Adopting Alternatives

1. Adopting Alternatives A methodology for improved economic decision-making in enterprise management

2. 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.

3. 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 alternativeplan). This is an iterative process, comparing the base plan to one alternative at a time.

5. Step 1: Monitor the base plan & identify a problem

6. Step 2: Consider all alternative solutions (“brain-storming”)

7. Step 3: Is the alternative compatible with this family’s values & thisfarm’s 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.

8. 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?

9. 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.

10. 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.

11. 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.

12. 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

13. Example A - Partial budget: Alternative: Base plan: HerbicideHand 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)

14. 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.

15. 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 alternative’s marginal cost (MC) and the resulting marginal benefit (MB).

16. 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 netbenefit 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.

17. 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?

18. 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.

19. 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.

20. 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.

21. Step 7: Is the perceivedrisk 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.

22. 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.

23. 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 alternative’s 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.

24. Or let’s 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.)

25. 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 alternative’s benefits are to variations in price and yield (or which ever variables are selected.)

26. Example E - Sensitivity analysis:(using the earlier herbicide alternative)

27. 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

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