Equipment cost management: pay me now or pay me later

Chris: And it all comes down to this. 2 on, 2 out, bottom of the 9th. The Farmers lead by 1. Full count, here comes the play at the plate, and it's the Ag View Pitch! Welcome everybody to another episode of the Ag View Pitch, and today you've got Chris Barron gonna have a little conversation with you about machinery and equipment replacement and cost analysis. And so we're starting to get a lot of phone calls and just questions on machinery and equipment valuation, ownership, should we trade, should we not trade, what's our true cost and some of those things.

So just as an observation, a couple of key things I wanna point out for everybody to kind of be thinking about is when we look at the machinery and equipment as a cost, one of the things that we try to make sure that our clients understand is that there's a, there's a cost element to machinery and equipment ownership that you actually don't write a check for. And those two components really are inflation and depreciation. And so I want to just spend a couple of minutes here with some perspective and to get some things out there just to kind of answer a lot of questions that we seem to be getting from producers when it comes to looking at your machinery and equipment costs, not only on a per-pass basis but also What is that real cost for you as an operator?

And so what we've seen, and to give you some perspective, we've gone back in the last couple of years and looked at what is the inflationary cost of owning machinery. So in other words, if you buy a piece of equipment and you own it for 3 years, and then you have to replace that exact same piece of equipment with your used machine for that same machine new, We're seeing about a 2.8% inflationary increase, and so you're not writing a check for that, but every year that is a cost increase. And so those are some things to think about, and I'm going to come back to that in a minute, a little bit more detail. The depreciation as an expense, what we've seen there is about 11%, 11 to 11.5% over the last 3 years or so. And with depreciation, that's obviously the utilization of the equipment. It's another year older, it's a couple more years older, it's getting used.

And in some cases, you know, when I say 11%, we see some machinery depreciating a lot less than that and some quite a bit more than that. And so there's a few factors that go into that, you know, including your, the number of acres you're running that machine over, what is the age of it. So for example, what we're seeing this year going into 2021 at this timeframe is that if you take, for example, grain carts, some of the tillage equipment, like a field cultivator and some of those things, we're seeing that a lot of that equipment, if it's maybe 2, 3 years old, isn't really depreciating much at all. So we can see things go the other way as well by individual piece of equipment, depending on the age and what has already happened with it in terms of depreciation. And so, you know, we also look at the brand.

Some of the equipment manufacturers have a little bit better resale than others in certain elements of your machinery and equipment fleet. So those are just some things to kind of think about as it relates to depreciation. And so I want to back up though now and just give you a little perspective on what we're seeing in the machinery and equipment as we stand here today in 2021, and, and a lot of this data comes off of 2020, but machinery and equipment as a percent of cost with our client base, we're seeing it be somewhere in that 12% to as high as 26% of the total cost of production. And so if we normalize that, and let's say we take a producer and use 200 bushel corn divide that out in terms of cost per bushel, there's a pretty good range. We're seeing anywhere from about 52 cents a bushel using 200-bushel corn up to about 97 cents a bushel.

And so we see some, some operations that still have a fairly high equipment cost, although what we've seen here lately over the last few years is people have not been replacing machinery Partially, obviously, just because we've had such low commodity prices and things have been under pressure that we just have not been replacing things to the degree maybe we would have liked to. And so that's the next thing I want to talk a little bit about is now that people are starting to look at trade, starting to update some things, what are some of the consequences of not staying current on machinery and what are some of the realization components coming out of that? And so I want to talk a little bit about the idea of owning machinery and then not factoring in depreciation and inflation. And again, that's not what you write a check for.

So what a lot of farmers will do is they'll look at their cost of machinery and they'll say, well, my repairs were X, my fuel was X, and my principal and interest payments, you know. So they add up principal and interest payments, they add up fuel, and they add up repairs and parts, those kind of things. So if you look at that from that perspective, it sort of gives you a pseudo cost of machinery and equipment ownership because you do have depreciation even though you're not writing a check for it, and you do have an inflationary component unless you're going to quit farming next year and you're just going to sell your equipment because you're going to have to take that salvage value machine and replace it. So let me go just a touch deeper into that. Let's give you a specific example of of if you go in and on year 1 you purchase a machine, let's, let's say $300,000, okay?

