David Heinjus and Partick Redden

Rural Directions Pty Ltd

Take home messages

• Develop a machinery decision making policy
• Machinery decision making – should focus on business case not tax
• A farm machinery business should be run like a manufacturing business. The owner should be continuously asking “what is the cheapest and most cost effective way to undertake an operation?”
• When the cost of owning a new or upgraded machine is cheaper in $/ha than the existing machine it should be changed over
• A benchmark to consider - machinery investment to income ratio at 1:1
• Calculate field efficiency to look at ways to improve efficiency and leverage off the total investment in machinery- be aware of bottle necks

Introduction

Machinery decision making can be a complex area requiring investment of significant capital. There is nearly always a combination of emotional and business case considerations driving decision making. All too often farmers make machinery decisions because they can, not because they should.

I am writing this paper having been exposed to many aspects of farm machinery decision making. As Managing Director of the Pareta Farms Group, we have invested significant capital into farm machinery. We manage our machinery business as a separate entity. This means we look at machinery as a profit centre, not just capital that is integrated with the rest of the farm assets. Many farmers separate their land business from their operations business. This then facilitates management that focuses on the real estate business as a profit centre and the operations business as a profit centre. My belief is machinery investment on many farms is so significant that this principle also needs to be adopted.

As Managing Director of Rural Directions, I also advise farmers on strategic machinery replacement plans. This also involves the development of customised changeover policy. Given the large capital investment required, I have seen plenty of examples where over capitalisation in farm machinery has lead to significant financial stress. As an on overarching management principle I like to see businesses operating with a machinery investment to income ratio of 1:1. If a client wants the toys, they need to do some more deals to leverage their overall business revenue.

I also advise several large scale machinery dealerships in business management and marketing. From this perspective I have seen plenty of examples of emotional, non-strategic and tax motivated purchases that really leave you wondering about the depth of thinking that has gone into the decision making process.

My approach will involve demonstrating appropriate business processes with case studies to assist with learning and some benchmarks that may assist with decision making.

Machinery Decision Making starts with a well-considered policy 

I was running a workshop with a group of farmers recently and we were discussing differences that exist in policy between farms.

Farm business policy is often intuitive, i.e. it is not written down. This does not mean it has not been well considered, the policy has been thought about reflectively for years. We were talking about machinery decision making as an approach to demonstrating the differences in policy. Within the group were three farmers all sitting in a row. The first farmer was adamant that they change over their harvester every 1200 hours. The next farmer said – we always look for good second hand harvesters and would look for a 1200 hour machine and run it out to 2500 hours. The third farmer then said, we only buy second machines and run them until they drop. Each business is successful and has their own set of reasons why they have such different policy. These often relate to risk, capacity to undertake repairs and maintenance and initial level of investment.

Farm vehicles are another example where both tangible and non-tangible criteria are applied to decision making policy. I have several clients who have very high standards regarding the image of their business. They look at investment in vehicles as a direct reflection on the brand image of their business. They believe that if employees are driving around in beaten up old utes, then this portrays a “broken down brand”. These clients want to portray a professional and modern farm business image. They believe this is important for attracting and retaining employees. Given this “brand” objective, these clients will religiously change over farm vehicles every 140,000 km. Strangely enough this is often more regular than the family car.

Another example of policy – several clients will replace their harvesters when the tyres need replacing.

Starting the machinery decision making process with a discussion about policy is a good place to begin. Policy should consider:

• Business case
• Brand image
• Proactive management of risk
• Occupational Health and Safety
• Personal productivity
• Capacity to manage breakdowns
• Efficiency objectives
• Upgrade frequency
• Ease of employee use and understanding
• Colour
• Budget
• Personal goals

Like all business policy discussions, it is important to have these with all business owners and stakeholders. This then leads to greater depth of thinking and commitment to the overall business strategy. Policy provides discipline and rigor in decision making.

It is also important that business policy is critically reviewed every 2-3 years. This will ensure the policy remains current and relevant. The risk with policy is it turns into universal strategy. Policy is situational. By this I mean, what somebody else does on their farm relates to their policy and their situation. It should not become the policy that becomes universally adopted by a region. There was a lot of universal strategy being adopted when the Government offered business owners the accelerated depreciation allowance on new machinery during the GFC.

Understanding Total Cost of Ownership

Case study one – the new truck

Recently a client sent me an email titled the “new truck equation”. The purpose of the email was to sound me out regarding a business case for a new prime mover and two trailers.

Before we judge the proposal, I will provide some context.

The client has picked up some signals from his existing contractor that started to worry him. His carrier has indicated he is planning to sell his trucks and retire in a couple of years. It has been a very productive relationship that has existed for the last 20 years. The current spend on freight is approximately $78,000 to carry 4,800t ($16.25 / t). The carrier is also very responsible and is very aware of the consequences of incorrect classifications. The contractor often requests reclassification of grain at the silo and has been happy to blend loads to achieve maximum quality. This has resulted in many loads achieving maximum value. Obviously this informal quality control system is highly valued by the client. The client now has many questions going around in their head. These include:

• How will I ever find another contract carrier who has the same level of care and one that I can trust?
• How can I control the misclassification risk?
• How can I still blend loads to manage quality risk?
• How will I keep the grain away from my harvesters?
• How can I control the whole logistics process at harvest?
• How can I manage the breakdown and compliance risk if I buy a second hand truck?

