As an undergraduate majoring in accounting, I took a few agricultural economics courses because I had been advised that the ag econ department taught “common sense” economics as opposed to the theoretical brand taught by the economics department. Yes, I’d have to say that I gained a better appreciation of economics from my ag econ courses. But there were still some “odd” concepts taught in ag econ.

One concept I had trouble understanding was that net farm income was the economic return to unpaid labor and capital. As an accounting major, I was inclined to conclude that a positive net farm income indicated that things were going well from a profitability standpoint. But my farm-management instructor pointed out that was not necessarily the case.

Earning a positive net farm income is one thing. But the real goal is to earn net farm profits that equal or exceed the returns that labor and capital resources could earn in their best alternative uses. This is the economic concept of opportunity cost, which, in essence, says that committing resources to one activity — say farming — comes at the “cost” of the returns that could be earned from another activity.

I’ve explained the issue of returns to unpaid labor and capital because dairy-farm managers need to remember that net farm income by itself is not a reliable indicator of a farm business’ performance. You need to look deeper.

Make the comparison

Let’s compare two dairy farms that both earn a net farm income of $50,000. The first farm, named Two Century Farm, is debt-free and has a net worth of $500,000. The second farm, named New Start Farm, is a start-up dairy with only $100,000 of equity.

Both farms earn the same level of net farm income, but, as the chart at right shows, they do not yield the same returns to labor. Once you take out the 5 percent return to capital for each farm, Two Century Farm generates $25,000 of returns for 2,500 hours of labor, while New Start Farm has a total return to labor of $45,000 for 2,500 hours of labor. The differences in the return to labor indicate that New Start Farm is yielding a higher rate of return to labor than Two Century Farm. Therefore, we would say that New Start Farm is performing better than Two Century Farm because it is yielding higher returns to labor.

Opportunity cost

This example shows that evaluating the performance of farms solely on net farm income does not tell the whole story.   In this particular case, the low-equity farm was actually the higher-performing farm because it paid the same return to capital (5 percent), but had a higher hourly return to labor than the high-equity farm. Without considering the capital positions of the farms, we would most likely — and wrongly — conclude that these two farms are performing at the same level.

In order to effectively manage their operations, dairy-farm managers need to remember the concept of opportunity cost. It is not enough to generate returns for labor and capital. These returns to labor and capital must at least be as high as the returns these resources could earn in alternative uses. If not, then the labor and capital committed to dairy farming incurs an economic loss.

Bruce Jones is a professor of agricultural economics and extension farm-management specialist at the University of Wisconsin-Madison.