Figuring investment costs

[tigerd]

I have had a debate with myself for a long time about figuring an investment cost within your fixed cost calculations. To me, your dollars invested should be used only to figure your net income interms of a yearly return percentage. For example one million dollars overall investment, and a net return of onehundred thousand, is a ten percent return. It should not be looked at in terms of part of a fixed cost per acre.

Depreciation, interest paid, if any, licences, taxes on land, etc are all valid costs per acre. Not overall investment dollars...

Any thoughts?

[kaniteo]

You may want to look at your overall investment in terms of opportunity cost or the return received if the money was invested in an alternative use. For example, if on that $1M your net farm income was $50K while your financial institute was offering 6.5% on that kind of money invested in a GIC, your net cost to your farm operation is $15K.

Using the opportunity cost concept works well if you are trying to evaluate different returns on investment for a resource allocation determination, however it falls short, as you are finding, when evaluating a "fixed" investment. The investment is fixed in the sense that without the investment there is no production and consequently no farm business. You can't easily take the money invested in the farm and put it into an alternative investment vehicle like a GIC.

I think the key to answering your question is consistency. In other words, it matters little how you allocate the cost as long as you evaluate it the same each and every year. By doing that you, can determine your progress in the farm business.

[tdarling]

I have to agree with "tigerd." Investment (or a return on investment) is not a cost of doing business. It may be easiest to see in the case of land. In accounting theory and practice, land neither appreciates nor depreciates. The only costs associated with land are ownership costs such as interest and taxes. Principal payments or land purchases are not costs since they're just a transfer from one asset account (your bank) to another asset account (land). In the same way, when you sell land it's not income but rather another asset transfer. Your equity doesn't change in either situation. Some of the confusion may come from the apparent inequity of businesses which have no debt having lower costs than those with high debt. The difference is obviously interest payments. However, this also shows how high equity operations can survive through tough times; they have lower fixed costs and they may be willing to accept a low (or even zero) return on their investment. In his "Tip of the Week," Roy Ferguson recently wrote a scathing criticism of Ag. Universities and Ag. Departments (presumably all in the US!). The gist of it was that principle payments and land investment are not costs of production and that some writers from the above institutions have been suggesting differently. You may be able to find the article at: http://www.roystipoftheweek.com.

[kaniteo]

Ted, I agree with you that ROI is not a cost of doing business. Rather, it is a measure of the efficiency of the business and how effectively the farm manager is using the resources of the farm operation.

If I'm reading your comments correctly, (I wasn't able to pull the article you mentioned from Ferguson's site) Ferguson's premise is that principle payments and land investment are not costs of production. I agree totally. One only has to ask how CCRA (Rev Can) would rule if you tried to deduct them. Even interest on long term debt is treated as a fixed cost and thus is kept out of the cost of production calculation. Keeping these costs out of the equation allows us to better benchmark cost of production and reduce the disparities between high & low equity producers.

An interesting aside is a similar discussion going on in the Business Planning forum concerning landownership. A renter has a fixed cost for land rental yet the high equity land owner has no corresponding "cost". Does the land owner really have lower total costs than the renter?