yielding paddy in Indonesia’s wet season. The area in which the rice is grown is assumed to have good water control. The physical components of the budget are laid out in the Input-Output table shown in Table 3.1
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The level of disaggregation depends on the data available. Disaggregating as much as possible makes it easier to do sensitivity analyses later on. Subsequent tables provide data on private prices and compute the commodity budget at private prices.
To create the table on a spreadsheet, start a new a workbook (file) and “rename” (right mouse button) the first worksheet tab to “C3-P-Budget” (no quotes). Type in the labels and data for Table 3.1. After constructing the I-O table, select the table and copy it below itself. Label the new table Table 3.2. Private Prices. Make the necessary changes in the labels and units.Type over the cell values to enter data for prices instead of physical input-output coefficients.
Copy Table 3.2 below itself, and identify the new table as Table 3.3. Private Prices Budget. Make the necessary changes in the labels (units).
Compute the cells in Table 3.3, the Private Prices Budget table, by multiplying the elements of the Prices table times the elements of the I-O table. To minimize typing as much as possible, compute the first cell, either by typing in the formula or by creating it with the aid of the mouse, then drag the formula down across the other rows. (The first element might be something like =C4*C31; this becomes =C5*C32 in the second row, etc.)
Because the tables have the same number of rows, the value for all elements of High Yield paddy up to and including Total Revenue, can be obtained by copying. (If you are unclear about how to copy in Excel, look up the topic under Excel Help.)
The Private Prices Budget contains three additional rows, Total Costs, Profits, and Net Profits. To compute Total Costs excluding Land, write a formula that sums the relevant cost elements, i.e., Urea through Thresher services. (e.g., =SUM(C56:75). To compute Profits (excluding Land), subtract Total Costs from Total Revenues. To compute Net Profits (including Land), subtract Land from Profits (excluding Land).
The distinction between profits that include or exclude returns to land is important. Whereas rental values can be observed and included in a private budget, the same is not true for social budgets. “Land is unique because it is the only truly fixed factor in agriculture. In suburban locations, agriculture might not be the only use for land, and prices and rental values will be influenced by off-farm opportunities. But in most areas, the only alternative to agricultural use is no use at all (if forestry is included as an agricultural activity). In these cases, land acts as a residual claimant on the profits from farming.”1
Save the three-table file under the heading: PAMTutorial.
With these calculations, we are now in a position to complete row 1 of the PAM. The figures, drawn directly for the numbers in Table 3.3, are as follows:
Sensitivity Analysis
It is often helpful in farming systems analyses to do a sensitivity analysis of the most important parameters. What happens if:
1) Fertilizer prices increase by 50% from their present values?
2) Fertilizer prices remain at their original values, but all labor costs double?
3) Paddy prices increase by Rp25%?
4) Yields increase by 25%.
Questions
1. Which of type of change has the greatest impact on farmer incentives: input prices, output prices, or productivity? Why?
Changes in the costs of inputs have much smaller effects on profits than changes in the prices of outputs because each input makes up only a fraction of the cost, whereas the output price applies to the whole of revenues. Likewise, changes in productivity also apply to the whole of revenues.
2. What are the implications of this kind of sensitivity analysis for data collection efforts? If resources for research on agricultural policy are scarce, do these results suggest the types of empirical work a ministry or planning unit ought to focus on?
The results of the sensitivity analysis strongly suggest that the highest research priority is to obtain the best possible data on output prices and yields. The next highest priority would be the largest item in costs, say, labor. Only after the larger cost items have been determined should minor costs be investigated. The “what-if” feature of spreadsheets makes it possible to determine quickly exactly how much impact a particular price has on the overall results. Efforts to improve the database can be organized accordingly.
3. In many countries, different government agencies administer output and input prices. What are the policy implications of these results for farmer incentives?
The total effect of all price and production policies influences farmer incentives to grow crops -- the farmer responds to changes in profitability, regardless of the source of these changes. Given the possibility that various policies could amplify or counteract one another, it is essential that different government agencies coordinate their efforts to ensure consistency.
Appendix 3.1. Estimating Capital Recovery Costs
Including the opportunity costs of fixed capital in the PAM analysis is somewhat awkward in a budgeting framework where the focus is on annual variable costs and not on fixed costs. However, over the usual lifetime of policies being analyzed, farmers make decisions about investment items whose costs are fixed. Failure to include annualized fixed input costs in some form would lead to distortions, not only in decisions about durable capital goods, but also in the selection of crops and technologies.