The business rationale emerging in the clients mind is:

• A desire to control the whole logistics process.
• A desire to have flexibility to blend grain on farm
• The worry about the risk associated with buying a second hand truck
• Simplistically, if they are currently spending $78,000 per annum, then the truck will roughly pay for itself in a bit over 5 years
• Some tax savings
• An underlying desire to buy and own a new rig

The new rig has everything – 90 tonne GCM, auto shift transmission, PTO hydraulics, auto slack adjusters on the brakes, 480Hp Cummins ISX 15L engine and is quoted at $225,000 plus gst. The trailers are the same. Gleaming new aluminium tippers and have been quoted at $218,000 plus GST. Proposed total spend is $443,000 plus GST.

Too often, farmers buy something because they can, not because they should. The other excuse is they have been advised to keep their tax down by “keeping their machinery new”.

We talked over the plan and agreed we should commence a business case process so a proposal can be put forward to fellow family members. We agreed the first step is a total cost of ownership analysis.

For a truck total cost of ownership analysis includes:

• Annual depreciation cost
• Interest cost
• Insurance cost
• Registration cost
• Annual repairs and maintenance costs
• Fuel costs
• Labour costs
• Valuing risk, penalty or timeliness costs

Annual depreciation can be difficult to calculate. This is because it relies on trying to value a piece of machinery in the future. Over the last few years we have witnessed variations in machinery values because of:

• The accelerated depreciation allowance creating demand for new machinery and flooding the trade market. There were many new machinery prices that were inflated because the farmers’ only objective was to claim the tax deduction. It was a tax motivated decision not a strategic business case decision. Many of these deals will experience significant management depreciation.
• Seasonal conditions either creating demand or no demand for machinery. Supply and demand curves then influence price. The wet harvest in 2010 created unprecedented demand for second hand harvesters and semi trailers. Farmers were paying higher prices to secure harvesters. Once the risk was managed the harvester will have depreciated significantly as the trade market returns to a normal level.

These market influences impact on the overall initial retail cost. If the farmer pays too much because of reactionary or non-strategic management, then the level of depreciation will generally be higher.

Generally depreciation accounts for wear and tear and obsolescence. There are multiple methods for calculating depreciation. In a management context, my preference is to use the straight line method. This involves subtracting the salvage value from the original purchase price and then dividing this by the years of its useful life. In the interest of keeping the process simple, the straight line method provides sufficient rigour for calculating management depreciation.

Using tax depreciation rates is not appropriate because they are generally disconnected to what may be happening in the market. Websites like www.trucksales.com.au and www.farmmachinerysales.com.au are very useful for assessing the current trade value of farm machinery and trucks.

Annual depreciation cost = (Original purchase price -salvage value)

                                                    Years of useful life

Interest on the amount of money that has been invested. This accounts for the opportunity cost associated with the acquisition. The formula to calculate this is:

Annual interest cost = (Original purchase price + salvage value)  x by an interest rate (8%)

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Insurance and registration are additional annual overhead costs. They will vary according to the value of the machine. With trucks, registration will vary according to the specification of the truck.

Repairs and maintenance, fuel and labour are all variable costs and will vary according to the annual usage of the machine or truck. The challenge with variable costs is understanding the actual future costs. Unfortunately there is often a discrepancy between what other farmers and the salespeople will tell you versus reality. Unfortunately basic fuel consumption and work rates are often not monitored or recorded.

Back to our case study – let’s have a look at the truck scenario.

The total cost of ownership figure can then be used to compare the outcome with a contractor. The total cost of ownership figure can also be divided by various contracting rates to look at breakeven tonnes. In this case the breakeven tonnes for the road train at $14.00 / tonne is 5656 tonnes, while for the second hand truck, the breakeven is 3657 tonnes.

Valuing risk, penalty or timeliness costs

Risks that need to be considered with the truck proposal include:

• Grain delivery risk – misclassifications of grain if delivered in a “dump and run” manner by a carrier is a significant risk. This client estimates 50% of their malt barley (1,500 tonne) could be classified as feed if a contractor strategy is adopted. This assumption is based on observations of ratio of malt to feed with overflow carriers in previous harvests. If there is a malt to feed grade spread of $100 / t (like 2010) then this would result in $150,000 addition revenue by managing this risk by carting the grain themselves. If the malt to feed spread is $30 / t, then this equates to $45,000 in additional revenue for the business. Either way, management of this risk contributes significantly to the viability of the proposal. However if the driver is not properly trained, then this risk may not be effectively managed.
• Compliance / obsolesce risk - annual registration inspections that operate in other states if adopted in South Australia may result in increased ownership costs to keep a truck compliant. Such a policy shift could result in trucks becoming newer and accelerating the depreciation on older trucks. There is also an increased risk of older trucks being given a non-roadworthy certificate. The cost of making the truck compliant may then be non-economic. I have had several clients with a $30,000 prime mover watch it become worthless once a defect notice has been served.
• Breakdown risk – unfortunately trucks do not breakdown when they are not being used. There is a higher risk a truck will breakdown if it is not well maintained or is older. If a truck breaks down during harvest, the farmer incurs the annual cost of ownership and the cost of contracting. In this situation, a cheaper truck does not look so cheap any more.
• OH&S risk – managing personal stress or managing potential safety risks need to be also considered. Sometimes this risk is difficult to quantify.
• Timeliness risk – if the freight logistics model that has been developed does not keep up with harvesting rate, and the harvesters have to stop harvesting and this is impacted by rain and therefore devalued, then there is a timeliness risk present.

