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Annual Costs of Investments
Annual Costs of Investments M. L, McGILLIARD Department of Dairy Science Virginia Polytechnic Institute and State University Blacksburg 24061
For many investments, accurate comparisons of expenses alone can shed much light on the decision. An easy and accurate method of comparing expenses is to compare estimated annual expenses of ownership. An annual expense or cost is a constant yearly a m o u n t which pays for purchasing, owning, and maintaining the investment. Once investments have been converted to annual costs, they can be compared fairly. Comparing initial prices, even
ABSTRACT
An annual cost is a constant yearly amount of money which pays for purchasing, owning, and maintaining an investment. Comparisons of annual costs can lead to more profitable investment decisions by dairymen. This guideline describes for dairymen expenditures which influence annual costs and provides a method for calculating annual costs of investments. An example and tables of interest are included with estimates o f years of life and rates of repair and insurance costs for c o m m o n dairy buildings and equipment.
including estimated yearly expenses, can be
misleading and m a y cause you to choose the
INTRODUCTION
Financial investment is a necessary component of a profitable dairy business. If not managed properly, however, poor investments can lead to financial difficulties. Certain types of investments are inherently safer than others. Land and cows, for instance, are the safest investments because they often increase in value and produce direct income for the business. Investments in equipment and facilities entail more risk as they generate receipts though the cows rather than directly. Overinvestment in equipment and facilities is a problem of many dairy farms. Evaluation of expected expenses and receipts of all investments before purchase can help alleviate excessive expenditures. Normally you will be choosing among several alternative investments. This requires careful comparisons of not only expenses and receipts but also consideration of benefits not easily quantitated. The value of additional mechanization in the milking parlor, for example, cannot be assessed fully on the basis of expected dollar receipts or decreased labor expenses.
least profitable alternative. This is because alternatives have different lengths of life and require expenditures at different times in the future. Remember, money has a time value. A dollar invested today should be worth more tomorrow. INTEREST
The foundation of the annual cost is a conversion o f initial price to an annua/expense. This is more involved than merely dividing initial price by number of years o f life because interest over time must be included. In the example (Fig. 1), the price expended per year is not $1260 ($12,600/10) but $2050, the initial price including 10% interest for 10 yr. If money
Annoa~ Costs
Description
s 1 4 , 0 0 0 BULK TANK
Years of Life liable 11 10 InitialExpense:
12.600
X
:
price (less invest, credit) factor from table 2 Salvage Value: 2,000 X .0627 : value at end of life factor from table 3 Annual Depreciation: (line l-line 21 Annual Repairs:
14,000
original value Annual Insurance:
14,000
original value Annual Taxes: (your best estimate)
X
10
I
125
2
1,925
3
560
4
210
5
.040
X
:015
fraction from table1 _ _
$ 2,695
FIG. 1. Annual costs for bulk tank example.
1683
%
2.050
fraction from table 1
Total Annual Expense: (add lines 3,4,5,6)
Received May 18, 1978.
1978 J Dairy Sci 61:1683--1686
Annual Interest .1627
6
7
1684
McGILLIARD
TABLE 1. Expected years o f life, annual rates of repair and insurance, a Annual b Building or equipment
Years life
Repairs
Insurance
Free stall barn Stall barn Hay barn Milking parlor Grain storage Silo, concrete bunker Silo, concrete tower Silo unloader/concrete Silo, gas-limited tower Silo unloader/gas-limited Tractor Feed bunk Baler, harv., condit., windrow., m o w e r Forage harvestor Forage attachments Mechanical feeder Forage wagon Mechanical feed wagon Silage blower Bulk tank Milking equipment Manure storage, concrete Manure spreader Liquid manure spreader Mechanical manure scraper Gutter cleaner Manure stacker Pump and agitator
20 20 20 20 20 20 20 8 25 8 10 15 8 8 8 5-8 10 8 8 10 10 20 3--5 8 8 12 10 8
.020 .020 .020 .040 .030 .010 .010 .050 .005 .055 .040 .030 .055 .055 .060 .050 .030 .050 .040 .040 .040 .010 .050 .040 .040 .050 .050 .050
.015 .015 .015 .015 .015 .015 .0t5 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015
aMichigan State University 1976 with modifications (2). These are average figures and may not apply to your business. Use your best estimate. bThese fractions represent percentages of the original value of the item (.020 represents 2.0%).
