How to define an opportunity

How to define an opportunity

When confronted with an opportunity, identify the alternatives and then analyze the trade-offs

Economic decision-making is the analysis of trade-offs. We'll use a common situation to illustrate the thought process.

Suppose you have excess machinery capacity. You explain to your spouse or business partner that a logical way to more fully utilize the equipment is to cover more acres. That's the opportunity. Doing so will spread fixed costs of the equipment over more acres or bushels, which lowers cost per acre or bushel, reduces your breakevens, and boosts efficiency.

You identify four ways to access more land:
• buy it
• crop share rent it
• cash rent it
• use a flexible cash lease

More effective utilization of equipment is an opportunity, but what are the alternatives and trade-offs?

Relative to the other three alternatives, buying land ties up a lot more capital, commits more of your borrowing capacity that may be needed elsewhere later and is a long-term commitment.

Related: Farm manager's notebook: Reasonable cash rents ahead?

Owning more land boosts your exposure to land market variability. That's a plus in a rising market – you capture the land value appreciation. It's a drawback in a weakening market. You lose value, plus slumping values hike your financial leverage. Those are some of the trade-offs.

Cash-renting commits more of your operating line of credit than does a crop share lease, which ups your risk exposure relative to the crop share lease. But you get all of the production, which positions you to pocket more profit from your superior marketing skills.

Cash rent puts more profit in your pocket from good yields and prices than does a crop share lease. But it saddles you with more financial risk should yields and or prices fall short.

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A crop share landowner furnishes the land, which dramatically reduces the amount of cash you need to come up with relative to the cash lease. The owner gets a share of the crop, which reduces your risk exposure to poor yields and low prices. But the landowner gets a sizable slice of the production from your superior production skill. Plus, you only get to market a portion of the crop to take advantage of your superior marketing skills.

Related: What’s Driving Decision-Making on Your Farm?

Flexible cash leases are gaining popularity. The operator pays all production expenses. The cash rent flexes with gross revenue. The range over which the cash rent can flex typically has a cap and a floor. A flex lease boosts owner's income in good years. It trims the operator's financial risk exposure in poor years.

Now crunch the numbers
Once you identify the trade-offs and directions that they push costs, potential production, possible revenue and risk position, you are ready to start applying numbers in your cash flow and projected profit-and-loss analysis of the trade-offs associated with the various alternatives.

Differences exist in farm program participation and crop insurance among the options. You need to consider them in your analysis of trade-offs and number-crunching.

Otte writes about farm management from Iowa

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