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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.
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).
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.
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.
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.
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.
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.
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.
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 |
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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. |
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