Profitability measures the amount a business earns from its use of labor, management and capital. Oversimplified, profit is what is left over from sales after all production expenses have been paid.

In a stable economic environment, both measuring and predicting output prices, input prices and profits becomes relatively mundane.

Inflation, the pandemic, supply chain disruptions, a tight labor supply, rising interest rates and geopolitical uncertainty make the current economic environment anything but stable. Still, farmers must find ways to navigate their businesses through the choppy seas of instability.

Peter Drucker is often described as the founder of modern management. One of his principles says, “If you can’t measure it, you can’t improve it.”

Fortunately, USDA’s National Agricultural Statistics Service (NASS) has been providing prices paid and prices received measuring aids for more than a century.

Indexes measure changes over time

A price index measures the change in prices from some reference point, or base period, to another point in time. Ideally the base period is one not impacted by inflation or supply chain disruptions. The closer the base period is to the current time, the more value an index may have in predicting future trends. The index reference point is generally one year, but can span multiple years.

Permanent legislation requires USDA to maintain the prices paid and prices received index series using the 1910 to 1914 base period for parity price purposes. In tandem, USDA also provides a more recent base period, which has undergone a number of updates through the years. The 2011 base year (2011=100) is the most recent update. The year 2011 was a favorable year for agricultural growth and profitability.

Two ways to interpret data

Movements of an index from one month to another can be expressed as changes in index values. Using the percent change of an index is more useful to express the movements of the price level. This is because index values are affected by the level of the index in relation to its base period, while percent changes are not.

The prices paid index for commodities, services, interest, taxes and wage rates, labeled PPITW, is a top-level index. NASS constructs it from all component indexes including production, interest, taxes, wage rates and family living. The production index includes feed, livestock and poultry, seeds, fertilizer, agricultural chemicals, fuels, supplies and repairs, autos and trucks, farm machinery, building materials, services and rent indexes. NASS breaks component indexes down further into subcomponent indexes and items. For example, the component feed index has separate subcomponent indexes for complete feeds, feed grains, hay and forages, concentrates and supplements. Items within feed grains are barley, corn, sorghum and oats.

Recent surges squeeze farmers

The July 2022 prices paid index for PPITW was up 12.6% from July 2021 and up 23.8% from two years ago. Production items were up 15.1% year over year. Indexes for interest and taxes are annual averages and are up 3.1% and 3.8%, respectively, in 2022 compared to 2021.

The wage rate index is a quarterly average and is up 3.8% from the third quarter of 2021. For the family living index, NASS uses the consumer price index (CPI) which is a measure of the average change over time in the prices paid by urban consumers for a market basket of goods and services. The Bureau of Labor Statistics compiles the CPI. From July 2021 to July 2022, the all-items CPI rose 8.5%. So, on top of higher production costs, farmers like everyone else, are experiencing higher living expenses.

Understand price vs. expense

Any price index, be it the PPITW or CPI, measures changes in prices only. They do not measure changes in expenses, which are calculated as prices times quantities consumed. While we as consumers can sometimes buy fewer items, buy different brands, buy substitutes, buy smaller packages — or for some items maybe not buy at all — this calculus is much different for producers. How easy is it for crop producers to quickly change expenses for seed, fertilizer, pesticides, fuel, maintenance and labor? Likewise, livestock producers need time to adjust feed, herd health, breeding and labor expenses.

NASS obtains prices paid from establishments that sell goods and services to farmers and ranchers. NASS asks firms to report the price for the specified item “most commonly bought by farmers,” or that was the “volume seller.” Selected individual items represent groups of inputs producers purchase. Approximately 135 items represent all input items. Additional data from the Bureau of Labor Statistics, the Energy Information Administration, the USDA Agricultural Marketing Service and the USDA Economic Research Service are also used in the calculation of indexes.

NASS weights index items by importance

In some cases, a large number of items can make up a small percentage of the index. In other cases, a few priced items must represent many functionally different items such as farm supplies.

NASS uses farm and household expenditure data, obtained through the Agricultural Resource Management Survey or ARMS, to compute the value weights which are measures of the relative importance of items in the prices paid index. These are a set of numbers between zero and one. Value shares sum to unity by definition and are used to weight items, sub-component indexes, and component indexes to obtain higher-level indexes. For 2022, the relative weights for the PPITW index are production items (72.5%), interest (2.2%), taxes (3.2%), wage rates (7.8%) and family living (14.3%).

The PPITW for the crop and livestock sectors are indexes constructed using weights derived from crop farm expenditures and livestock farm expenditures, respectively. These indexes were up 12.7% and 12.5%, respectively, in July 2022 compared to July 2021.

The prices received indexes for grain and oilseed production (think corn and soybeans) and cattle production (including calves, feeder cattle, fed cattle, and cull cows and bulls) are up 20.9% and 16.2%, respectively.

At this point, the prices farmers receive for crops and livestock have risen slightly more than have the prices farms paid for inputs. Of course, this isn’t the case for all farms and hasn’t been always the case. Economic pressure continues as input prices have surged and commodity prices have been volatile and lagging cost increases at times.

Feeder cattle prices reflect outside market forces

Feedlot managers understand how cattle characteristics like weight, lot size, frame, muscling, gender and breed impact feeder cattle prices. Secondary impacts from related markets also impact prices. Previous research has disentangled some of these impacts.

Diesel fuel prices impact transportation costs to get feeder cattle from auctions or off the farm to a feedlot and therefore affect feeder cattle prices. Research on Iowa feeder cattle auction sales shows that a 10-cent-per-gallon hike in diesel fuel price is associated with a 20-cent-per-cwt dip in calf price. Without an offsetting rise in fed cattle prices, or decrease in something else, feedlots have no choice other than paying less for calves. If all other factors held steady, the roughly $2-per-gallon rise in diesel fuel prices from July 2021 to July 2022 resulted in feeder calf prices that were $4 per cwt lower than they would have been.

Other market characteristics like fed cattle prices and corn prices help determine what a buyer “can pay” for calves. Research on Wisconsin feeder cattle auction sales shows that a 10-cent per bushel hike in corn prices is associated with a 70-cent-per-cwt decrease in calf price, assuming all other factors remain the same. This would be the impact for a 700-pound feeder steer. The impact is greater at lighter weights because feedlots must put on more pounds of gain, which takes more bushels of expensive corn.

Schulz is an Extension ag economist with Iowa State University.