January 30, 2023
Strong net farm income in the last couple of years means the liquidity position of many farms has improved substantially. If this describes your farm, is it a good time to expand your operation?
Start by thinking about reasons for farms to expand in the first place. Possible reasons may include reducing per-unit costs, improving profit margins, improving asset utilization, bringing in new family members, investing retained earnings and more fully utilizing skills of key managers.
Economies of size
Reduction in per-unit costs and improvement in profit margins and asset utilization are related to economies of size. As farms become larger, fixed costs per unit of production decline. These fixed-cost declines are typically related to machinery, equipment and labor costs. In addition, as farms expand, they are often in a better position to purchase and adopt new technology. These technologies often reduce per-unit machinery and equipment costs and improve labor productivity.
Farm growth is a consequence of reinvesting retained earnings. The relatively larger operating profit margins per unit of output, combined with higher output levels, allow larger farms to reinvest more of their earnings into the business. For many small and medium-sized farms, salaries, withdrawals and payouts to the business owners and managers typically account for a relatively high percentage of the farm’s annual earnings. That results in fewer funds that can be used to reinvest in the farm business.
The larger absolute amount of retained earnings for larger-scale farms means that larger-scale farms can acquire more resources and increase their output more rapidly than a smaller-scale business. A smaller-scale business may need to use most of its earnings to support withdrawals or payouts to managers.
Expanding to better use talent
Besides economies of size, there are many other reasons why farms expand. Many managers are motivated to expand their businesses to provide more opportunities to employ the skill sets of an increasingly capable management team or to bring in another family member or key employee. Growth often allows managers to focus on one or two aspects of the business rather than trying to manage all aspects of the business.
Growth can also allow a farm to capture what is called “pecuniary economies of size.” These economies of size may relate to input purchases and output sales. Larger farms often can purchase inputs, such as seed, at a relatively lower per-unit cost and sell products at a relatively higher per-unit price. In addition, buyers of products often prefer to do business with fewer firms. So, they often will provide preferred supplier incentives to businesses with larger and growing volumes.
Expansion could help you move from a smaller or midsize business to one in a class-size category higher. This could help you take advantage of some of these pluses that usually accrue to larger businesses.
Langemeier is a Purdue Extension agricultural economist and associate director of the Purdue Center for Commercial Agriculture.
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