Wednesday, February 18, 2009

Corn acres and sunk costs...

As we awake this morning hoping yesterday's markets were a really bad dream (no such luck), more fuel is dripping onto the flaming controversy of corn acres.  One assertion is many producers had time last fall to apply some very pricey fertilizer and have prepaid some equally expensive seed, hence they are locked in to growing corn.  This is a strong argument.

I suspect this outlook also has to do with changing your mind, something we are not very good at as a profession.  Our customers rely on it as well. It shows up in the deeply ingrained, albeit economically questionable, conviction that rotation will pay off better in the the long run than trying to grow what the market seems to be wanting each year.

But if you have parted with the money, that is a sunk cost, and should not be part of your break-even calculations for your crop mix. 
In economics and business decision-making, sunk costs are costs that cannot be recovered once they have been incurred. Sunk costs are sometimes contrasted with variable costs, which are the costs that will change due to the proposed course of action, and prospective costs which are costs that will be incurred if an action is taken. In microeconomic theory, only variable costs are relevant to a decision. Economics proposes that a rational actor does not let sunk costs influence one's decisions, because doing so would not be assessing a decision exclusively on its own merits. The decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem.
For example, when one pre-orders a non-refundable and non-transferable movie ticket, the price of the ticket becomes a sunk cost. Even if the ticket-buyer decides that he would rather not go to the movie, there is no way to get back the money he originally paid. Therefore, the sunk cost of the ticket should have no bearing on the decision of whether or not to actually go to the movie. In other words, it is a fallacy to conclude that he should go to the movie so as to avoid "wasting" the cost of the ticket.
While sunk costs should not affect the rational decision maker's best choice, the sinking of a cost can. Until you commit your resources, the sunk cost becomes known as an avoidable fixed cost, and should be included in any decision making processes.[1] If the cost is large enough, it could potentially alter your next best choice, or opportunity cost. For example, if you are considering pre-ordering movie tickets, but haven't actually purchased them yet, the cost to you remains avoidable. If the price of the tickets rises to an amount that requires you to pay more than the value you place on them, the cost should be figured into your decision-making, and you should reallocate your resources to your next best choice. [More]
It simply doesn't matter what applied fertilizer cost, since that money is gone. When you drop input costs like that out of your profit calculations, corn looks like a winner even at dismal prices.  Beans simply lack the gross income.

This may be what is going on in farmer brains, but conveniently set aside too often is the whacking loss that will still be realized since despite not being used to compare planting choices, sunk costs have been paid.  For those have there by constrained their range of choices by prepaying, two words: accrual accounting.  Letting a tax decision you made waaay back in your career (to advance crop input costs) lock in your actions regardless of market signals may not optimize your results.

My guess is shifting to accrual accounting would drastically improve our thinking process by neutralizing our inordinate glee from postponing (NOT eliminating) income taxes.  You're talking to a man of 60 who's trying to figure out how to unwind these strategies.  It's not easy or cheap.

Nor are those applied inputs necessarily all sunk costs.  To be sure, if you applied N you're hosed, but the P & K could be better considered unfortunate, but still valuable inventory additions. After all they are still out there, right.  And they could be available for corn in 2010.

Those of us who have yet to apply/buy such inputs have a more different set of numbers - which demonstrate a loss that may be preventable.  While we don't deserve the good fortune of a break because we were poorly prepared last year, we don't have to squander our advantage right now.

Sunk costs are hard for our brains to deal with rationally.

Last March, I decided to tackle my physical fitness by setting some big goals for myself. One of those was to go from couch-potato to marathon runner in about six months. To goad myself into action, I paid about $100 (non-refundable, non-transferable) to sign up for the Portland Marathon (which is being run at this very moment).
For a while, this seemed like a brilliant idea. Having paid for the marathon in advance, I was motivated to train so that my money didn’t go to waste. I began to run with a group. I lost weight. I felt great.
At the end of May, however, I hurt myself. I took some time off. I didn’t worry too much, because there were still four months left before the marathon. But when I tried to return to running, the pain persisted. I went to see a physical therapist. June turned to July turned to August. Eventually I decided that maybe I could walk the marathon. I’d paid $100 for it, dammit, and I wasn’t going to let that money go to waste!
Over the last couple months, however, I’ve come to realize that I’m engaging in the sunk-cost fallacy again. The fact that I’ve already spent $100 for the marathon is meaningless. It’s a sunk cost. It’s not recoverable. What matters is the future cost in time and money. And, as it turns out, health.
I could have continued to push myself to prepare for the marathon, but the most likely result would have been additional doctor bills and physical therapy visits. I would be spending future money attempting to make past money “good” again.
Instead, I’ve changed my focus.
I’ve begun to prepare for the 2009 Portland Marathon. I’m running short distances (three miles) a couple times a week. I’m lifting weights to build my leg strength. Meanwhile, I’ve learned a lesson. In the future, I won’t sign up for the marathon until later in the summer, when I’m sure that I’m physically ready to go. [More]

This admittedly off-topic example of sunk costs illustrates how much we dread realizing a loss.  As long as the grain is unpriced we can, with varying degrees of legitimacy, fantasize about making a profit.  Once we cash the check, those happy moments are no more.  Brains don't like those feelings.

Overall, I think a fair analog for corn acres could be percent of normal fall applications that actually got spread. As cash corn drops below $3 the odds that any of the high-priced fertilizer and other inputs gets fully utilized drops with it.

I may well be wrong on corn acres, and they will be much higher than I think. But a case can be reluctantly made that this year is one to minimize losses versus maximizing profits.  In that case, coping rationally with sunk costs will be a crucial component of our planning.


Anonymous said...


I appreciate your emphasis on accrual accounting. We in production agriculture have tended to ignore the accounting principles utilized by the rest of the business community because we felt we were different. As operations become larger and the ag economy more volatile, we may no longer be able to afford that luxury.

I have always struggled with the concept of "sunk costs" but your blog helped clear it up a little.

Ron in IA

John Phipps said...


thanks for your comment. As Aaron and I form a new farming "company" we are sucking it up and beginning with accrual accounting.

I'm pretty sure it won't be pretty, but hey - I've got a younger brain to help this time.

FWIW, your comment about clearing up sunk costs turned an otherwise dismal day into a good one. Thanks.

Anonymous said...

In short "don't throw good money after bad" could be twisted to "don't throw better alternative money after poorly spent money". Every decision is a new decision and you can't redo any choice once its sunk. But it is soooooo hard to seperate the two emotionaly.

Dick W - ID said...

John - good observation on accrual accounting. Can imagine running our farm business without it. I is amazing after all these years how few farmers (and their professional "tax preparation focused" accountants don't understand or apply this concept. Every opportunity you and Farm Journal/Top Producer have to promote this is appreciated.