6.11 Profitability
6.12 Return on Investment
6.13 Depreciation Theory
6.14 Depreciation for Income Tax Purposes
6.15 Deprecitation for Management Purposes
6.16 Depreciation Based on Use
6.17 Depreciation and Relationship to Cash Flow
6.2 Economic Impact of Agriculture
6.3 Cost of Production
6.4 Calculating Estimated Crop Yield
6.5 Balance Sheet
6.6 Assets
6.7 Depreciation
6.8 Liabilities
6.9 Owner's Equity
6_Basic-Crop-Accounting
Exercise 5a Selective Breeding and Bioengineering
Exercise 5b Plant Identification and Uses
Basic Crop Accounting
Overview
Economics is USDA’s Helping Science by the United States Department of Agriculture is in the Public Domain.
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Introduction
Discussion Topic* What are the current prices of the fruit and vegetables in the title image? What factors create the sale price?
Lesson Objectives
Evaluate the economic impact of field crops, forage crops, vegetable crops, and fruit crops.
Explain the significance of ROI to investment decision making.
Evaluate the role of depreciation in evaluating production of crops.
Key Terms
asset - items of value that a farm owns or uses
cost of production - the total dollar amount of inputs related to a specific crop
debt - money that is owed
depreciation - the non-cash expense related to the loss of value of an asset
expense summary - a list of all financial contributions to the business
liabilities - an obligation to pay a debt
liquidity - the ability to meet the short-term cash needs of a farm
owner equity - the difference between a farm’s assets and its liabilities
return on investment (ROI) - the amount of money gained in relation to the amount invested
solvency - the ability to repay the money loaned if a farm stopped doing business today
Introduction
Tennessee agriculture includes a diverse list of livestock, poultry, fruits and vegetables, row crop, nursery, forestry, ornamental, agritourism, value added and other nontraditional enterprises. These farms vary in size from less than a quarter of an acre to thousands of acres, and the specific goal for each farm can vary. For example, producers’ goals might include maximizing profits, maintaining a way of life, enjoyment, transitioning the operation to the next generation, etc. Regardless of the farm size, enterprises and objectives, it is important to keep proper farm financial records to improve the long-term viability of the farm. Accurate recordkeeping and organized financial statements allow producers to measure key financial components of their business such as profitability, liquidity and solvency. These measurements are vital to making knowledgeable decisions to achieve farm goals.
Economic Impact of Agriculture
Economics is the study of using resources to produce goods and services as effectively and efficiently as possible to satisfy the needs and wants of consumers. In agriculture, the producer of goods or services may be an agribusiness firm manufacturing a food product that meets the desires of consumers, or agricultural producers growing a crop to meet the needs of a food processor. To produce a product (a good or service), a business needs resources, such as labor (i.e., workers), land (e.g., a building), equipment, cash (capital) and other resources. Restated: to operate a business, the manager needs resources, and one of the manager's responsibilities is to decide which resources to use and how to use them.
The United States produces and sells a wide variety of agricultural products across the Nation. In terms of sales value, California leads the country as the largest producer of agricultural products (crops and livestock), accounting for almost 11 percent of the national total, based on the 2012 Census of Agriculture. Iowa, Texas, Nebraska, and Minnesota round out the top five agricultural-producing States, with those five representing more than a third of U.S. agricultural-output value.
U.S. fruit and tree nut value of production has increased steadily over the past decade, while the value of vegetable production has been more stable. Grapes, apples, strawberries, and oranges top the list of fruits; tomatoes and potatoes are the leading vegetables. Tree-nut value rose dramatically to record levels of around $10 billion in recent years (Figure 5.6.1), with crop value for most major tree nut crops led by almonds, walnuts, and pistachios achieving historical highs.
Cost of Production
Cost of production is the dollar value of all your inputs for growing a specific crop. For example, to produce an acre of tomatoes, these inputs would include so many units of seed, fertilizer, irrigation water, labor and machinery time, etc. Each of these units has a dollar value. Add them up, and you have the cost of production for the crop.
Knowing the production costs of your crops is a prerequisite for determining how well your farm business is doing: the difference between the value of yield per acre and inputs value. It enables you to evaluate how efficiently resources are being used in your farm operations, to predict how your business will respond to specific changes, and how to make other useful decisions for attaining your goals.
