Can I afford this stuff?, CY, May 2010
A simplistic capital budgeting template that may help us answer this question
Why bother with a capital budget? If I have the money in the bank, then I can afford it, right? It turns out we should think a little longer in order to understand the longer term profitability of our businesses. The concept of a capital budget can help us avoid the following common scenarios:
1.) Owners of a (usually) new operation are discouraged because it looks like they aren’t profitable. A consideration of capital versus operating expenses may allow them to realize they are actually en route to profitability.
2.) A (typically) more established operation’s profitability suffers when it must unexpectedly replace big ticket capital items. A capital budget might have encouraged owners to plan for these expenses by showing that what they thought was a profitable business model was instead based on liquidating (wearing out) their capital assets.
3.) An operation (of any maturity) has difficulty answering the question “can I afford this stuff”? This could lead to over-aggressive capitalization which threatens the financial sustainability of the operation, but in my experience among our crowd more often leads to under-capitalization which typically burns out farmers both mentally and physically. A capital budget can help us chart a course between these two perils by generating a number we could call the “annual capital payment”. This payment represents the annual amount of revenue a business must generate just to replace its current capital fleet (where “fleet” means all capital equipment which includes things like buildings, irrigation, and fences as well as trucks, tractors and implements).
A capital budget does not make risk disappear. It may help us get something of a handle on risk by forcing us to make some of our previously implicit assumptions about risk explicit. By now it should also be clear that this exercise is not about finding access to capital, but about how and whether to invest capital in your business once you are lucky enough to have it.
The Simplistic Template
Take the replacement cost of your capital item (in dollars), divide it by the useful lifetime (in years); that’s your annual replacement cost. Write a list of capital assets for your operation (you can neglect small things), calculate the annual replacement cost for each asset in the fleet and add them all up – that’s the total annual capital payment the business needs to generate if it is not to be in danger of running down its assets. Very simplistic.
Item Total Replacemt Cost Useful Life Annual Replacemt. Cost
Truck $5 K 5 years $1000
Tractor w/ 10 years
Loader & tiller $10 K (or 3K hrs?) $1000
Greenhouse $5 K 20 years $ 250
Total annual capital payment for this fleet : $2250
1.) So one dimension of the answer to the question “can I afford this stuff” is “ yes if I think it will generate increased annual revenue (or savings) at minimum consistent with the expense added to my capital payment”.
2.) Some may want to account for inflation in this process – I think this is a second-order consideration (not simplistic enough for me).
3.) It’s important to realize that the “annual capital payment” is not necessarily a literal amount that gets put into a savings account – although this will probably be part of the picture in most businesses. In addition to such a deposit, any annual expense to replace an item in the existing fleet counts towards calculating the actual capital replacement contribution in any given year. However, if you make a capital expenditure to expand your fleet, you have to come up with a new total replacement cost to take the bigger fleet into account.
4.) A fleet may include some items which are soldiering on past their “useful life”. We may choose not to account for them and assign them a zero replacement cost, but if we do so we have to be aware that we are in effect planning on someday running our operation without them. We need to honestly evaluate just how dependent we are on that tool for the everyday functioning of our business.