Grains Research and Development

Date: 06.05.2013

Analysing the economics of machinery purchases

Author: Barry Mudge

Photo of one green, one red and one yellow machine - arranged on a field

Machinery investment can have significant implications on the ability of a farm business to produce grain profitably.

Barry Mudge, a farm business consultant from South Australia, looks at some of the simple analyses that can be done to aid machinery purchase decisions.

The clever and effective use of machinery on Australian broadacre farms has been a prime driver in achieving substantial productivity gains over many years. Investment in machinery on most properties is considerable and would usually only be exceeded by land purchases as the single biggest farm expenditure. Getting machinery purchase decisions right can have substantial implications for the resilience of individual farm businesses.

Growers are frequently influenced by taxation considerations. These are relevant, but do not necessarily take account of the real value of the machine to the business or the risks of the investment.

While the human mind has a wonderful capacity to work through the maze of considerations to arrive at fitting outcomes, the decision process involving machinery purchases can be supported by some simple analysis at both a strategic (whole-of-business) level and tactical (individual-machine level).

Whole-of-business

A question often asked is: “What is the appropriate level of investment in machinery for my business?” Table 1 sets out two ratios commonly used within mixed-farming businesses to benchmark machinery investment. The important aspect of these benchmarks is that they are only guides and there may be valid reasons for operating outside them.

There is an important logic behind these benchmarks, relating to the cost of producing the commodity for which the machinery is being used.

As an example, a recent case study of a modest wheat-growing farm near Booleroo Centre in upper-north South Australia compared investment in machinery with cost of production of wheat (Table 2). Ongoing investment in machinery at levels significantly outside of conventional benchmarks has a strong effect on the ability to produce wheat at competitive prices.

In this case, running a level of machinery investment significantly above what would be regarded as reasonable resulted in the cost of production of wheat in an average year rising by $14 per tonne, even after allowing a five per cent improvement in productivity due to better equipment. The effect of this is to expose the business to considerably higher risks, with the greatest impact during periods of poor productivity or prices.

The simple point is that the choice by the farm business decision-maker about the overall level of machinery investment can have significant effects on the ability of a farm business to produce commodities at a price competitive with other businesses. Unless a business is capable of achieving cost competitiveness, it is unlikely to survive in the longer term.

 Ratio  Benchmark
Table 1 Common machinery benchmarks for broadacre cropping farms in southern Australia
 Machinery investment ($) per tonne of grain and hay produced
 $250 to $300/tonne
 Machinery investment ($) / gross farm income
 1.2 to 0.8
 Total machinery investment ($)
 Machinery investment per tonne of grain produced on average ($/t)
 Ratio of machinery investment to gross income
 Estimated wheat cost of production in an average year ($/t)
Table 2 Effect on average cost of production of wheat by different levels of machinery investment at Booleroo Centre in South Australia
 250,000  170  0.52  265
 500,000  311  0.97  267
 750,000  445  1.41  281

Individual machinery

Simple analyses can also be informative when deciding on individual machinery purchases.

Machinery costs can be divided into two areas: fixed (or overhead costs); and operating costs.

Overhead costs are the costs that are incurred irrespective of whether the machine is actually used. These include insurance and registration (if applicable), depreciation, the opportunity cost of capital, shedding and operating costs.

Depreciation is usually calculated by estimating the value of the machine at the end of its use in the business and allocating this reduction in value on an annual basis over its years in the business. Another approach is to use a percentage annual reduction in value (for example, seven to 12 per cent, depending on the machine).

The opportunity cost of capital reflects either the borrowing costs of financing the machine or the alternative return that could have been achieved on cash equity funds used to purchase the machine (this will often equate to bank deposit interest). This is usually calculated on the expected average value of the machine over its ownership. The rate used will depend, to an extent, on the current interest rate cycle, but would normally be expected to be between five and 10 per cent.

Normally allow 0.5 to one per cent of machine value for shedding.

Operating costs include fuel, labour, repairs and maintenance. Growers are usually quite comfortable in estimating costs in this area. It is important to value labour on a commercial basis even if it is your own labour that is being used to operate the machinery.

Table 3 sets out a simple example of the total annual ownership costs of a second-hand harvester.

In this example, it is interesting to note that fixed or overhead costs amount to more than half of the total annual machinery ownership costs. It is an important rule of thumb – which drops out of much machinery analysis – that often more than 50 per cent of the costs of machinery ownership occur before you turn the key, rather than after.

Table 3 Example of calculation of annual machinery costs for the purchase of a $300,000 second-hand harvester.
 Purchase price ($)
 300,000
 Estimated salvage value ($)
 120,000
 Estimated life (years)
 8
 Opportunity cost of capital (%)
 7%
 Shedding cost (% of new cost)
 0.75%
 Annual fixed (or overhead) costs
 Depreciation (purchase price – salvage value) / estimated life
 A  22,500
 Opportunity capital cost (average price * OCC%)
 B  14,700
 Shedding  C  2250
 Insurance  D  800
 Registration  E  200
 Total overhead costs
 (Sum A-E)
 40,450
 Annual operating costs
 Fuel and oil
 F  15,000
 Repairs  G  10,000
 Tyres and batteries
 H  1500
 Labour  I  12,000
 Total operating costs
 (Sum F-I)
 38,500
 Total annual machinery costs
 Overhead 40,450
 Operating  38,500
 Total  78,950
 Estimated annual usage (hours)
 300
 Estimated cost per hour (excluding allowance for profit)
 263
Note: The estimates used in this example are for demonstration only and should not be considered indicative of actual costs incurred in owning and operating a harvester. Individual circumstances will vary and decision-makers should adopt their own estimates.

Another ‘rough’ rule of thumb is that the total annual costs to own and operate a machine will be usually about 25 to 30 per cent of the value of the machine. This rule can allow a prospective purchaser to undertake a first ‘quick and dirty’ analysis of the financial effects of a machinery purchase.

The decision to buy machinery invariably involves the assessment of a wide range of factors and potential benefits, many of which are difficult to quantify. These can include the potential for productivity improvements, risk of breakdowns, operator comfort and ease of use, timeliness risk, potential for environmental benefits, and workplace health and safety considerations. Whether valid or not, the colour of the paint and the desire to have the newest and best can also be important in the final decision.

However, some simple economic analysis will insert some important objectivity into the process of making what could well be a make-or-break decision.

More information:

Barry Mudge
0417 826 790

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