Estimating costs is easy in some instances and more difficult in others. Assigning costs is more straightforward for those inputs or raw materials you purchase for a single production period. If you use 20 pounds of fresh tomato seed an acre at $0.80 per pound, your seed cost is $16 (the seed quantity multiplied by its price). Costs for fertilizer, pesticides, irrigation water, and hired labor can be determined the same way. Production expenses that aren't itemized also are included in this category as miscellaneous expenses. These can include entries to cover expenses such as office use, supplies, bookkeeping, and legal fees. The name for a cost category is determined by its contents. For example, "direct operating costs" indicates that values of items included in the category are straightforward and used only in the production of one specific crop. A "variable cost" category means that its values can fluctuate, depending upon the amount of input used.
Another cost category is that of "imputed costs." In this category are costs for interest charges, insurance, depreciation and taxes.
Interest charge is the cost of your money that is tied up in the production of a crop. It reflects the amount of money you pay on borrowed money or that amount you could have earned had you invested your own resources in alternative uses in the market. Interest on operating capital is calculated using the current interest rate. In the attached cost example, an annual interest charge of 15 percent or 1.25 percent per month is assumed. Interest charge on operating costs is calculated as follows:
(Total cash operating expense for the month) x (The number of months the capital is used) x (Interest charge)
The number of months the capital is used begins when the operating capital is invested and ends when it is recovered (usually the harvesting period or sale month for the crop). For example, if your fertilization and weed control operations are done in April, your interest charge for these expenses will cover 5 months, assuming August is the recovery or sale time.
Thus, interest charge is calculated:
$(40 + 40) * 5 * .0125 = $5
Note: .0125 = 1.25% or 1.25/100
The same procedure is used to determine other operating expenses. Interest of investment is charged at the current annual interest rate of the average investment and is calculated as follows:
Interest on investment/acre = (Investment cost)/(2 X No. of acres) * Annual Interest Rate
Note: Investment cost is the Average investment per acre * Average investment per acre
If your investment for machinery, equipment and irrigation system amounts of $102,700 and your farm is 40 acres, your investment interest charge per acre will be:
(102,700)/(2*40) * .15 = $192
Note: .15 = 15% or 15/100
The purpose of insurance is to cover the risk of having farm machinery or irrigation equipment destroyed or stolen. A charge of 0.5 to 1 percent of the average investment generally is sufficient. Insurance per acre at 0.5 percent is:
(102,700 / 2 * 40) * .005 = 6
Note: .005 = .5% or 5/100
The other imputed cost item is depreciation. Depreciation can be calculated in various ways for various purposes. Fast write-off techniques can be used on the original cost of machinery for income tax purposes. However, for continued production, the machinery needs to be replaced. In such cases, depreciation reflects the cost of replacement and is based on the current value of the machinery. The straight-line method is the simplest and the most straightforward way of calculating depreciation. Simply divide the current cost of the machine by its useful life. Following is an example of a depreciation schedule. Since the purpose of the attached schedule is to serve as a guideline, an attempt has neither been made to provide exact machinery current costs nor a complete list of machinery complement. Current machinery values can be obtained from local dealers or up-to-date publications.
Direct costs of plants can be plant material, hard material, material sales tax, direct labor, casual labor, equipment applied, equipment rental, subcontracts, and more. Indirect expenses can be extensive such as bad debt expense, bidding expense, benefit labor, indirect labor, replacement labor, supervision wages, premium compensation, payroll taxes, workers compensation insurance, job travel and lodging, replacement material, safety expenses, self-insurance, small tools, supplies, trash removal and uniform expenses.
Calculating Estimated Crop Yield
Anticipating expenses and revenue can be a useful tool in managing finances. Grain yield can be estimated prior to harvest. Remember this is just an estimate as field conditions are rarely uniform. The general formula to estimate grain yield is:
For 7” row spacing:
Wheat: Grain yield (bu/acre) = (kernels per spike x spikes per 3 ft of row) x 0.0319
Barley: Grain yield (bu/acre) = (kernels per spike x spikes per 3 ft of row) x 0.0389
Oats: Grain yield (bu/acre) = (kernels per spike x spikes per 3 ft of row) x 0.0504
To adjust to other row spacing:
6 inch row width = multiply grain yield estimate by 1.17
7.5 inch row width = multiply grain yield estimate by 0.93
10 inch row width = multiply grain yield estimate by 0.70
12 inch row width = multiply grain yield estimate by 0.58
Determining Yield Potential By Assessing Ears at or Near Dent Stage
The following procedures can be used to assess potential yield in corn. This assessment is best done at or near dent stage so that you can identify the kernels at the tip of the cob that will fill and reach maturity.
