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The Choice

Because machinery decisions have such a huge impact on cash flow and solvency, we tend to forget that these are actually decisions about per-acre production costs. Or if we do think of them as costs, we don’t think of them as rigorously as we think about other inputs, such as seed or cop protection.

It’s easy to understand why. In my part of Manitoba, the total investment in machinery for a 5,000-acre farm can top $1.5 million. In other parts of the country, the acreage or the commodiies may be different, but the machinery bill is similarly massive.

At such totals, machinery affects everything. Servicing the debt related to machinery, for instance, can force farm managers’ hands in terms of when and how their grain is sold. Liabilities associated with farm machinery can put farms at risk of insolvency, driving up their cost of borrowing.

So there is a lot riding on the farm managers’ ability to get their machinery buying decisions right.

When a producer walks into Toromont Cat in Elie, Man. for the first time, they are likely to be greeted by a salesperson with a bunch of questions. That’s because Martin Windus, the general manager of this large central-Manitoba dealership is adamant that the only way to show a customer the value of purchasing one of their products is to understand the customer’s needs.

“We’ll start by asking some basic things,” Windus explains, “things like what your acreage is, what kind of tillage tools you have, do you plan on growing your land base, what problems are you hoping to address by making this capital purchase… In other words, we’re trying to get a sense of what the ideal picture would look like.”

The next step is to talk budget, says Windus. “There are very few people who can afford what is ideal, so it’s really a matter of working with customers to come up with a strategy that makes the most sense for them in their current situation.”

To do that, a dealership like Toromont will typically present their customers with a series of options, some of which are within their budget and some that may be a bit beyond.

But at the same time, there is recognition that the customer who is looking to pay $150,000 for a four-wheel drive tractor probably won’t be interested in looking at a new model that is worth $300,000.

“Usually, it’s more a matter of choosing, for example, between a three-year and a five-year old model where the spread is maybe $50,000 or so,” Windus says. “Then, you try to determine with the customer which piece of equipment will provide the best return to investment over time.”

This is no easy process. Especially on a used piece of equipment, there is nothing set in stone, Windus says, and no way to know for sure what the future holds in terms of major repairs and resale value. The machine’s history, the way it was engineered and especially its service record can tell you a lot about how it was maintained.

Still, there’s no denying that used equipment, while cheaper on the price side, does not offer the peace of mind that you get with new equipment that is under warranty. It is a trade-off between cost and risk, and one that isn’t simple to quantify.

Don Johnson agrees with Windus on this point. Johnson farms southwest of Winnipeg in the Red River Valley and has been teaching ag engineering courses at the University of Manitoba for over 30 years, where his teaching has won numerous awards.

“Try to talk to the former owner,” Johnson tells farmers who want to estimate future repair costs. “If a dealership doesn’t want you to talk to the person who had it before, it’s probably a bad sign. Sometimes there’s a reason why a particular piece of equipment was traded in.”

Some costs can be predicted with more accuracy, especially things like loan payments and the Capital Cost Allowance (CCA) that a capital purchase will generate. Johnson takes his students through a budgeting example that shows them how it all interrelates.

“We do an exercise with students,” Johnson says. “They have to calculate what it would cost them to buy versus lease an 80-hp tractor at different income levels.”

The students are given a loan schedule with a five-year payback period for a fictional tractor that is valued at $77,000. Using this, they plug principal and interest payments into a chart alongside the CCA that this purchase would generate over time (15 per cent in the first year, 30 per cent on the remaining pool of value in each subsequent year).

Then the students grab a card from a special deck Johnson has made with different levels of taxable income. This enables them to figure out exactly how much they would save with the increased CCA. (Of course, the higher the income and the higher the marginal tax rate, the greater the annual tax savings.) The cost of paying the tractor loan off less the tax savings gives the students their net cost.

Johnson then gets the students to do another calculation, this time with a straight leasing agreement (no buy-out) on the same tractor, and gets them to calculate which would end up costing them more over the same five-year period.

The farm management specialists at Kansas State University (KSU) have taken the analysis of machinery purchases a bit further. On their website at www.agmanager.info/ farmmgt/machinery, they have various spreadsheets that enable a producer to compare the ownership and operating costs of different pieces of machinery like tractors, combines and sprayers over time.

Their models include figures for average repair costs that are based on formulas from the American Society of Agricultural Engineers. These formulas project the average accumulated repair costs for a piece of equipment over the course of its useful life. Market information from Iron Solutions, the official guide of the equipment industry, is used to estimate resale values and depreciation.