TABLE 2. Factors to convert initial cost to annual expense at given rates of interest and years of life. Interest Yr
8%
9%
10%
11%
12%
1 3 5
1.0800 .3880 .2505
1.0900 .3951 .2571
1.1000 .4021 .2638
1.1100 .4092 .2706
1.1200 .4163
8 10 12
.1740 .1490 .1327
.1807 .1558 .1397
.1874 .1627 .1468
.1943 .1698 .1540
.2013 .1770 .1614
15 20 25
.1168 .1019 .0937
.1241 .1095 .1018
.1315 .1175 .1102
.1391 .1256 .1187
.1468 .1339 .1275
Journal of Dairy Science Vol. 61, No. 11, 1978
.2774
OUR INDUSTRY TODAY
1685
TABLE 3. Factors to convert salvage value to annual receipts at given rates o f interest and years of life. Interest Yr
8%
9%
10%
11%
12%
1 3 5
1.0000 .3080 .1705
1.0000 .3051 .1671
1.0000 .3021 .1638
1.0000 .2992 .1606
1.0000 .2963 .1574
8 10 12
.0940 .0690 .0527
.0907 .0658 .0497
.0874 .0627 .0468
.0843 .0598 .0440
.0813 .0570 .0414
15 20 25
.0368 .0219 .0137
.0341 .0195 .0118
.0315 .0175 .0102
.0291 .0156 .0087
.0268 .0139 .0075
Annual Costs Description Years of Life (table 1)
Annual Interest
%
Initial Expense: X : price (less invest, credit] factor from table 2
1
Salvage Value:
2
X value at end of life
-factor from table 3
Annual Depreciation: (line l-line 2) Annual Repairs:
3 X
original value Annual Insurance: original value
-fraction from table 1 X -fraction from table 1
4 5
Annual Taxes: (your best estimate) Total Annual Expense: (add lines 3,4,5,6) E X P L A N A T I O N OF LINES F R O M A N N U A L COST F O R M 1
2
3 4
The a m o u n t o f money y o u w o u l d have to pay eacll year to cover the initial cost (plus interest) o f this item. The a m o u n t y o u w o u l d receive each year if the salvage value were returned t o y o u annually instead o f at the end o f life. The annual a m o u n t o f depreciation. ( A m o u n t y o u pay minus the a m o u n t you receive, each year.) The yearly payment f o r repairs if y o u could spread
5
6
7
7
all repairs equally across all years o f life. The yearly payment f o r insurance if y o u could spread all insurance payments equally across all years o f life. The yearly p a y m e n t f o r taxes (if applicable) if y o u could spread all tax payments equally across all years o f life. The total expense o f owning this item, converted t o a constant yearly expense (considering interest).
This is the expense. What will be the receipts? Is there a better investment?
FIG. 2. Annual cost form. Journal of Dairy Science Vol. 61, No. 11, 1978
1686
McGILLIARD
for the purchase has been borrowed, interest must be paid the lender, and at 10%, the annual payment for 10 yr would be $2050. If owned capital (not borrowed) has been expended, then the purchase is truly an investment, and as such, should return interest to you, the investor. So either way, borrowed or owned capital, the purchase must be charged an annual interest which is at least the rate currently charged by lending agencies.
difficult to estimate. Costs of repairs, of course, tend to increase with the age of equipment. Insurance tends to decrease with the market value of equipment. Table 1 lists reasonable estimates of rates of repairs and insurance for various buildings and equipment. The table factor, multipled by the original value of the item, expresses repairs and insurance as payments made each year. Annual property taxes, if applicable for an investment, must be estimated by you.
SALVAGE
At the end of life, a salvage value is returned to the investor. This is a fair market value for the item at that time, whether or not the investor intends to sell. For annual comparisons, this salvage value is converted, minus interest, to an annual receipt. Figure 1 indicates that if someone gave you $125 per year which you invest at 10% interest, you would have $2000, the salvage value, after 10 yr. The difference between the annual price and the annual salvage is annual depreciation. This depreciation, however, is not that used for. income taxes, but instead, merely a fair estimate of the loss in value each year (adjusted for interest). REPAIRS
Annual costs for repairs and insurance are
Journal oDairy f
Science Vol. 61, No. 11, 1 9 7 8
EXAMPLE
Figure 1 illustrates the expenses involved in owning a $14,000 bulk tank. Note that the initial expense is based on the original price minus 10% investment credit, but the repairs and insurance are based on the original value of the tank. The annual expense of this bulk tank is $2695. Study this example and use additional forms (Fig. 2) to calculate annual costs for investments you are contemplating.
REFERENCES
Fabrycky, W. J., and G. J. Thuesen. 1974. Economic decision analysis. Prentice-Hall, Inc., Englewood Cliffs, NJ. Hoglund, C. R. 1976. Dairy system analysis handbook. Agr. Econ. Rep. No. 300. Michigan State University, East Lansing.