Step 1: Determine the number of plants in 1/1000th of an acre
Mark off a section of row representing 1/1000th of an acre. Table 1 shows the row length required to do this at different row spacing. Count the number of plants with productive ears in this area.
Step 2: Determine the number of kernels on each ear.
Select ears from five consecutive plants at five different locations in the field. For each ear, count the number of rows around the ear (Figure 5.6.2). Select one or two rows of kernels and count the number of kernels from the base to the tip of the ear (Figure 5.6.3). Do not count the first kernels at the base of the ear or very small kernels at the ear tip. Multiply the number of rows on the ear by the kernels per row to determine kernel number per ear. Average the kernel number per ear across all twenty-five ears selected from the field.
Step 3: Determine corn yield potential
Use the following equation to determine yield in bushels per acre:
(Plants per 1/1000th of an acre X average number of kernels per ear) / 90
The denominator (90) represents the average number of dry kernels in a bushel of corn and considers the fact that you have measured 1/1000th of an acre. If the kernels are bigger than normal then you could consider dividing by 85 or if the kernels are smaller than normal you could divide by 105.
In the ear examples above the equation (based on a plant population of 33,000 plants per acre) is: (33 X 20 X 28) / 90 = 205.3 bushels per acre (Figure 5.6.4). Row length needed to measure 1/1000th of an acre for determining plant populations at different row spacing.
Balance Sheet
A balance sheet is a financial statement that shows a detailed list of all assets, liabilities and the owner's equity position of the farming operation at a specific point in time. To begin constructing a balance sheet, we need to first start with the standard accounting equation:
Total Assets = Total Liabilities + Owner’s Equity
The balance sheet is designed with assets on the left-hand side and liabilities plus owner’s equity on the right-hand side. This format allows both sides of the balance sheet to equal each other. After all, a balance sheet must balance.
A change in liquidity, solvency and equity can be found by comparing balance sheets from two different time periods. Typically, changes in the balance sheet measurements are analyzed for the operation’s fiscal year (i.e., January 1 to December 31); however, these values can be compared for any time interval. A change in owner’s equity occurs from two sources: 1) income or loss from operations; and/or 2) a change in the value of an asset or liability. Changes in owner’s equity can indicate whether the farm is heading in a profitable direction. However, the balance sheet must be analyzed in conjunction with the income statement to determine profitability. The income statement summarizes revenue and expenses and is used to compute profit over a period of time. An expense summarygives a comprehensive look at all incoming revenue.
Assets
Assets are items of value that a farm owns or uses. Assets are generally split into two categories: current and noncurrent. A current asset is either cash (or cash equivalents) or an item that will become cash within a fiscal year (12 months). A noncurrent asset is something the farm owns or uses that will not turn into cash within the next accounting period and typically has a multiyear useful life. Some balance sheets further divide noncurrent assets into intermediate and long-term assets. In general, an intermediate asset is an asset with a useful life of one to 10 years (e.g., a tractor), while a long-term asset has a useful life of greater than 10 years (e.g., land) (Holland, 1997).
Noncurrent Asset Valuation
Assets can be valued using two different approaches: cost value and market value.
Cost valuation, sometimes referred to as book value, is the original price paid for the asset minus the accumulated depreciation of that asset. Because the cost method takes into consideration depreciation, a producer can examine changes in the farm owner’s equity (net worth) and the overall invested capital performance (Langemeier, 2017).
Market valuation is an estimate of what the asset would sell for on the date of the balance sheet. This valuation considers current prices, meaning the asset is valued based on what a buyer would pay at a specific point in time. For example, the market value for a tractor might be the trade-in value or what it could sell for at auction. The market value approach is important because it provides an estimate of what the farmer would actually receive for an asset if it was liquidated that day (sale proceeds could be less due to transaction costs and contingent liabilities). When selling costs are taken out of the market value, a farmer then has a clear picture of the cost or gain of that asset disposal (Langemeier, 2017).
