By Howard Doster
As a farm manager, you ask this question every moment: Should I retain the use of my assets, or replace the use of one or more? Most moments I just continue monitoring my present plan, looking for a surprise.
A surprise could be the opportunity to rent another farm. If so, I compare what I expect to make on the new farm vs. what I now make on my least-profitable lease, using my labor, machinery and money resources on the same last plant and harvest dates.
In each comparison, I’m now starting with the same balance sheet after-tax equity. One option is to create a whole-entity budget for my present business and family, and a whole-entity budget with my present worst-case lease replaced by the new potential lease.
I don’t have software to do this, but I have paper and pencil. I will make a partial budget comparison, where I don’t trade any land or machinery and spend the same for labor and family living. I will look at how contribution margin changes. That’s expected revenue from crops and government payments minus variable costs for seed, fertilizer, pesticide, fuel, repairs, operating interest and machine use loss of value.
Machine use loss
In future variable costs, which I use to figure contribution margin budgets, I include the part of machine use loss of value that’s due to use. Until I find a better number, I’m using $20 per acre. Machine loss due to obsolescence reduces equity, but I don’t need to calculate it to pick the better lease.
Why add this new variable cost — machine use loss — into the contribution margin formula to decide whether to replace my least-profitable lease or retain it? If a machine is used, its loss in value increases. When appraised at a lower value, it causes less balance sheet equity than if it’s not used. Remember, the goal is to maximize balance sheet equity.
Some farmers may be willing to eat loss of machine value for using machinery rather than let it set in the shed on their equity asset sheet. I wouldn’t be willing to do that. Even in variable expenses you should account for what’s happening to the value of your machinery. You at least need to recoup its loss in appraised value because you farmed that farm rather than ran it on fewer acres.
For my present lease, I subtract my cash rent from the contribution margin I calculated. What’s left is adjusted contribution margin.
For my possible replacement rental, the surprise opportunity, I guess what competitors will bid. I add a dollar to it for my rent bid and subtract from the contribution margin for the replacement farm to get adjusted contribution margin.
I would pick the alternative with the larger adjusted contribution margin. It adds more to my after-tax equity.
Rent bidders and landowners tend to adjust leases toward an equilibrium rent, but a negotiations lag occurs. When crop prices are high, most rents will be less than equilibrium. When crop prices are low, most rents are less than equilibrium.
Plus, some farmers get higher yields, receive higher prices through marketing or pay lower input prices. They outbid average tenants. Of course, if prices don’t improve, some tenants wear out machinery.
Consider studying the Purdue Crop Budget Guide. Look for contribution margins, reported average rent and equilibrium rent.
Doster is a professor emeritus in the Purdue University Agricultural Economics Department.