Ag
Ec Home Course
Description 
Best if printed in landscape.
This is a question received in 2007 from a farm manager and my response.
QUESTION
I have been working on an analysis of the operating and repair costs for our business’ cropping machinery. The company keeps excellent records on repairs so it has been fairly easy to calculate annual repair costs on each piece of equipment. However, I'm struggling with calculating the annual ownership costs for each machine. I have the company's depreciation schedule which uses the straight line method but it does not account for any interest cost.
How do I incorporate the interest cost into the depreciation to recognize the interest as an annual ownership cost? For example, we have a planter that we bought in 2002 for $54,945 (trade difference: $93,842 purchase price - $38,992 trade in allowance) and the annual straight line depreciation is $5,494 figured with a life of 10 years and no salvage value. The remaining book value in 2007 is $30,220, although the value of the planter right now is about $55,000. I know that we will trade this planter before it is totally depreciated so I'm not sure if using zero for a salvage value is correct but that's how the office calculated it.
Assuming a 6% interest rate, how do I calculate the annual interest cost? Do I work out an amortization schedule and use the interest values from that or is there a different way?
We're not financing all of our machinery purchases but I want to account for the opportunity cost of that investment. I want to be able to calculate my costs as accurately as possible so I can calculate the cost for each individual field operation. I would appreciate any insight you would be able to provide.
Also I was interested in your opinion about rules for deciding when to replace a piece of equipment. How high should you let repair costs get compared to the cost of upgrading. I know this is a hard management decision, but just wanted your opinion.
RESPONSE
Several thoughts come to mind as I think about your question(s).
1. How much does the business have invested in the new planter?
In the simplest terms, the business has invested $54,900 plus an old planter.
More specifically, the business has invested $54,900 plus the value of the old planter. If the old planter could have been sold to a neighbor for $25,100 (for example) in 2002, the business has $54,900 cash and an old planter worth $25,100 invested in the new planter for a total of $80,000.
The $38,992 trade-in allowance generally is NOT a consideration in calculating the cost of a new machine because it may not reflect the value of the old (traded-in) machine. For example, the dealer may have provided that trade-in allowance just to attract the customer. Perhaps the dealer would have been willing to sell the new planter for $90,000 if the trade-in allowance was no more than $35,000, which again would have had the farm business paying $55,000 in cash. Thus the purchase price and trade-in allowance on the purchase agreement has minimal impact on determining the “cost” of the new planter. The critical numbers are the amount of the cash payment and the “real” value of the trade-in.
Another way to think about this is how much would the business have to pay if there was no trade-in? However, many dealers are not willing to share that number once they know there will be a trade-in.
2. How much, according to tax law, does the business have invested in this planter?
In the simplest terms, the tax law says the business has invested $54,900 in cash plus the old planter; the same answer as stated above, BUT …
More specifically, tax law states the business has invested $54,900 in cash plus the “remaining tax basis” of the old planter. If the old planter was fully depreciated for income tax purposes, the tax law says the business has $54,900 invested in the new planter. If the older planter had, for example, a remaining basis of $10,000 in the old planter when it was traded, the tax law would say the business has $64,900 invested in the new planter (54,900 + 10,000).
The remaining basis of the old planter is found by looking at the 2001 income tax returns for the business (that is, the income tax return before the old planter was traded).
Again the trade-in allowance that the dealer wrote on the purchase agreement is not an important consideration.
It appears, from your description, that the old planter had no remaining basis, so the basis for the new planter would be just the $54,900 cash that was paid. However, I sense there must have been some “market value” for the trade-in, otherwise, the dealer would not have written down $38,990. Accordingly, I think the cost of the new planter is probably closer to $80,000 than $55,000.
3. How much depreciation does the tax law allow the business?
If the basis is $54,900 (see comment 2 above) and the useful life is 10 years with no salvage value, straight-line depreciation would be $5,490 annually. This appears to be your situation.
4. How much depreciation do you think the business is incurring?The business most likely has more than $55,000 invested in the new planter (assuming the planter traded-in in 2002 had some value); that is, the business has invested $55,000 in cash plus the value of the old planter (see comment 1 above). Perhaps it could be $80,000 if the assumptions made in comment 1 are correct. If the new planter will last 10 years and then have no value (that is, no salvage value), straight-line depreciation would indicate that the annual depreciation cost is $8,000.