Depreciation
There are two common methods in which assets can be depreciated: straight-line depreciation and declining balance depreciation. Straight-line depreciation is when an asset is depreciated by the same amount each year. It is also the simplest type of depreciation to calculate. The equation for the straight-line depreciation method is (Warren, 2013):
Annual Depreciation = Original Cost – Salvage Value
Useful Life
Declining balance depreciation is a method in which an asset depreciates rapidly in the first few years, and then the annual depreciation expense, in dollar terms, becomes smaller the closer the asset gets to reaching the end of its useful life. For the example depicted in Appendix 3, initially, the depreciation rate for the declining balance method is double the straight-line depreciation rate (20 percent compared to 10 percent ~ not reflective of current tax rules).
The graph below (Figure 5.4.1) illustrates the two depreciation methods. With straight-line depreciation, the asset depreciates steadily (by the same amount each year) until it reaches its salvage value.
With the declining balance method, the asset depreciates more rapidly initially but then slowly depreciates until the end of its useful life (Figure 5.6.5). In this example, both methods produce the same amount of accumulated depreciation at the end of the useful life of the asset. Depreciation of property used in the course of a farming business is allowed as a tax deduction for taxpayers.
Liabilities
An obligation to pay a debt is known as a liability. Just like assets, the liabilities section of the balance sheet can be separated into two sections (current and noncurrent) or three sections (current, intermediate and long-term). A current liability is a debt that must be paid within one fiscal year (12 months); an intermediate liability is a debt that is due within one to 10 years; and a long-term liability has a payback term longer than 10 years.
In farming, liabilities are commonly associated with different loan types. An example of a current liability would be an operating or production loan. Operating loans are normally used to finance short-term cash flow short falls and/or to cover day-to-day business expenses. Interest on operating loans is typically paid monthly, with no set terms of principal repayment (operating loans should be paid in full annually upon the sale of commodities or liquidation of other current assets).
An example of an intermediate liability is a machinery loan. Machinery loans are typically considered intermediate because most farm machinery has an estimated useful life of 10 years or less (the machine may require constant repairs, be less dependable or become technologically obsolete). Intermediate loans should be amortized for fewer years than the useful life of the asset being purchased. These loans can be paid annually or monthly. The payment that is due consists of both interest and part of the principal balance.
Lastly, an example of a long-term liability would be a farm real estate loan for purchase of land. Typically, farm land can be amortized over a maximum of 30 years. Long-term farm loans are normally paid on an annual basis; however, loan payments should coincide with income (i.e., a dairy may desire monthly payments, rather than annually).
The loan schedule in Appendix 4 displays all three types of loans, and their payments have been calculated based on individual interest rates and the remaining term of the loan.
Owner's Equity
The difference between a farm’s assets and its liabilities is called owner’s equity. It is sometimes referred to as a farm’s net worth. Depending on the legal entity of the farm (sole proprietorship, partnership, LLC, etc.), owner’s equity can be referred to differently. As a result, each owner’s equity section on the balance sheet will vary. For the purposes of this publication, owner’s equity is simply the farm’s net worth, which can be calculated by taking total assets less total liabilities.
Liquidity and Solvency
Two important farm financial measures that can be calculated from a balance sheet include liquidity and solvency.
Liquidity is the ability to meet the short-term cash needs of a farm. Two common liquidity measures are the current ratio and working capital. The current ratio is current assets divided by current liabilities. In Appendix 1, the current ratio for the beginning of the year was 2.76, meaning that the farm has $2.76 of current assets for every $1 of current liabilities. A current ratio greater than 2.0 is classified as strong (FINPACK, 2016). Working capital is a farm’s current assets less its current liabilities. This is the amount of cash the farm would have if all current assets were converted to cash and all current debts (including principal payments on term debts that are due in 12 months) were paid (excluding contingent liabilities and transaction costs).
Solvency is the ability to repay the money loaned if a farm stopped doing business today. There are three commonly used ratios to measure solvency.