You own that machine for the next 5 years, and let's say that that thing depreciates $150,000, just for easy math, okay? Well, in that scenario then, you have $150,000 replacement cost, or do you? Well, we have to add in that inflation that I was just talking about. So what's the price increase over that period of time? Well, let's just say that, you know, over that 5-year period, on average, we have another $100,000 of inflationary component. That $100,000 may be a, uh, have to do with just the inflation, but a lot of times what we see too is people are looking at maybe the next size bigger machine, or let's say you have a 90-foot boom on your sprayer and you want to go to 120 or whatever, you know, a lot of times there are some additional add-ons. So it's not just inflation, but it's better technology.

And so we pay more than just the inflation, usually 3, 4, 5 years down the road, because of these technology components that continually are being added to our fleet. And so what we do when we analyze these costs is we do, we don't just take into account repairs, we don't just take into account fuel and principal and interest payments, we also add in depreciation and inflation. So back to the example of $300,000, you go for 5 years, the salvage value of that machine is $150,000, the new replacement is $400,000, so now your update cost or your cost to trade is $250,000, almost the same as what you paid initially, for the machine. And so you sit there and say, well, how can we afford to do this, you know?

And that's, that's precisely why I'm having this podcast right now, is we have a lot of people that are getting some sticker shock that have ran several years, you know, looking at their accounting, which the accounting is really good, but accounting doesn't account for necessarily your depreciation and inflationary component. And some people will put depreciation in there but typically the depreciation that you use from a tax perspective is inaccurate. And so that's another area where I think it's important that we'll get to in a minute, but I just want to point out that again, go back to that $300,000 investment on year 1. You're going to run it for 5 years. If it costs you another $100,000, your inflationary cost is $20,000 per year on that $300,000 investment.

So keep in mind, if you invest in a new piece of equipment, it's not just the principal and interest, the fuel, the labor, and repairs, but it's inflation and depreciation. The last thing I want to touch on here for some perspective for you to think about is in order to understand what your depreciation is and what possibly that inflationary cost might be on an annualized basis, is as we recommend that people sit down and have your machinery and equipment list assembled in an organized manner with power units at the top, harvest equipment at the top, and then just work your way down from largest to smallest value of equipment in the fleet. The next step is we like to see people go to their machinery and equipment dealer and say, or two of them in the area, and just ask them to give you a value on all of your pieces of equipment, whether they come and look at it or not, that's best.

But give them that list, give them the age of the machine, the condition of the machine, and the hours if it's a power unit or a harvest or a combine or something along those lines, so that you can get established a baseline of what the value of that machinery is. Once you have the baseline value of that equipment on year 1, then at the end of year 1 or going into the next year, you do the same thing at the same time with the same people. So that you can say, okay, now I can look at the value of that machine versus what it was last year, and now I have an accurate depreciation line by line for every piece of equipment in that fleet. Now, you don't have to do every little thing, every tiny little piece of equipment that you have that's maybe been sitting around you haven't used for 3 years.

I'm talking the primary equipment that you use in your machinery and equipment fleet so that, that way, you can kind of really look at what your true depreciation cost is. Because quite frankly, the tax number or what the lender uses or what you use as a depreciation number is a fallacy unless you annually look at what the true depreciation is. Because for example, you may have, um, some pieces of equipment that are, say, 5 years old and they've already depreciated. And a lot of times we see some planters um, grain carts, sometimes sprayers and different things, they get to a certain age, we actually see them appreciate. They don't— they stop depreciating and they start going the other way. And so if you continually sit there and depreciate that stuff on your balance sheet, your balance sheet's inaccurate.