For many investments, accurate comparisons of expenses alone can shed much light on the decision. An easy and accurate method of comparing expenses is to compare estimated annual expenses of ownership. An annual expense or cost is a constant yearly a m o u n t which pays for purchasing, owning, and maintaining the investment. Once investments have been converted to annual costs, they can be compared fairly. Comparing initial prices, even
ABSTRACT
An annual cost is a constant yearly amount of money which pays for purchasing, owning, and maintaining an investment. Comparisons of annual costs can lead to more profitable investment decisions by dairymen. This guideline describes for dairymen expenditures which influence annual costs and provides a method for calculating annual costs of investments. An example and tables of interest are included with estimates o f years of life and rates of repair and insurance costs for c o m m o n dairy buildings and equipment.
including estimated yearly expenses, can be
misleading and m a y cause you to choose the
INTRODUCTION
Financial investment is a necessary component of a profitable dairy business. If not managed properly, however, poor investments can lead to financial difficulties. Certain types of investments are inherently safer than others. Land and cows, for instance, are the safest investments because they often increase in value and produce direct income for the business. Investments in equipment and facilities entail more risk as they generate receipts though the cows rather than directly. Overinvestment in equipment and facilities is a problem of many dairy farms. Evaluation of expected expenses and receipts of all investments before purchase can help alleviate excessive expenditures. Normally you will be choosing among several alternative investments. This requires careful comparisons of not only expenses and receipts but also consideration of benefits not easily quantitated. The value of additional mechanization in the milking parlor, for example, cannot be assessed fully on the basis of expected dollar receipts or decreased labor expenses.
least profitable alternative. This is because alternatives have different lengths of life and require expenditures at different times in the future. Remember, money has a time value. A dollar invested today should be worth more tomorrow. INTEREST
The foundation of the annual cost is a conversion o f initial price to an annua/expense. This is more involved than merely dividing initial price by number of years o f life because interest over time must be included. In the example (Fig. 1), the price expended per year is not $1260 ($12,600/10) but $2050, the initial price including 10% interest for 10 yr. If money
Annoa~ Costs
Description
s 1 4 , 0 0 0 BULK TANK
Years of Life liable 11 10 InitialExpense:
12.600
X
:
price (less invest, credit) factor from table 2 Salvage Value: 2,000 X .0627 : value at end of life factor from table 3 Annual Depreciation: (line l-line 21 Annual Repairs:
14,000
original value Annual Insurance:
14,000
original value Annual Taxes: (your best estimate)
X
10
I
125
2
1,925
3
560
4
210
5
.040
X
:015
fraction from table1 _ _
$ 2,695
FIG. 1. Annual costs for bulk tank example.
1683
%
2.050
fraction from table 1
Total Annual Expense: (add lines 3,4,5,6)
Received May 18, 1978.
1978 J Dairy Sci 61:1683--1686
Annual Interest .1627
6
7
1684
McGILLIARD
TABLE 1. Expected years o f life, annual rates of repair and insurance, a Annual b Building or equipment
Years life
Repairs
Insurance
Free stall barn Stall barn Hay barn Milking parlor Grain storage Silo, concrete bunker Silo, concrete tower Silo unloader/concrete Silo, gas-limited tower Silo unloader/gas-limited Tractor Feed bunk Baler, harv., condit., windrow., m o w e r Forage harvestor Forage attachments Mechanical feeder Forage wagon Mechanical feed wagon Silage blower Bulk tank Milking equipment Manure storage, concrete Manure spreader Liquid manure spreader Mechanical manure scraper Gutter cleaner Manure stacker Pump and agitator
20 20 20 20 20 20 20 8 25 8 10 15 8 8 8 5-8 10 8 8 10 10 20 3--5 8 8 12 10 8
.020 .020 .020 .040 .030 .010 .010 .050 .005 .055 .040 .030 .055 .055 .060 .050 .030 .050 .040 .040 .040 .010 .050 .040 .040 .050 .050 .050
.015 .015 .015 .015 .015 .015 .0t5 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015 .015
aMichigan State University 1976 with modifications (2). These are average figures and may not apply to your business. Use your best estimate. bThese fractions represent percentages of the original value of the item (.020 represents 2.0%).