The first is the debt-to-asset ratio, and it is calculated as total liabilities divided by total assets. This ratio signifies a farm’s debt load compared to its assets. The higher or closer to 1 (if over 1, the business has become insolvent; liabilities exceed assets) a debt-to-asset ratio is, the greater the percentage of farm assets financed by debt (Holland, 1997). In the ratio analysis in Appendix 1, the debt-to-asset ratio at the beginning of the year was 0.229. This means roughly 23 percent of the farm’s assets are financed through debt.
The equity-to-asset ratio (total owner’s equity divided by total assets) represents the proportion of total assets that are unencumbered (or debt free). A farm will have a higher equity-to-asset ratio the more it is able to pay its expenses without the use of loans.
The last ratio is a measure of how much capital is being supplied by creditors, compared to capital used from farm equity. This is called the debt-to-equity ratio and is calculated by dividing the total liabilities by total owner’s equity. A lower debt-to-equity ratio is more desirable because that means the proportion of capital the farm is supplying through equity is greater than the portion supplied by creditors (debt).
Appendix 2 contains a breakdown of each of the ratios and includes the desired outcome of each. When calculating solvency, a consistent value method needs to be used, either cost value or market value but not both.
Understanding how to construct and analyze a balance sheet is important for farmers. Farmers should utilize a balance sheet annually to examine and implement changes to improve their operations’ financial position. A farmer can use farm financial analysis to identify financial components of his or her business that could be improved (one cannot manage what they cannot measure). Improved financial performance can provide access to credit, reduced interest rates and open opportunities for expanding the farm.
Profitability
One of the primary goals of a company is to be profitable. There are many ways a company can use profits. For example, companies can retain profits for future use, they can distribute them to shareholders in the form of dividends, or they can use the profits to pay off debts. However, none of these options actually contributes to the growth of the company. In order to stay profitable, a company must continuously evolve. A fourth option for the use of company profits is to reinvest the profits into the company in order to help it grow. For example, a company can buy new assets such as equipment, buildings, or patents; finance research and development; acquire other companies; or implement a vigorous advertising campaign. There are many options that will help the company to grow and to continue to be profitable.
One way to measure how effective a company is at using its invested profits to be profitable is by measuring its return on investment (ROI), which shows the percentage of income generated by profits that were invested in capital assets. It is calculated using the following formula:
Capital assets are those tangible and intangible assets that have lives longer than one year; they are also called fixed assets. ROI in its basic form is useful; however, there are really two components of ROI: sales margin and asset turnover. This is known as the DuPont Model. It originated in the 1920s when the DuPont company implemented it for internal measurement purposes. The DuPont model can be expressed using this formula:
Sales margin indicates how much profit is generated by each dollar of sales and is computed as shown:
Asset turnover indicates the number of sales dollars produced by every dollar invested in capital assets—in other words, how efficiently the company is using its capital assets to generate sales. It is computed as:
Using ROI represented as Sales Margin × Asset Turnover, we can get another formula for ROI. Substituting the formulas for each of these individual ratios, ROI can be expressed as:
To visualize this ROI formula in another way, we can deconstruct it into its components, as in Figure 12.4.
When sales margin and asset turnover are multiplied by each other, the sales components of each measure will cancel out, leaving
ROI captures the nuances of both elements. A good sales margin and a proper asset turnover are both needed for a successful operation. As an example, a jewelry store typically has a very low turnover but is profitable because of its high sales margin. A grocery store has a much lower sales margin but is successful because of high turnover. You can see it is important to understand each of these individual components of ROI.
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Return on Investment
To put these concepts in context, consider a bakery called Scrumptious Sweets, Inc., that has three divisions and evaluates the managers of each of these decisions based on ROI. The following information is available for these divisions:
This information can be used to find the sales margin, asset turnover, and ROI for each division:
Alternatively, ROI could have been calculated by multiplying Sales Margin × Asset Turnover:
ROI measures the return in a percentage form rather than in absolute dollars, which is helpful when comparing projects, divisions, or departments of different sizes. How do we interpret the ROIs for Scrumptious Sweets? Suppose Scrumptious has set a target ROI for each division at 30% in order to share in the bonus pool. In this case, both the donut division and the bagel division would participate in the company bonus pool. What does the analysis regarding the brownie division show? By looking at the breakdown of ROI into its component parts of sales margin and asset turnover, it is apparent that the brownie division has a higher sales margin than the donut division, but it has a lower asset turnover than the other divisions, and this is affecting the brownie division’s ROI. This would provide direction for management of the brownie division to investigate why their asset turnover is significantly lower than the other two divisions. Again, ROI is useful if there is a benchmark against which to compare, but it cannot be judged as a stand-alone measure without that comparison. ROI helps an agribusiness manager to compare two crop options and make the best decision about which to produce for their business.
