… when debate or queries arise about the validity of the gross margin (GM) in decision analysis, then the GM is not the correct technique. Almost always, in such cases, what is needed is partial and whole farm budgeting, not simple GM analysis. Often, GMs are asked to do far more than they were intended for or are equipped to do. Widespread misuse of the GM concept and technique has lead in some quarters to the gross margin earning the unflattering title ‘the gross illusion’. (Makeham and Malcolm 1993, p.338)
One rationale for water reform is that some water could be used more productively than in its current use. For example, removing impediments to trade, an important element of water reform, allows the opportunity cost of water to become evident and may reveal opportunities for more productive uses by irrigators and others. Policy makers considering the impacts of lifting trade restrictions are interested in the benefits from liberalising trade as well as the regional and sectoral impacts.
In some cases, unadjusted activity gross margins for various irrigated enterprises have been compared to highlight potential gains from water reform. Irrigated farming activities with higher gross margins per hectare and/or per megalitre of water use (such as premium grapes and vegetables) have been portrayed as activities to which farmers operating lower gross margin activities (such as rice and irrigated pasture) will move, and to which water should be traded.
The purpose of this note is to highlight the dangers of using activity gross margins to measure future net economic benefits from shifting irrigation water use between different farming enterprises. Gross margins can be useful as a farm management tool for considering the contribution of a particular farming activity to total gross margin, or for comparing similar production options — for example, whether planting long-grain or medium-grain rice will give a larger gross margin. They are not a good guide for reallocating water between farming activities or enterprises using different resources.
Three reasons why gross margins per megalitre are not a useful indicator of the benefits of water reform are discussed. First, gross margins per megalitre are an average rather than a marginal measure of the productivity of water. Second, when considering productivity, other inputs used by the irrigators such as capital and labour also need to be included. And third, gross margins per megalitre usually do not capture the price volatility that can characterise agricultural commodity markets.
The gross margin for a farming activity is the difference between the gross income earned and the variable (direct) costs incurred and is probably the most commonly used measure in farm analysis and planning (Makeham and Malcolm 1981, p.71). Gross margins are normally expressed in relation to the farmer’s most limiting short term constraint, usually land. Gross margins are also sometimes expressed in terms of other inputs such as gross margin per cow or per megalitre of water used. Many published activity gross margins are prepared by State Agriculture departments (see Box 1).
Box 1. Gross margins for rice production, Murrumbidgee Valley
NSW Agriculture annually publishes crop and pasture gross margin budgets for typical activities. The budgets presented are based on average production and assume management according to regimes suggested by District Agronomists for the region.
For a typical long-grain aerially sown rice activity in the Murrumbidgee Valley in 2004, the gross revenue is $2867 and variable costs are $1113 per hectare (NSW Agriculture 2003). Thus the gross margin per hectare is $1754. It is assumed that this typical farm requires 13ML of water per hectare which costs an average $25 per ML. The gross margin per ML of water used is $135, which implies growing rice would become unviable as the average price of water approaches $160 per ML.
Gross margins are calculated for different types of grain and planting options (sod versus aerial sown rice) in the district. For example, gross revenue for medium grain aerially sown rice is $2910 and variable costs $1157 per hectare, giving a similar gross margin per hectare of $1753. However, this requires 14ML of water per hectare and results in a gross margin per ML of water used of $125.
Source: NSW Agriculture 2003.
Gross margins may relate to an activity or to the entire farm enterprise. In a mixed farming system, an activity gross margin is dependent on all of the other activities that also take place — the activity gross margin may be unique to the activity, or to a chosen mix of activities within the farming enterprise.
The benefit to an irrigator of using an extra unit of water depends on the change in production from using the water; the price received for the production; the cost of the extra water and the costs of any additional inputs that are associated with using the water.
A gross margin per unit of an input used does not imply that using more (or less) units of the input would lead to a change in gross margin in proportion to the change in that input. In the example in Box 1, the activity gross margin for aerially sown long grain rice was reported as $135 per ML of water used. Applying an additional megalitre would not increase the gross margin by $135. If the mix of inputs specified in those activity gross margins were near optimal for the agronomic conditions described, a marginal change in the specified quantities of an input should reduce the gross margin. For example, applying more water than specified is likely to increase marginal costs by more than the corresponding increase in marginal revenue. Similarly, applying less water than specified is likely to reduce marginal revenue by more than the corresponding decrease in marginal costs.