Link to an additional description of the concept of depreciation.
This would suggest that the business would have $72,000 (80,000 – 8,000) still invested in the new planter at the end of year 1 (beginning of year 2). The investment would be $64,000 at the end of year 2 (beginning of year 3); $56,000 at the end of year 3 (beginning of year 4); and so forth.
Note – the cost and depreciation for tax purposes and business management purposes can be different.
Note -- the trade-in allowance on the older planter and the purchase price of the new planter were not used in determining how much was invested in the new planter. Instead the focus was on the cash paid plus the remaining “value” of old planter.
5. What should be the depreciation if this planter (in which the business has invested $80,000) will be used only 7 years and then traded, especially if it will have some market value when it is traded?
Assume the machine will have a market value of $25,000 at the end of year 7 and that is when it will be traded (note again – there may be a difference between market value at that time and what a dealer might write on the purchase agreement). The depreciation of those 7 years could have been calculated as (80,000 - 25,000) / 7 = $7,857 – not much different than the $8,000 calculated in comment 4.
Bottom line – if you think 10 years of use (even if your business may not be the owner/user for all 10 years) will fully consume the machine, the approach currently being used by your business is acceptable. You just need to recognize that there will be some value in the machine when it is traded sometime before the 10th year.
Alternatively, if you want to consider only the time that you are likely to own the machine and you recognize that the machine will have some (salvage) value at the time that you trade it, you can calculate your depreciation with those values.
Whichever approach is used, be careful to recognize the assumptions you are making
Note – the $5,490 annual depreciation might be correct for income tax purposes (and for an accountant), but it may not reflect what the business is really incurring; that is how much the value of the planter declines each year because it is being used.
This demonstrates why depreciation for “management” purposes can be very different than depreciation for “income tax” purposes (and also how it may differ from the depreciation calculations of an accountant who does not think about opportunity cost).
Now the second part of the question – assessing an opportunity cost.
6. Opportunity cost is “how much we could be earning if our assets were not invested in this machine.” Return to comment 1 again – how much is invested in this planter. Again, I would suggest (based on the information you provided) that the business has more than $54,900 invested in this machine – let’s assume that my assumption about the market value of the old planter in 2002 is correct and the business has $80,000 invested in the new planter.
If this $80,000 was not invested in the planter in 2002, it could have been invested in the bank at (let’s say it would earn 4% interest). The assumption is that the $54,900 in cash would have remained in the bank, and the old planter would have been sold for its market value and that cash also would have been deposited in the bank. Thus the business did not earn $3,200 in interest in 2002 because the cash and old planter had been used to acquire the new planter. This $3,200 is your opportunity cost for 2002.
In 2003, the planter is worth only $72,000; that is, we used it in 2002; the wear on the machine was $8,000 (see the depreciation calculation under comment 4). The opportunity cost for 2003 would be 72,000 x .04 = $2,880. The opportunity cost in 2004 would be 64,000 x .04 = $2,560.
It may be tempting at times to calculate opportunity cost on the current "market value" of the machine rather than the "book value." I would encourage you to NOT do that; instead, use the machine's book value to calculate opportunity cost even though it differs from the machine's current market value. Why?
The book value represents how much the business has invested in the machine and opportunity cost measures how much the business could be earning if its capital was not invested in the machine. Thus, using the book value is consistent with the concept of opportunity cost.
If the market value of the machine differs from the book value, the manager should consider that difference as a gain or loss due to owning the machine (i.e., a capital asset). That gain or loss is due to owning the machine -- which is distinct from the revenue and expense resulting from owning AND operating the machine. The gain or loss (difference between book value and market value) would then be recognized at the time the machine is disposed of -- which is similar to how the gain or loss from owning any capital asset is determined.
7. The next question may be “how do I perform these calculations if the purchase of the new planter in 2001 involved some borrowed cash.” Let’s assume the business borrowed $10,000 at 7% interest and this loan would be repaid in two years.
The cost of the planter would still be $80,000; that is, $25,100 value of trade-in, $44,900 from the business cash account, and $10,000 borrowed from a bank. The amount the business has invested in the planter is only $70,000 – its equity (80,000 – 10,000). The last $10,000 has been “invested” by the bank in the form of its loan to the business.