Managers want a high ROI, so they strive to increase it. Closely monitoring costs of an operation can promote a strong ROI. Looking at its components, there are certain decisions managers can make to increase their ROI. For example, the sales margin component can be increased by increasing income, which can be done by either increasing sales revenue or decreasing expenses. Sales revenue can be increased by increasing sales price per unit without losing volume, or by maintaining current sales price but increasing the volume of sales. Asset turnover can be increased by increasing sales revenue or decreasing the amount of capital assets. Capital assets can be decreased by selling off assets such as equipment.
For example, suppose the manager of the brownie division has been running a new advertising campaign and is estimating that his sales volume will increase by 5% over the next year due to this ad campaign. This increase in sales volume will lead to an increase in income of $140,000. What does this do to his ROI? Division income will increase from $1,300,000 to $1,440,000, and the division average assets will stay the same, at $4,835,000. This will lead to an ROI of 30%, which is the ROI that must be achieved to participate in the bonus pool.
Another factor to consider is the effect of depreciation on ROI. Assets are depreciated over time, and this will reduce the value of the capital assets. A reduction in the capital assets results in an increase in ROI. Looking at the bagel division, suppose the assets in that division depreciated $500,000 from the beginning of the year to the end of the year and that no capital assets were sold and none were purchased. Look at the effect on ROI:
Notice that depreciation helped to improve the division’s ROI even though management made no new decisions. Some companies will calculate ROI based on historical cost, while others keep the calculation based on depreciated assets with the idea that the manager is efficiently using the assets as they age. However, if depreciated values are used in the calculation of ROI, as assets are replaced, the ROI will drop from the prior period.
One drawback to using ROI is the potential of decreased goal congruence. For example, assume that one of the goals of a corporation is to have ROI of at least 15% (the cost of capital) on all new projects. Suppose one of the divisions within this corporation currently has a ROI of 20%, and the manager is evaluating the production of a new product in his division. If analysis shows that the new project is predicted to have a ROI of 18%, would the manager move forward with the project? Top management would opt to accept the production of the new product. However, since the project would decrease the division’s current ROI, the division manager may reject the project to avoid decreasing his overall performance and possibly his overall compensation. The division manager is making an intentional choice based on his division’s ROI relative to corporate ROI.
In other situations, the use of ROI can unintentionally lead to improper decision-making. For example, look at the ROI for the following investment opportunities faced by a manager:
In this example, though investment opportunity 1 has a higher ROI, it does not generate any significant income. Therefore, it is important to look at ROI among other factors in order to make an informed decision.
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Depreciation Theory
Depreciation is the allocation of cost of an asset among the time periods when the asset is used. For example, the cost of a machine that is used to produce products during several production periods should be distributed among those production periods. Depreciation is the concept for allocating that cost. Do not allow "managing depreciation for income tax purposes" to interfere with understanding depreciation for management purposes. These are distinct topics and should be addressed as distinct topics. In managing depreciation for tax purposes, the manager will strive to make decisions, as allowed by federal income tax law, to maximize the business' after-tax income.
- In understanding depreciation for management purposes, the manager will strive to develop and follow a depreciation method that results in an accurate statement of costs and net income, without income tax considerations.
- Depreciation for purposes of management can be described as a procedure to allocate or assign a portion of the cost of an asset to each production period during which the asset is used.
- Deducting a depreciation allowance from the cost of an item does NOT reveal value of the item. However, the value of an item provides insight into depreciation.
- Example. A $100,000 depreciable item that has an annual depreciation allowance of $18,000 does not mean the market (resale) value of that item will be $82,000 at the end of the first year.
- A $100,000 item that has a resale value of $87,000 after one year cost the owner $13,000 that year; the decrease in the value may be due to use (wear and tear), the fact that the item is one year old, or any other reason why the market value may have declined.
- Market value reveals some insight into depreciation but a depreciation allowance has little or no relationship to the item's market value.