If all other inputs are held constant, the increase in production from applying an extra unit of water is the marginal product (MP) of the water. For example, a rice farmer may use extra water to increase the yield of a rice crop while a dairy farmer may use extra water to grow more pasture to produce extra milk. Typically, at some point, the MP falls as more units of water are added. Beyond some threshold, additional units of water can reduce production — the MP can be negative. The value of the marginal product (VMP) of water is determined by multiplying the MP with the price of the output (such as rice or milk). Assuming there are no changes in other costs, the VMP is the gross benefit to the irrigator from an extra unit of water.
Individual irrigators will only find it profitable to use an extra unit of water on a given crop if the marginal benefit (VMP) is greater than the marginal cost. Depending on the situation, the marginal cost of water may be the price at which an extra unit of water can be bought or sold, or it may be the lost VMP of water in another activity within the farming enterprise if the farmer diverts water from it.
Although VMP is difficult to measure, this is the best estimate of the value of additional water (or less water) use on-farm or elsewhere. It is also the best estimate of the value to the Australian economy of more or less water being applied to various uses. If an input, for example water, has a low VMP in one use and a high VMP in another, national output would be increased by transferring water from the low productivity use to the higher productivity uses (if the difference in VMPs exceed the costs, for example of transport of water between uses). National output is maximised when VMPs of all factors of production (land, labour, capital, water etc) are equal in all uses.
Gross margins per megalitre do not provide information about the VMP of water. Even if the VMP of water were equal across uses, we would expect to still see large variations in gross margin per megalitre. Grape production, for example, may have a higher gross margin per megalitre than dairying even after water has been optimally allocated between grapes and dairying.
While it is possible to build gross margin models that are based on physical production functions, most published gross margins for farming activities (sometimes referred to as activity gross margins) are based on a ‘snapshot’ of a production function and assume a specific mix of inputs and expected outputs for representative farm types. The activity gross margin is derived by multiplying specified quantities of physical outputs and inputs by their respective prices to estimate the net revenue. Published activity gross margins therefore do not capture the physical relationships between the various inputs and outputs. This means that most published activity gross margins do not provide information about the marginal costs and benefits of changing the quantity of any input, including water.
The marginal costs and benefits of using a particular input change during an irrigation season. For example, once an annual crop is planted, the irrigator’s decisions are restricted (in the normal range of events) to controlling the inputs to that crop so as to maximise revenue. In the normal range of costs and revenues, in the short run the irrigator will try to maximise marginal revenue less the marginal costs still to be incurred. The irrigator will continue production of the crop as long as marginal revenue exceeds marginal costs still to be incurred. As the growing season progresses, more and more of the costs become sunk costs. The final decision to be made is the decision to harvest. This will be done as long as the revenue from harvest exceeds the harvest and post-harvest costs.
In the example presented in Box 1, the average gross margin was $135 per ML of water used. This implies that if the price of each ML of water increased by more than an average of $135 per ML over the average utility price of $25 per ML, the irrigator should not plant because they would expect to lose money. However, it should be remembered that irrigators can obtain water from both water utilities and other irrigators, and therefore may pay different prices for irrigation water from different sources. For example, assume that an irrigator needs 1 000 ML of water to plant their crop, and that it becomes relatively unprofitable to grow rice when the average cost of water exceeds $100 per ML (after allowing for alternative land and water uses). This would mean that they could afford to pay up $100 000 for irrigation water before growing rice became relatively unprofitable. If their water utility were to make, say, 800 ML of water available at $25 per ML (a total cost of $20 000), this would mean that they could pay up to $80,000 to secure the remaining 200 ML required to plant their crop.
Edwards’ observation that ‘economists become wary when they see normative statements about efficiency which disregard prices, especially if they also disregard all but one input’ (Edwards, 1976, p.179) is relevant to gross margin per megalitre comparisons which ignore the contribution of fixed capital and farm family labour.
The costs of farm infrastructure are ignored in activity gross margin analysis — such analysis is typically undertaken within a short-term context where capital is considered to be fixed and it is assumed that the farm has sufficient infrastructure and machinery to undertake the enterprise. For example, an activity gross margin analysis for a rice farm assumes the farm has the necessary infrastructure and machinery to grow rice. Since the rice grower would not be able to change to, say, dairy without making major changes to the infrastructure of the farm, it is not sensible to draw inferences about improvements in resource allocation from comparisons of gross margins of such different activities as rice and dairy farming.