TABLE 2. Factors to convert initial cost to annual expense at given rates of interest and years of life. Interest Yr
8%
9%
10%
11%
12%
1 3 5
1.0800 .3880 .2505
1.0900 .3951 .2571
1.1000 .4021 .2638
1.1100 .4092 .2706
1.1200 .4163
8 10 12
.1740 .1490 .1327
.1807 .1558 .1397
.1874 .1627 .1468
.1943 .1698 .1540
.2013 .1770 .1614
15 20 25
.1168 .1019 .0937
.1241 .1095 .1018
.1315 .1175 .1102
.1391 .1256 .1187
.1468 .1339 .1275
Journal of Dairy Science Vol. 61, No. 11, 1978
.2774
OUR INDUSTRY TODAY
1685
TABLE 3. Factors to convert salvage value to annual receipts at given rates o f interest and years of life. Interest Yr
8%
9%
10%
11%
12%
1 3 5
1.0000 .3080 .1705
1.0000 .3051 .1671
1.0000 .3021 .1638
1.0000 .2992 .1606
1.0000 .2963 .1574
8 10 12
.0940 .0690 .0527
.0907 .0658 .0497
.0874 .0627 .0468
.0843 .0598 .0440
.0813 .0570 .0414
15 20 25
.0368 .0219 .0137
.0341 .0195 .0118
.0315 .0175 .0102
.0291 .0156 .0087
.0268 .0139 .0075
Annual Costs Description Years of Life (table 1)
Annual Interest
%
Initial Expense: X : price (less invest, credit] factor from table 2
1
Salvage Value:
2
X value at end of life
-factor from table 3
Annual Depreciation: (line l-line 2) Annual Repairs:
3 X
original value Annual Insurance: original value
-fraction from table 1 X -fraction from table 1
4 5
Annual Taxes: (your best estimate) Total Annual Expense: (add lines 3,4,5,6) E X P L A N A T I O N OF LINES F R O M A N N U A L COST F O R M 1
2
3 4
The a m o u n t o f money y o u w o u l d have to pay eacll year to cover the initial cost (plus interest) o f this item. The a m o u n t y o u w o u l d receive each year if the salvage value were returned t o y o u annually instead o f at the end o f life. The annual a m o u n t o f depreciation. ( A m o u n t y o u pay minus the a m o u n t you receive, each year.) The yearly payment f o r repairs if y o u could spread
5
6
7
7
all repairs equally across all years o f life. The yearly payment f o r insurance if y o u could spread all insurance payments equally across all years o f life. The yearly p a y m e n t f o r taxes (if applicable) if y o u could spread all tax payments equally across all years o f life. The total expense o f owning this item, converted t o a constant yearly expense (considering interest).
This is the expense. What will be the receipts? Is there a better investment?
FIG. 2. Annual cost form. Journal of Dairy Science Vol. 61, No. 11, 1978
1686
McGILLIARD
for the purchase has been borrowed, interest must be paid the lender, and at 10%, the annual payment for 10 yr would be $2050. If owned capital (not borrowed) has been expended, then the purchase is truly an investment, and as such, should return interest to you, the investor. So either way, borrowed or owned capital, the purchase must be charged an annual interest which is at least the rate currently charged by lending agencies.
difficult to estimate. Costs of repairs, of course, tend to increase with the age of equipment. Insurance tends to decrease with the market value of equipment. Table 1 lists reasonable estimates of rates of repairs and insurance for various buildings and equipment. The table factor, multipled by the original value of the item, expresses repairs and insurance as payments made each year. Annual property taxes, if applicable for an investment, must be estimated by you.
SALVAGE
At the end of life, a salvage value is returned to the investor. This is a fair market value for the item at that time, whether or not the investor intends to sell. For annual comparisons, this salvage value is converted, minus interest, to an annual receipt. Figure 1 indicates that if someone gave you $125 per year which you invest at 10% interest, you would have $2000, the salvage value, after 10 yr. The difference between the annual price and the annual salvage is annual depreciation. This depreciation, however, is not that used for. income taxes, but instead, merely a fair estimate of the loss in value each year (adjusted for interest). REPAIRS
Annual costs for repairs and insurance are
Journal oDairy f
Science Vol. 61, No. 11, 1 9 7 8
EXAMPLE
Figure 1 illustrates the expenses involved in owning a $14,000 bulk tank. Note that the initial expense is based on the original price minus 10% investment credit, but the repairs and insurance are based on the original value of the tank. The annual expense of this bulk tank is $2695. Study this example and use additional forms (Fig. 2) to calculate annual costs for investments you are contemplating.
REFERENCES
Fabrycky, W. J., and G. J. Thuesen. 1974. Economic decision analysis. Prentice-Hall, Inc., Englewood Cliffs, NJ. Hoglund, C. R. 1976. Dairy system analysis handbook. Agr. Econ. Rep. No. 300. Michigan State University, East Lansing.