- An example of calculating depreciation based on a question from a farm manager (who also is a former student).
Also see Cost v. Cash Outflow.
Depreciation is a procedure to allocate or assign a portion of the cost of an asset to each production period during which the asset is used.
Related link: "The Cost of Owning and Operating Farm Machinery -- Utah 1997", pp. 6 and 7 of the pdf file.
Profit is defined as "the difference between the revenue generated during a period to time and the costs incurred to generate that revenue during that period of time." Some assets or inputs, however, will be used during more than one production period; an easy example is equipment. Accordingly, a procedure is necessary to allocate an appropriate portion of the cost of the input among the several time periods during which it will be used in the production process. This procedure of allocating cost is generally referred to as calculating depreciation; that is, assigning a portion of the cost of an asset to each production period during which the asset is used.
To simplify the procedure, the calculations are often based on time; for example, some methods of depreciation allocate a portion of the cost of the machine to each production period during which the machine will be used. An alternative to allocating cost on the basis of time is to allocate the cost on the basis of use; thus, if the machine is used more heavily during one production period than during another, more of the cost of the machine will be assigned to the period of heavy use than to the period of light use. This alternative should provide the business manager with better information, that is, a more accurate measure of the cost to operate the business, and thus the profit generated by the business during each production period.
Land is not considered a depreciable asset; presumably, land will not wear out or become obsolete. However, improvements to land are considered depreciable assets; for example, a well, dam, building, fence, irrigation system, or drainage system will wear out.
A depreciable asset is an item that is used in more than one production period but will not last forever.
Depreciation is a procedure for allocating the cost of a depreciable asset among the production periods (and enterprises?) in which the asset is used.
Depreciation for Income Tax Purposes
Perhaps the most frequent application of depreciation is in calculating the business net income (profit?) for purposes of determining the amount of income tax owed by the business or its owners. However, the depreciation allowance for income tax purposes is not likely to reflect the actual use of the machine. Accordingly, it is a common recommendation that businesses maintain two depreciation schedules -- one that complies with income tax law and one that more accurately allocates the cost of the machine over its useful life. This page focuses on the second objective.
Depreciation for Management Purposes
Perhaps the simplest procedure for calculating depreciation is a straight-line method; that is, assign an equal portion of the cost of the machine to each production period during which it will be used. For example, a machine that cost $75,000 and will be used for 6 production periods, would have a straight-line annual depreciation of $12,500 (75,000/6).
This simple approach, however, may not provide the best information for the manager. For example, a new machine may be used more intensely immediately after it is acquired than it may be used in later years. Accordingly, depreciation procedures have been devised that allocate a greater portion of the cost to the first years of the machine's useful life. Another justification for this practice is that the market value drops most significantly during the early years even if the machine is not being heavily used. Likewise, there is an income tax benefit to depreciate the machine "as quickly as possible," but this page does not focus on this last justification.
Depreciation Based on Use
Another way to consider depreciation for management purposes (as opposed to depreciation for income tax purposes). Rather than measure the machine's useful life in terms of time, how about measuring it in terms of possible production? For example, a tractor may have a projected useful life of 15,000 hours (even if the original buyer does not intend to own it that long; presumably someone else will purchase the used tractor and continue to operate it until it is "fully consumed" at 15,000 hours). If the tractor costs $135,000, the hourly depreciation over its useful life would be $9 per hour (135,000/15,000).
Using an hourly rate to calculate depreciate now allows the manager to assign an appropriate portion of the cost of the tractor to each activity. For example, if the tractor is used 1,000 hours one year and 2,500 hours another year, the first year would have to bear $9,000 of the tractor's original cost (1,000 x 9) whereas the second year would have to bear $22,500 of the tractor's original cost (2,500 x 9).
Using an hourly rate for depreciation also simplifies the question of allocating cost among enterprise. For example, if the tractor was used 700 hours in the production of wheat one year and 300 hours in the production of bagel (for a total of 1,000 hours as in the previous example), the wheat enterprise would have to bear $6,300 of the tractor's original cost (700 x 9) whereas the soybean enterprise would have to cover $2,700 of the cost (300 x 9).
This method assumes a form of straight-line depreciation, but it allows the manager to more accurately assign the cost of the tractor to its actual use.
