[nafex] Nursery econ 101 (long, arcane)

jhecksel at voyager.net jhecksel at voyager.net
Fri Mar 2 20:57:39 EST 2001


So what is a "fair price" for an agricultural product like an apple
tree?

An economist would tell you that a fair price is the variable cost
(rootstock, scion, labor, pesticides) + fixed cost (depreciation of
equipment, taxes, comparable wage for the manager, rent) plus 6% -to-
15% return on assets.  It is doubtful that many nursery owners see that
kind of return.

Paul Hawkins wrote that the market is a wonderfully efficient device for
setting prices but is completely oblivious to costs.  Theoretical
economics says that prices will fluctuate as players enter and leave the
field.  An decrease in demand will cause prices to drop and players will
leave the field.  Fewer players means less product.  Less product means
higher prices.  Eventually an equilibrium will occur.  The same
mechanism works in reverse.  So costs effect prices by way of the
mortality rate among suppliers.

Reality does not seem to reflect theory.  It seems as if the remaining
suppliers increase production to fill the gap and keep prices beaten
down.

My observation is that there are many marginal producers who produce and
sell at their variable cost of production.  Typically, it is some guy
who inherited money and land when Aunt Maude slipped her mortal coil. 
He produces trees with little regard to replacing his tractor,
irrigation equipment etc.  Essentially, he is "mining" his initial
investment (or Aunt Maude's) just like a miner depletes an ore body. 
When it is gone, it is gone.

Else he subsidizes depreciation with a day job and congratulates himself
on how he is outsmarting the tax system.  Eventually, he leaves the
business but is replaced by a guy 15 miles down the road who's Aunt
Sally just passed on.  

The end result is that the market for nursery products are pretty much
pegged at the variable cost of production and the guy who is actually
trying to make a living and tries to treat the business as a going
concern takes a beating.

There are a few other things happening in the background that make the
cost situation murkier.

**************************************

One is that the ground under the business is appreciating.  Economists
are big on "opportunity costs."  They contend that businesses should
liquidate and invest the money in bonds if they cannot make 6% on
assets.  Economists also like to have a risk premium.  So a risky (i.e.,
return bounces around from year-to-year) business like nurseries should
command 10% or more on assets.  That means that the nursery owner should
be getting a *net* profit of $2000/acre on those parcels near the road
that he could sell for $20,000 per acre.  That is profit over and above
the "fair market wage" is extracted to pay the owner/manager.  Yeah,
right.  And pigs fly.

***************************************

An economist would advise breaking the typical small nursery into
separate "cost" centers.  One center would be the actual growing
operation.  They are probably losing money as they can only book
wholesale prices, about $8.50 a tree.  Another center is the retail end
of the business.  They double the "value" of the tree by combining it
with "information", "service" and "entertainment".  A third center might
be the mail order business.  And refering back to the previous
paragraph, perhaps there should be a center for "land speculation".

***************************************

One of the most interesting concepts to come down the pike is Activity
Based Accounting (sometimes called Activity Based Costing).  Traditional
accounting can lead to some large distortions in perceived cost.  These
distortions are exacerbated by product complexity and can be large
enough to make you go out of business.

By way of example, visualize a nursery that produces apple trees and
orchids.  They sell 10,000 of each at $15 each.  The traditional
accountant will take the costs of the greenhouses and divide by 20,000,
the total volume of the nursery.  The orchids end up being subsidized by
the apple business because some cost of orchid production has been
irrationally assigned to the apple trees.  

The manager sees that he is a high cost producer of apple trees but a
low cost producer of orchids.  He increases production of orchids and
reduces production of apples because that is where the parallel universe
of "The Books" tell him the large profit margin is. Pretty soon, more
greenhouse cost (remember, more orchids) is assigned to fewer apple
trees.  The grower leaves the apple business in a couple of years.  And
then leaves the nursery business all together the next.   Simply because
he pursued the most profitable business. 

Activity Based Accounting attempts to assess incremental costs to the
activities that caused them.  Therefore, if the nursery owner built the
greenhouses solely to grow orchids, then ABA would assess the total cost
of the greenhouses against the orchids, as if it were a totally separate
business.

*****************************************

I apologize for the extravagant consumption of bandwidth on a topic that
concerns such a narrow segment of the list.  Sometimes, you just have to
get something off your chest.
-- 

                                               -Joe Hecksel
                                                Eaton Rapids, Michigan


Personal webpage open to the public at
http://my.voyager.net/jhecksel
Criticism welcomed.

 

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