Conversely, on the other side of it, you could end up having your machinery and equipment overvalued because you're not depreciating things at the appropriate level either. And so Again, to, to, to wrap up and to remind you again here, consider putting that list together. We have a form that we can send you, so if you're interested, you can, you can send either Shay or myself, excuse me, an email asking for that information, and we would send you a spreadsheet. It's just a blank spreadsheet with information that you just populate your machinery and equipment, and then you put in the values based on what your equipment dealer gives you for values. We like to see 2 equipment dealers and then just average the 2 numbers, and then that gives you a baseline of the equipment value.

And so just wanted to have a little conversation with everybody, um, sort of about what we're seeing with the equipment. As people start to buy more things. And again, we're seeing a little sticker shock out there, and part of it is just comes right back to that inflationary component. One thing, uh, other thing I do want to mention though, as we look into 2021 and you look at how we are starting to maybe see an increase in inflation, and you look at the demand of the machinery and equipment, and you look at where commodity prices are at right now, I would venture to say that as producers, we're going to have to start to be real careful and watch how that inflation may increase. As I said, you know, the last 3 years we've seen about a 2.8% inflationary cost increase.

You know, you go back to 2012, we saw machinery and equipment go up and into the tune of, you know, 5.5% to as much as 7% depending on the machine. And in terms of just one year because commodity prices were so high at that point in time and the demand for machinery was high. And so I'm not predicting the future, but I am saying that I would be cognizant of the fact that we could easily see machinery and equipment inflate significantly, especially on the new stuff, you know, close to that 5 or 6% if the demand is there to warrant that much of an increase. And if you take a $500,000 piece of machinery and, uh, today But you will eventually when you update Trade. And so again, the idea is just for you to step back and think through this stuff. If anybody has any questions, feel free to give us a call. Again, like I said, we have tools on analyzing this stuff.

We have tools on analyzing machinery and equipment to get to a cost on a per-pass basis, which really starts to enlighten you and give you more specific information on what your true cost of production is. Because what we see is if people aren't calculating the depreciation and inflation as part of their cost of production, you may be starting your marketing 15, 10, 15 cents sooner than you should because your cost's actually a little higher than what you think it is.

The other dilemma that I see happening with machinery and equipment that gets paid off and you don't have any principal interest payments and you go a few years and you're wearing out your equipment, um, and I'm not saying anybody listening to this would be guilty of this, but we see land rents going up and a little bit more competition on the land rent side because people aren't, aren't accurately calculating their machinery and equipment costs. Sometimes I hear, well, I've got my machinery and equipment paid for, so I don't have that as an expense, so I can pay a little bit more for the land rent. And that's really, in my opinion, is a fallacy as well, unless again you're not ever going to replace that equipment, you're just going to wear it out and quit farming, you know.

So if you're going to have to replace that machinery someday we need to be really careful how we manage these other line item expenses that we have, in particular land. That's the one that I invariably see people miscalculating their machinery and equipment cost and then feeling like they can pay more for rent than they probably should. Consequently, we all pay the bill on that with land rents probably being, you know, higher than they should be partially because of miscalculating the machinery and equipment. So I think that's all I have today, and I hope this wasn't a ramble, but I wanted get some of these conceptual ideas out there on machinery and equipment. Again, like I said, we keep getting phone calls on this and people are updating machinery at a pretty rapid pace now versus what we've seen in the last 4 or 5 years.

It looks like the 1-, 2-, and 3-year-old machinery is really starting to increase in value. And I think, you know, that's that inflationary component that we're starting to see impact us. So If anybody has any questions, again, give us a call, give Shay a holler, give me a call, email us and say, hey, we'd like a copy of the machinery equipment list tool. And so that way you can populate your machinery and equipment fleet and get started on understanding what that depreciation inflation might look like as you go into the future. So hope everybody has a good day. Hope this was a useful and beneficial podcast. And if Anybody has other topics or things they'd like us to cover, let us know, and we will catch you again next time on the Ag View Pitch.