This method could also be applied in terms of acreage; for example, a machine that has an expected life of 16,000 acres and cost $240,000 would have a depreciation expense of $15 per acre of use (240,000/16,000). This depreciation cost per acre can then be used to allocate cost of the machine among enterprises and production periods.
Depreciation and Relationship to Cash Flow
The concept of depreciation has some unique characteristics relative to other operating cost. The primary difference is that when the cost of depreciation will be accounted for by the business in computing, its profit will not align with when the business has to pay for the machine. For example, purchasing the $135,000 tractor will require that the dealer be paid immediately even though the 15,000 hours of useful life may be spread over 5 to 20 years. Thus, the cash outflow to purchase the tractor does not align with when the depreciation will be recognized and subtracted as a cost.
Likewise, if the producer borrowed the $135,000 to purchase the tractor and will repay the debt to the bank over the next 4 years; the cash outflow will most likely not align with when the tractor is being used; that is, the tractor will likely be used for more than 4 years.
It is critical that managers understand the distinction between cost (as reported on an income statement) and cash outflow (as reported on a cash flow statement). The two concepts are not the same. Certainly, principal payments on a loan to buy a tractor and depreciation allowance to account for the cost of the tractor is one such example. Also see Cost v. Cash Outflow.
Depreciation Schedule (example)
- Initial data
Information to record might include the item; a unit of measure; the item’s useful life (in units of measure), cost and salvage value (if any); and the calculated depreciation per unit of measure.
|
|
|
|
| Calculated |
X | Acre | 12,000 | $180,000 | $0 | $15/acre |
Y | Hour | 20,000 | $240,000 | $20,000 | $11/hour |
Z | Acre | 35,000 | $87,500 | $0 | $2.50/acre |
- Record of Use
Information to record could include item, depreciation per unit of use, enterprise in which the activity occurs, the quantity of use, and the calculated depreciation cost for the activity.
Item | Depreciation per unit of measure | Enterprise | Quantity of Use | Calculated Depreciation |
X | $15/acre | Wheat | 400 acres | $6,000 |
X | $15/acre | Corn | 500 acres | $7,500 |
Y | $11/hour | Wheat | 28 hours | $308 |
Z | $2.50/acre | Wheat | 400 acres | $1,000 |
Unit 5 Lab Exercises
Exercise 5a: Selective Breeding and Bioengineering
Students explore the principles and techniques of selective breeding and bioengineering in plants. They will learn methods to enhance desirable traits and understand the impact of these practices on agriculture and biodiversity.
Exercise 5b: Plant Identification and Uses
Students identify various plant species and understand their practical applications. It provides guidelines for recognizing different plants and explores their uses in agriculture, medicine, and other fields.
Attributions
Title Image https://www.usda.gov/media/blog/2021/12/01/economics-usdas-helping-science
Agricultural Production and Prices by the United States Department of Agriculture is in the Public Domain.
Fruit and tree nuts lead the growth of horticultural production value chart by the United States Department of Agriculture is in the Public Domain.
How to Determine Your Cost of Production by Etaferahu (Eta) Takele Copyright (c) 2022 Regents of the University of California. This work is licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-nd/4.0/ or send a letter to Creative Commons, PO Box 1866, Mountain View, CA 94042, USA.
Introduction to Basic Farm Financial Statement: Balance Sheet by Chris Boyer, et al., University of Tennessee. Copyright © University of Tennessee. Used with permission.
Introduction to Return on Investment, Residual Income, and Economic Value Added as Evaluative Tools by Mitchell Franklin, Patty Graybeal, Dixon Cooper is licensed
CC NC-SA. Access for free at https://openstax.org/books/principles-managerial-accounting/pages/1-why-it-matters
Using Kernel Counts to Estimate Corn Yield Potential by Ron Heiniger, North Carolina State University, is Copyright © and used with permission.
Depreciation by North Dakota State University is licensed CC NC-SA.
Estimating Yield by North Dakota State University is licensed CC NC-SA.
Overview of Economic Resources by North Dakota State University is licensed CC NC-SA.
This work is licensed under the Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported License. To view a copy of this license, visit http://creativecommons.org/licenses/by-nc-sa/3.0/ or send a letter to Creative Commons, 171 Second Street, Suite 300, San Francisco, California, 94105, USA.