Fixed cost calculation

[tigerd]

I have had a burning question that I have debated with varoius people and cannot seem to find a good answer.

On provincial worksheets, in the fixed cost sections, there is always the line with machinery, land, etc. INVESTMENT cost. I don't think this should be included with fixed cost calculations, unless there is a loan, and one is paying interest on a loan.

My arguement is this. If I pay 60000.00 in a quarter of land, or 200000.00 in a combine, that is an investment. I want to see an after tax return on that investment.

When I buy a 60000.00 mutual fund, I want to see an after tax return on that investment.

Having said that, it is expected with fixed cost calculations on the farm, I am supposed to deduct something like 10% or so for a supposed investment cost. In a mutual fund, or other type of investment, there is no investment cost deducted off of it! Why is this to be figured in the fixed cost calculations for a farm? An investment is an investment.

[kaniteo]

I'm wondering if your question is best answered by thinking of the cost as an opportunity cost rather than an investment cost.

The principle of opportunity cost states that "when resources are scare, (and money is always scare) the cost of a resource is not its cost in the market place, but its cost in terms of the returns which must be given up by not using it in its best alternative."

Investing funds in a GIC that may only pay 3% rather than your mutual fund paying 10% would be an opportunity cost of 7%, money foregone by investing in the GIC rather than the mutual fund.

Currently, opportunity cost is not as big an issue as it was in the early '80's when ROI on farming may have been 5% compared to a return one could have received investing in Canada Savings Bonds which at times paid 20%.

[winston]

I agree that the fixed cost should not include imvestment costs.

No one prepares a budget that way.

[tigerd]

Kaniteo, I know what you are saying, but that opportunity cost I don't think should be figured into the fixed cost for farming, or anything.

There are always "what if's" and "should have's".

One cannot usually sell canola at the top of the market peak for the year. The cost of the missed opportunity is not figured in this case. The opportunity cost here is that that asset in the bin was worth more two months later when the market did peak. When that asset was liquidated (sold) one does not apply the missed opportunity cost against the net sales. Thus, I don't believe it should be applied to fixed costs either.

[dyck]

Investment costs are an essential part of cost accounting. By definition, investment costs are a measure of the value of money tied up in a capital asset. In other words, it is the money you could have earned by putting the money into another investment.

Using your example, if you have $60,000 you could go one of two ways - purchase a mutual fund OR purchase a quarter of land. Either decision means you are buying something to earn income in a given year. For simplicity sake, let's earn 6% on the mutual fund, or $3,600 per year. So, if you buy a quarter of land, you should earn $3,600 every year ($22.50/ac) over and above operating expenses to justify the land investment.
Thus, investment costs are a way of comparing the purchase of assets.

To compare after tax returns on this same quarter, you would compute income less variable costs to get a return to labour, management and capital. Then factor out labour and management and divide by the capital cost to get the return. For example, if you earned $32,000 on the quarter, had variable costs of $24,000 and labour of $5,000, your return would be $3,000 or 5%. As with any agricultural assets, return varies considerably from year to year. That's part of your risk bearing capability - if you can handle the variability in returns, then invest in land. Otherwise, if you want a relatively consistent return, invest in mutuals.

[tigerd]

dyck, thank you for your comment. It is a good way to compare. The past two years, however, seems hard to earn a modest 6%!

To me, it is a good comparison. However, I don't really need a comparison. If a quarter of land is earning me a six percent return, good. A fifteen percent return, better. Maybe sometimes it will lose money. After all, one can compare it with one's other investments.

I do not feel I should have to deduct it (investment cost) from what that quarter of land is earning, like some of the government worksheet calculations suggest to do.

[rsomer]

tigerd:

Interesting comments...I tend to agree. I find when I go back through the years of crop enterprise analysis Alberta Agriculture did for me that although they do have line items for Investment in Land, Buildings, Machinery that these items are not included as costs rather they come later under Return to Investment. For my analysis, the province grouped costs as variable costs and capital costs rather than variable and fixed costs like I would have liked to do. I see the province included what I would have called fixed cost items, Utilities and Misc. Overhead as well as Paid Labour, as a variable cost but for certain they are not capital costs. When I look for budget and cost examples on the Ropin the Web site, more and more they are listing just the variable costs with the remainder called contribution which I like better. . Everyone has their own individual fixed costs anyway.

I think land investment and mutual funds are different investments and as such are difficult to compare. Most of us expect long term growth in the value of our land investment and that is where a significant portion of the ROI would come from. If we knew we could be sure to buy a quarter of land 10 years from now for the same price it is today it would be smart to wait the 10 years because most likely the annual returns from the land would not justify the interest or investment costs.

Re your comments on canola. We sometimes see "cost of carry" as an opportunity cost of holding grain or cattle even if there may be no actual interest cost or loan against this production. Elevator companies are particularly fond of pointing out the cost of holding grain in the bin because they want you to sell it sooner rather than later so they can get their money for elevation this year instead of next. Typically, land, buildings, equipment and other capital items are expected to earn a return on investment. I would view your canola and other farm produce yet unsold (net of the variable and fixed cost of growing it) as part of that return on your capital investment. If you choose to store it rather than sell it right away, that would be like your mutual fund investment. Hopefully the value of the produce will rise and your decision to store will be profitable. Lets face it, the value of mutual funds can flucuate just like the value of your canola.

Hope this helps and that it makes some sense.