Depreciation would still be $8,000 annually (assuming 10 years useful life and no salvage value).
At the end of 2002, the interest payment to the bank would be $700 (10,000 x .07) and the opportunity cost for the business would be $2,800 ($70,000 equity in the planter times the 4% opportunity cost).
After the bank payment is made at the end of 2002 and the depreciation allowance is subtracted, the planter (at the start of 2003) is worth 72,000 (80,000 – 8,000) and the business’ equity in the machine would be $67,000 ($72,000 value minus the remaining bank debt of $5,000). Depreciation for 2003 would again be $8,000, interest to the bank would be $350 (5000 x .07) and opportunity cost would be $2,680 (67,000 x .04).
At the end of 2003/beginning of 2004, the bank is paid off, the machine depreciates to $64,000; the business’ equity in the machine would now by $64,000. Interest expense for 2004 would be $0 (there is no bank loan), depreciation will remain at $8,000 annually, and opportunity cost would be $2,560 (64,000 equity times 4%).
The two sheets in the attached Excel file summarize comments 6 and 7.
The “Business Equity in the Planter” is a proxy for the market value of the planter, assuming the depreciation allowance approximates the annual decline in the market value of the planter.
Note that the $30,220 “book value” might reflect remaining basis for income tax purposes, but it does not necessarily reflect how much the business has invested (equity) in the planter at this time.
Comment 6 Data/Assumptions Cash paid 54900 Market Value of Trade-in 25100 Salvage Value of new Machine 0 Useful Life of new Machine 10 Bank Loan (original principal) 0 Bank Loan principal -- 2nd year 0 Bank interest rate 0.07 Bus. Opportunity Cost on Equity 0.04 Calculations Amount Invested Interest Bus. Equity Opportunity Year in Planter* Debt Deprecation Expense** in Planter Cost (book value??) (for mgmt purposes) 2002 80000 0 8000 0 80000 3200 2003 72000 0 8000 0 72000 2880 2004 64000 8000 0 64000 2560 2005 56000 8000 0 56000 2240 2006 48000 8000 0 48000 1920 2007 40000 8000 0 40000 1600 2008 32000 8000 0 32000 1280 2009 24000 8000 0 24000 960 * beginning of the year ** incurred during the year and paid at the end of the year
Comment 7 Data/Assumptions Cash paid 54900 Market Value of Trade-in 25100 Salvage Value of new Machine 0 Useful Life of new Machine 10 Bank Loan (original principal) 10000 Bank Loan principal -- 2nd year 5000 manually calculated*** Bank interest rate 0.07 Bus. Opportunity Cost on Equity 0.04 Calculations Amount Invested Interest Bus. Equity Opportunity Year in Planter* Debt Deprecation Expense** in Planter Cost (book value??) (for mgmt purposes) 2002 80000 10000 8000 700 70000 2800 2003 72000 5000 8000 350 67000 2680 2004 64000 8000 0 64000 2560 2005 56000 8000 0 56000 2240 2006 48000 8000 0 48000 1920 2007 40000 8000 0 40000 1600 2008 32000 8000 0 32000 1280 2009 24000 8000 0 24000 960 * beginning of the year ** incurred during the year and paid at the end of the year ***assumes declining payments
8. Your last question is “when should the business trade?” Dr. Gustafson researched this question years ago; I am copying him on this message. He may have some suggestions (he may also have some comments on my previous explanation).
Managers need to consider more than the cost of repairs versus the cost of the new machine. The manager also needs to think about the critical natural of the operation performed with the machine. A break-down at the wrong time could have major adverse consequences on the overall business performance; that has to be considered in the decision of when to replace.
Note that this comment no longer focuses just on cost – but also focuses on risk management; that is, “how much do I invest now to reduce the risk of a breakdown during a critical time.” That is why this question – as you correctly indicated – is difficult. It is not about just cost – it is about risk!!!
Risk management – a topic for another day!!!
In summary -- even though my response suggests how to calculate depreciation and opportunity cost from a manager's perspective, it is still the responsibility of the manager to use that cost information in the decision making process. These calculations did not make the decision; they merely provided additional information for the manager to use.
I hope this makes sense.
Last Updated November 5, 2009
Email: David.Saxowsky@ndsu.edu
This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.
Phone
Book Campus
Map NDSU
Search College
of Agriculture