When looking at risk management, the first step is to assess the likelihood of something happening. The second step is then assessing the consequence or impact on the business. If the likelihood and consequence assumptions in the risk analysis are realistic and balanced, then many proposals with marginal economic return from operations can become economic. The trick is to also rigorously “question” all assumptions. Do not just accept them as read.

Another client has a 6 year old spray tractor that has done 4,800 hours. Over the last 12 months it has had a couple of major breakdowns and this has resulted in $12,000 being spent on repairs and maintenance. Up until 4,200 hours it had only incurred the annual servicing costs. The two breakdowns were both inconvenient and because this tractor is the main spray tractor and a favourite (because of comfort) it gets used more than any other tractor on the farm.

The client gained a quote for a change over and the new tractor was quoted at $239,000.

The questions going through the clients mind:

• Mmmm, this is a lot of money, what if my crop does not go as well as I hope?
• What am I going to tell my wife, when we also have kids at boarding school and a kitchen that needs doing up?
• Should I fix up my existing tractor and hope it goes ok for another 12 months?

Like the truck we need to look at the total cost of ownership equation to assess the different options.

The analysis clearly demonstrates the new tractor (despite its increased purchase price) is cheaper to own in $ per hour than the existing tractor. Reconditioning the tractor and keeping it for another year or two was also not appropriate in this situation. A common scenario I have observed is a farmer undertakes a major repair or reconditions a machine and then trades soon afterwards. In this case the money has been spent, but not amortised over a few years to enable the investment to be justified.

If the cost of ownership of the new machine is cheaper than keeping and maintaining the existing machine, then it should be changed over.

Tools for calculating the Total Cost of Ownership of farm machinery are available on the Rural Directions website. www.ruraldirections.com

Achieving efficient operations

Calculating work rates for different operations is a useful way to look at how efficient an operation is being undertaken.

The formula for calculating a machinery work rate is:

Work rate in Ha / Hr = (Speed (km/hr) x width (m)) x efficiency %

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If sowing a crop at 8 km / hr and using an 18.33m air seeder and operating at 80% efficiency, this farmer should be able to sow the crop at 11.73 ha / hr.

The formula for calculating field efficiency is:

Field efficiency % = Time spend operating the machine x 100

                                Total time spent in the paddock

Total time spent in a paddock generally includes filling time, travel, fixing breakdowns, turning, overlapping and undertaking maintenance. Field efficiency can be a highly variable factor between farms. The table below demonstrates the impact of field efficiency on work rate.

Across a 2,000 ha sowing program, field efficiency can have a significant impact on time of sowing. If operating a seeding program for 10 hours per day the difference in sowing area is 30 ha per day. This then potentially blows out total time to an additional 6 days of operation. This may not sound that significant, but if there are weather delays as well, then time blow outs can result in later sowing than is desirable. This principle flows across all major farm operations like spraying and harvesting.

Overcoming potential bottle necks can also provide appropriate justification for changing over piece of machinery. An example of a bottle neck is a windrow pick up. There are plenty of examples where a new high capacity harvester has been purchased, but fitted with the old windrow pick up. In this case the harvesting capacity is limited by the front, not the harvester. Simply applying the total cost of ownership process will determine if it is cheaper to recondition the existing pickup or buy a new one.

Some properties will have physical limitations to improving field efficiency. For instance paddocks with contour banks, hills, creeks, areas of non-arable country or tress will have a lower field efficiency when compared to large flat rectangular paddocks. There can be as much as 20% difference in field efficiency.

Some tips for improving field efficiency include:

• Preventative maintenance of machinery
• Increasing paddock size
• Chaser bin
• Nurse tank for spraying
• Block farming crops
• Laneways (sheep and cropping access)
• Staff training
• Large air seeder boxes, or sprayer tanks
• GPS - autosteer

Businesses that have focused on increasing field efficiency through paddock shape and block cropping can generally also farm a larger area with the same size plant. This then increases the potential revenue and improves the whole position of the farm business. We have seen variations of up 400 hectares per FTE difference in crop areas managed. This is basically due to focusing on improving field efficiencies.

Contact Details

David Heinjus

Rural Directions Pty Ltd
dheinjus@ruraldirections.com
08 8842 1103