Profit maximising farmers should not try to maximise gross margin per unit of land, water or other input. Rather, their aim should be to maximise the net return that can be obtained from their endowments of all factors of production.
Activity gross margins do not provide information on whether the margin is a return on capital, labour, or a particular input. For example, a relatively high activity gross margin per hectare from perennial horticulture should be expected because much of the return is a return on capital — the establishment costs for perennial horticulture are comparatively high, and there may be a relatively long pre-productive period.
A large part of the commonly perceived gap between the NPV of water in ‘high’ and ‘low value’ use is due to the inappropriate use of unadjusted gross margins as a means of comparison. The annualised additional capital development costs should first be deducted from the gross margin of the expanding enterprise. This substantially reduces the annual net margin for the ‘high value’ use. (Gyles 2003)
It should be remembered that, in the long run, there are strong forces at work for competitive industries (with ease of entry and exit) to provide ‘normal’ returns on investment. Therefore, it is unsurprising that Gyles (2003) concluded that:
‘…the inclusion of development costs and risk adjusted discount rates reconciles a large disparity in gross margins between enterprises. … the NPV of irrigated development in horticulture and dairy generating gross margins of $600/ML and $163/ML respectively is much the same as that of an existing irrigated grazing enterprise with a gross margin of $30/ML’.
Another important factor to consider is the treatment of the farming family’s labour. Calculations of activity gross margins typically include casual labour as a variable cost but treat labour provided by the farm family as a fixed cost (and therefore excluded from the gross margin). To the extent that this practice is followed, the high activity gross margins commonly cited for irrigated vegetables, for example, may mainly be due to the relatively high contributions of family labour to this particular type of farming.
Calculations of activity gross margins are usually based on the assumption that prices received and paid do not change over the period of analysis. Constant prices paid and received are a useful assumption when undertaking short-term budgeting for a farmer who is a price-taker.
However, assuming constant prices is not likely to be appropriate for evaluating the long-term impact of industry-level changes. Commodity prices can change quickly and substantially for many reasons, including climatic conditions, cyclical movements, technical changes and policy changes. For exported commodities, developments overseas may affect commodity prices within Australia.
Further, if a large number of irrigators choose to move from one enterprise to another, the change may affect prices received in both the industry they leave (prices may go higher) and the one they enter (prices may go lower). In many industries, the long-run price response can be slow, and difficult to see. In industries with long pre-productive periods such as perennial horticulture, the market may not achieve equilibrium and overshoot. Wine-grapes provides an example of an industry where high after-tax returns led to substantial investment. After a number of years, this led to a significant increase in production, which along with increased production overseas, in turn led to a subsequent decline in prices received.
For an individual farming enterprise, gross margins can be of some use comparing the short term gross returns and variable costs of similar farming activities (such as growing wheat or barley), or for comparing similar production options (such as sod-seeding, or aerially seeding rice). However, they have serious limitations when used for deciding the merits of changing farming enterprises over the longer term. Gross margins do not provide a sound basis for illustrating the net economic benefits of water trade across farming activities or enterprises. The greatest economic return from the share of water allocated to irrigation will occur when irrigation water use is optimised in conjunction with other factors of production such as land, labour and capital.
Doll, J. P. and Ozarem, F. 1984 Production Economics, John Wiley and Sons, New York.
Edwards, G. W. 1976, ‘Energy budgeting: Joules or dollars’, Australian Journal of Agricultural Economics, vol. 20, no. 3, pp. 179-191.
Gyles, O. 2003, ‘More water for the environment: Some problems and prospects for worthwhile investments’, Connections, Autumn, http://www.agribusiness. asn.au/Connections/Autumn2003/Gyles.htm (accessed 25 February 2004).
Makeham, J. P. and Malcolm, L. R. 1981, The Farming Game, Gill Publications, Armidale.
—— 1993, The Farming Game Now, Cambridge University Press.
NSW Agriculture 2003, Gross margin budget for long grain rice in the Murrumbidgee Valley, http://www.agric.nsw.gov.au/reader/meirrsu (accessed 17 February 2004).