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Farm Size and Efficiency

June 1, 2016

Growth is a common denominator of various business objectives. A business may want to grow profits, sales, market share, etc. The growth of a business itself usually refers to growth in equity, or growth in assets after debts have been paid. Farms, from a business perspective, are no exception. Farmers seeking to grow equity need to be willing and able to retain earnings and cannot be overleveraged. More profitable farms may, but would not have to, also become physically larger by adding assets such as land and machinery. A potential source of profitability would be economies of size, where costs decrease as the size of a firm’s output increases. The presence of economies of size may link farm size to profitability, potentially leading to greater equity growth and farm size growth among efficient farms.

Economies of Size
There have been recent examples documenting different aspects of economies of size. MacDonald, Korb, and Hoppe (2013) use information from the Agricultural Resource Management Survey (ARMS) and the Census of Agriculture to document changes nationally on crop farms. There are now more farms that are larger and smaller in terms of acres than in earlier decades. For crop farms in particular the median acreage was 1,071 acres nationally in 2007, with substantial midpoint growth among North Central states. Nationally, as the size of harvested crop acres increases across farms, the rates of return on equity are also higher. Lower production costs on larger farms is the dominant reason for higher returns, as labor costs are lower as are investment levels in equipment per acre.

Similarly, Sumner (2014) cites shifts in the center of farm size distributions across major enterprise types. Thus, what is considered a large livestock farm today has many more animal units than were on farms considered large in the past. He gives the “cost of monitoring” and “specific local knowledge” as potential reasons limiting farm size. Often monitoring is used by lenders concerned about leveraged borrowers. Local knowledge seems to imply the ability of a farmer to know a piece of ground, which may diminish as the absolute acres farmed increases. Finally, Sumner also argues that past growth by today’s large farms may have led to aggregate productivity growth if inefficient farms left the sector.

South Dakota Farms
These studies were the motivation for Brown (2016), who examined different aspects of economies of size for South Dakota using data from the Census of Agriculture. At the state level the ratio of production costs to sales was compared across different sales classes of farms. The “Less than $1,000” sales class is excluded here, as it reflects farms that are very small and often have a retired operator. In 2012 as the sales classes became larger, the production costs fell per dollar of sales. This is evidence that in aggregate there were economies of size for South Dakota farms. Expenses exceed sales (the ratio was above 1.0) for all of the sales classes below the $100,000-$249,999 class. Thus, smaller farms were not profitable and the larger the farm the more profitable they were in 2012. The pattern holds in earlier Census years also. The finding by Brown (2016) across all farm types is consistent with the crop farm observations in MacDonald, Korb, and Hoppe (2013).

Machinery Investment
Brown also investigated the machinery investment across sales classes of South Dakota farms in 2012. The value of machinery is divided by acres for all farms within each sales class. Machinery values were the highest for the $1,000-$2,499 sales class. In contrast to MacDonald, Korb, and Hoppe (2013), machinery values have a non-linear pattern that increases after the middle sales class levels. South Dakota farmers in the higher sales classes may be substituting machinery for labor and making a greater investment in machinery compared to farmers in the lower sales classes. If machinery is looked at differently, based on the investment per dollar of sales instead of per acre, the ratio declines as sales classes increase. Thus, farmers in the higher sales classes are able to generate more sales for every dollar of machinery, even though the machinery value per-acre is higher than in the middle sales class levels.

Brown further examined economies of size using county level data. The same breakouts by sales class are not available at the county level, thus a different approach was taken. Because of regional effects of the 2012 drought on yields and production levels, the agriculture sales were augmented with other imputed income from the U.S. Bureau of Economic Analysis. Across counties, the ratio of expenses to sales was modeled as a function of the proportion of cropland to total farmland, the proportion of full-time farmers, the proportion of farms in sales classes above $100,000, the value of machinery per farm, and the value of land and buildings per acre. Across different specifications, the greater the proportion of cropland to total farmland in a county, the lower the ratio of expenses to sales. This suggest crops were relatively profitable compared to other enterprises during recent Census years and/or that cropland was more efficient at generating a dollar of sales. The greater the proportion of large farms in a county, the lower the ratio of expenses to sales. This suggests that the economies of size measured state-wide were also realized at the county level.

The Bottom Line
There is evidence of economies of size in South Dakota farms. Farms in larger sales classes, generally larger size farms, have lower costs of production than farms in smaller sales classes. Machinery is one investment area where larger farms are able to afford and/or utilize a factor of production to their advantage. Across counties, there were lower costs attributable to having a greater proportion of cropland to farmland and a greater proportion of large farms than in the average level county. The disparity in cost structures does not automatically lead to ever-larger farms, but that can be one objective as farms seek increased equity.

Source: Matthew Diersen, South Dakota State University