As Monke and Pearson note in the text (pp. 139-141), one simplified, but incomplete, way to find the annual cost of a fixed input would be to divide its initial cost by the life of the input. This same method can be used to apportion the annual cost between different commodities, i.e., each crop could be debited in proportion to the time the fixed inputs were used in its cultivation. However, this approach ignores the opportunity cost of the capital tied up in the fixed input. The farmer could have banked the money rather than investing in a fixed production asset. The true cost of the capital, therefore, is the annual cost plus the interest on the embodied capital. This fixed input charge is then apportioned to the various commodities serviced by the investment item.
Estimating Capital Recovery Costs
Estimating capital recovery costs requires several steps. The first is to gather the information on the cost of recovering the capital from an investment. This includes the initial cost of the investment (in private and social terms), an estimate of the useful life of the machinery, its salvage value, and the total number of "horsepower" hours it is expected to provide. The initial cost and useful life of the machine represent the two most important parameters of the capital cost recovery calculations. After its useful life has expired, the machine may still have a salvage value as scrap and a source of parts. The salvage value is received several years in the future and, therefore, must be discounted using data on the private and social interest rates found in the existing Prices tables. It is then deducted from the initial cost to derive today's net cost.
Perhaps the most complicated derivation is the recovery ratio, which involves adjusting the interest rate by the life expectancy of the investment. As defined by Monke and Pearson, this is the share of the net cost that must be recovered each year "to repay the cost of the fixed input at the end of its useful life." Once the recovery ratio is determined, the actual monetary sum is calculated. This figure, the annual recovery cost, is then prorated to an hourly basis.
In the current chapter, these steps will be followed to incorporate the capital recovery costs of one particular investment: an irrigation pump. In reality, the farmer may own other implements that would require such accounting in the budgeting process such as the tractor or a thresher.
Modifications to the Spreadsheet
Creating the Capital Recovery Cost Table.
- Write the assumptions, shown in bold in Table 3.1.1, into the table: Initial Cost, Useful Life, Salvage Value, and Total Horsepower Hours.2
- Fill in the private Interest Rate cell by writing a formula that references the interest rate in the first column of the Private Prices table. Follow the same procedure for the Social Prices table. These steps integrate the spreadsheet so that subsequent sensitivity analysis on the interest rate will require the alteration of only one cell.
Cell address of salvage value/ (1 + cell for interest rate ) ^ cell address for useful life
(^ is the character for exponentiation.)
- Calculate the Recovery Ratio using the formula:3
((1 + i) ^ useful life * i)/ (((1 + i)^ useful life) -1)
In many developing countries manufactured equipment is often wholly or partially imported. It then must be treated like any other input. The tradable components must be valued at international prices, which are in turn converted to domestic prices using the equilibrium exchange rate. The nontradable factors used in its domestic manufacture or assembly must be valued at their shadow prices.
Modifying the Input-Output, Prices, and Budget Tables.
The structure of the Input-Output, Private Prices, Private Budget, Social Prices, and Social Budget tables are each modified in an identical fashion, by inserting a new row in the capital section. Data are then linked from the newly created Capital Recovery table. It is easiest to complete all structural and data changes on each table before progressing to the next. A sample drawn from the I-O table is shown in Table 8.2. Consistent with the original design of these tables, the units of measure depend on the table.
- Go to the Private Prices table. Add a line for the water pump under the capital section in the same way that it was added in the Input-Output table. In the first (leftmost) pump cell, enter the absolute address of the Recovery rate per HP-hour in the private prices column in Table 7.1. Copy the formula across the row.
ave the workbook as PAMTutorial.
Sensitivity Analysis
What effect does a change in the social interest rate from 12% to 20% have on capital recovery costs? To 5%?
Further explanation can be found on pp. 207-209 in Monke-Pearson.
Total hours is annual machine capacity in hours. Using the capacity of the machine as the denominator seems preferable to the practice of computing percentage of use on the basis of total hours actually used. The latter depends upon the choice of a cropping pattern and thus is a function of the entire cropping system. By using capacity, the denominator becomes exogenous. The assumption that there is no surplus machine capacity in the sector also seems more consistent with the long run concerns of the PAM analysis than using total actual hours.
Monke and Pearson derive the formula used to compute the capital recovery cost factor on p. 140 of their text.
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