The typical question when deciding on a large purchase, or expense, for a farm is whether the tractor, or fencing, or truck is essential or not. In other words, do we need it or would we like to have it. Non-essential items seem to be easy to figure out since our gut instinct will often tell us that something is frivolous. The tough question to ask is if the needed items are really needed, and if what we think is a luxury item is in fact a necessary expense. The next question is: If it is essential, is it affordable?
When looking at the cost of a tractor, fencing or extra barn help, there are several hard costs to consider when deciding to buy (or hire) or not; purchase price and interest rate are the two most obvious ones for equipment. What is often less discussed are soft costs, like what the purchase will save in time and opportunity costs.
Time saving is very straightforward. If you are being paid X amount of dollars to give riding lessons, and you have to give up 10 lessons each week because you are too busy mucking stalls to teach, it is a no brainer to hire someone at a rate less than X to clean stalls if it costs less than what your income is for the lessons.
By freeing up your time, you can do an activity that will make you more money than what you were doing.
Opportunity costs are similar, but in this case apply directly to the value of possible investments over time. For example, if you have $20,000 to invest in a tractor, is there something else you can use that money to buy that would give you a better return, or is the financial saving over time worth the original investment? Then we can asks ourselves if when all these costs are figured, would it be better to use that money on something smaller and less expensive?
Evaluating opportunity costs are a great way to figure out if that essential item loses it’s luster and becomes a luxury.
Wheel Barrow vs Tractor
Lets use the example of using a wheel barrow to haul manure to a pile or deciding to buy a $10,000 small tractor to throw the manure in at each stall, then dump it all at once. We can use two analysis; a “back of the envelope” to give us a general idea if the purchase is worthwhile, and a more detailed way of looking at it.
To make any calculations, we need to make some assumptions. So let’s assume for this scenario that we have 20 stalls to clean every day and that a wheelbarrow holds the manure and wet shavings from two stalls. Let’s further assume that it takes three minutes to walk to the manure pile and back to empty the wheelbarrow. This means it will take 10 trips to clean all the stalls, or 30 minutes/day or 3.5 hours/week. If your barn help is getting paid $10/hour, that would mean you are paying $35/week to empty the wheelbarrow.
The “back of the envelope” requires using any of the online mortgage calculators. Add in your interest rate and the length of the loan to figure out the total cost of purchasing the tractor. If the interest rate is 5% over six years, the $10,000 tractor would cost us $11,600 by the end of that time. If the life of the tractor is expected to be 10 years, then it would cost us $1,160 each year. Going back to our initial cost of emptying the wheelbarrow at $35/week, then over 52 weeks it would cost you $1,820 in labor. So using the tractor would give us $660 saving every year ($1,820-$1,160). That is far more than the yearly cost of the tractor if you were planning to use it for 10 years.
Money Has Value
The more complicated way is to examine the value of money over time. This concept is called net present value of money, or what would the combined savings be worth over the 10 years in our previous example in today’s money. Let me explain how that would work.
If you invested $1,000 today and you received 7% compounded annual return a over 10 years, it would be worth $1,967 at the end of the 10 years. What this means is if you are offered an amount higher than $1,000 today or $1,967 in 10 years, you would take the amount offered today, since it will be worth more than the $1,967 in our calculation. Again, there are numerous online sources that can help with this. One site I like is http://www.investopedia.com/calculator/netpresentvalue.aspx.
If we return to the previous example, when using this online calculator, we would use 7% as the discount rate. This is equivalent to the rate you would want if the money were invested. Then add in the $10,000 in upfront costs as a negative number because this is an expense. Finally, for each year of useable life of the tractor, put in the savings of $660. Hmm, things look different now. It tells us that the net present value is -$5,364! This means that we lost that amount of the $10,000 we invested in the tractor.
Another way of looking at it is that the 10 years of savings is equal to $4,636 invested now at 7% over the next 10 years. In other words on a dollar basis, this is not a savings over time–you are spending $10,000 to save $4,636.
Again, a site like this is interesting when you start playing around with it and try different scenarios. For example, if you were able to buy a used tractor for $4,500 then it would be worthwhile because you would have saved$136 over 10 years.
The question is: Do we buy or not. On one hand it looks like we save $660 per year, so why not buy it. Yet, on the other, money is worth something over time, and at the rate the tractor is purchased at, you would be better off investing the money.
When we have the debate of whether something is essential or not, we must consider other factors than the money involved. Are you hiring new staff every two months because they resent having to use wheelbarrows, or can you use the tractor for other things on the farm? Sometimes it is worth the investment just for the improvement of your quality or life.
Regardless of your reason for wanting to make a purchase, it is worthwhile digging a bit deeper to appreciate the financial impact of the item or service. What looks like a no brainer on the surface might have a different story when you look at it differently.