Last week, we kicked off our 11th annual Farm and Ranch Business Planning Short Course. Every Thursday night for the next six weeks, a group of local farmers and ranchers will come together to discuss and learn about operating an economically viable agricultural business. The class is intense - but very rewarding!
Several weeks into the course, we'll talk about purchasing equipment. For the farmers in the class, this discussion usually centers on tractors. This seems to be a “guy” thing – the male of our species can't conceive of a commercial farming enterprise without a tractor! For most small-scale foothill crop farms, however, a tractor shouldn't be the first capital expenditure. Things like deer fencing, irrigation systems and hand tools are far more critical to a small-scale vegetable grower – buying a tractor to cultivate an acre of crops just doesn't make economic sense.
Start-up livestock operations face similar decisions relative to capital expenditures. In many ways, squeeze chutes and corral panels (or tilt tables and sheep yards for new sheep producers) are similar to that shiny new tractor – there must be something enticing about shiny paint on steel equipment! Despite my own attraction to shiny things, our commercial sheep operation has always been under-capitalized. I've never had enough money all at once to go out and buy the breeding animals, fencing, equipment and tools I needed in one fell swoop. Consequently, I've been forced to prioritize my capital purchases. For livestock, at least, I think new (and established) producers should ask themselves three key questions regarding capital purchases:
- Will this purchase increase my production?
- Will this purchase reduce my overhead?
- Is there a less expensive alternative to accomplishing the same goal?
There are a variety of economic analysis tools we use in our Business Planning Short Course to help farm and ranch businesses answer these questions. One of the simplest tools is to calculate a simple payback period. If we know how much money the capital purchase will generate (or how much we'll save in time or other inputs), we can simply estimate the length of time it will take pay off the purchase.
While calculating a payback period is simple, it ignores additional returns (or savings) after the end of the payback period, as well as the impact of the investment on the timing of cash flows. Other analyses may be helpful in providing a more detailed evaluation of a capital purchase. These include:
- Simple Rate of Return: Calculated as the average annual net return divided by the initial cost. A purchase with a higher simple rate of return might make more sense than one with a lower rate.
- Net Present Value: Most of us intuitively know that we'd rather get a dollar today than wait for that same dollar next year. This is due largely to risk - inflation risk, risk that the dollar won't be available next year. Net present value analysis allows us to compare the potential income (or savings) from alternative capital purchases in today's dollars. This type of analysis takes into account the fact that different capital purchases may have different useful lives, costs of ownership (like maintenance) and salvage values. It also accounts for the timing of these savings or benefits - a purchase that generates more revenue or savings early in its useful life will have a greater net present value.
While I've been known to make impulsive purchases on occasion, these types of analyses have become an important part of my business planning tool box. For example, our homemade sheep corrals (which cost us less than $500 in materials) function just as well (and are nearly as portable) as a set of $15,000 Prattley sheep yards. In this case, we were able to find a less costly option that fulfilled our needs. Our payback period was less than a year. On the other hand, we may be better off purchasing a new ATV when our current bike finally wears out - we'll do a net present value analysis to compare our alternatives.
While this year's Farm and Ranch Business Planning Short Course is full, consider signing up next year! Based on feedback from previous students, it might be the best investment you can make in your business!