The KSU model leaves fuel and labour out of their calculations. Basically, they assume tractors of similar size and capacity will have similar fuel and labour requirements.

The KSU model also discounts payments and expenses occurring in the future to bring them back to today’s dollars. The discounting principle states that a dollar you receive or that you must pay at some point in the future is worth less than it is today. This is true because of three main factors: the interest you can earn on the dollar if you have possession of it right now: inflation that reduces its future buying power; and the risk that the future dollar will never actually materialize.

Discount rates are subjective but they are used extensively in the business world to express future inflows and outflows in terms of their Net Present Value (NPV). To find NPV, you divide the amount to be received at some future date by 1.0 plus the discount rate to the nth power where n is the number of years you have to wait. If this leaves you in the dark, just remember the longer you have to wait and the bigger the discount rate, the less a future dollar is worth to you today.

The KSU programs are very well-designed and simple to use. You plug information on the user page and the program generates figures for the overall cost of ownership. Unfortunately, because of different tax laws in the U.S., some of the results are not as meaningful as they could be for Canadian farmers.

With Excel or other similar financial software, it isn’t difficult to build spreadsheets that incorporate as much or as little of these types of analysis as a producer wants. Farm managers who do not feel comfortable building one themselves can find an accountant or a farm adviser who will.

The example in Tables A and B looks at the costs associated with the purchase of a one-year old 375-horsepower four-wheel- drive tractor with 500 hours. It is being bought for $200,000 with a $50,000 downpayment and payments of just under $26,000 per year for seven years. A number of assumptions are built into this example such as the marginal tax rate for the farm (28 per cent), the market value of the tractor at the end of the seven-year repayment period ($85,000), the discount rate (4.0 per cent, made up of 2.5 per cent for interest and 1.5 per cent for inflation), the number of hours that will be put on the tractor (500 hours yearly), the expected annual repair bill (based on the KSU formulas) and lastly,

the fact the tractor is being purchased late in the fall so that no hours are being put on the tractor in the year of purchase (Year 0).

Any of these assumptions can be changed, but once the spreadsheet is built, it is easy to use it to assess different options that either a dealership or the classified ads or even Kijiji might have to offer.

This first example shows discounted net costs of $91,733.74 over a seven-year period. But it also shows how the yearly net costs move up over time as projected repair costs increase and the CCA the farm can claim drops substantially. Of course, in year 8 — if the analysis was continued — there would no longer be any principal and interest payments and net costs would be far less. By the same token, the farm would then be relying on a 10-year-old tractor with higher risk of mechanical failure and significant down time.

But the real benefit of such a spreadsheet is its help in comparing options. So let’s say there is another 375 horsepower tractor that would meet the farm’s power requirements equally well. This second tractor is five years old, has 2,000 hours and comes with a price tag of $150,000. Its estimated salvage value is $60,000 but the other assumptions are the same.

Although the initial cost of the tractor is $50,000 less, the net cost over the seven-year period covered by the analysis is much smaller — about $14,000 in fact. There are several reasons for the narrowing of the gap between the two tractors but mostly it has to do with the greater tax benefits of the more expensive unit and the lower repair costs that the owner can expect over time.

On the other side of the equation, the older tractor is easier to cash flow and will keep the per-acre costs lower. As well, the difference in value between a one-year-old and a five-year-old tractor will typically be greater than the spread when the tractors are eight and 12 respectively.

Which is the better deal? It’s hard to say. The older unit has a lower net cost but what happens if in a warm spring in Year 4 or 5, it suffers a breakdown, costing the farm a couple of days of prime seeding time? What happens if it then starts to rain and two weeks pass before the farmer can get back out to seed? In my area, that might mean a section of land where yields are reduced: 640 acres times four bushels per acre times $6 per bushel in wheat and you’ve lost $15,360 –— enough to cover the difference in discounted cost between the two units.

It comes down to the trade-off between risk and cost that Martin Windus pointed out. There is something to be said for a two-year bumper-to-bumper warranty on a new unit with extended four-year coverage on the power train, especially in the high-stakes game that grain farming has become.

But there are lots of producers who manage the risk of mechanical breakdown in other ways. Sometimes it’s a matter of having a well-equipped shop and a mechanic who can’t be stumped. Other times, it is lots of older units that can be brought into service at a moment’s notice. Or maybe there is a neighbour who is always looking for more acres to plant, spray or combine.

In the final analysis, machinery purchase decisions, like so many other farm management issues, remain a matter of individual preferences, risk tolerance and liquidity.CG

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