Range 101: Partial Budgeting

Partial budgeting or cost-benefit analysis

A useful tool to help guide investment decisions in farm businesses. The premise is simply “if I invest in the business will it pay off”. Since most investments take several years to realize the benefit, the time value of money must be considered. I use the internal rate of return (IRR) method to do a cost-benefit analysis. The cost equals the investment expenses (one time expense over the lifetime of the project) and the benefit equals the net annual return (annual revenue minus annual expense). The answer to the equation (investment expense divided by the net annual return) equals the number of years to pay off. Then you look up (Google) in a table of “Present value interest factor of an ordinary annuity of $1 per period (i) for n periods”; where n=the life expectancy of the project, i=the years to pay off, and the IRR or interest rate is at the top of column heading in the table.

For example, lets say you invest in a rural water pasture tank system to provide a cleaner water supply for cattle in a region where high saline water exists. Research suggests a conservative increase of 0.1 lb/day in average daily gain of steers can be expected drinking clean water out of a tank compared with surface water. If you had a 120 day grazing season and beef is worth $1.25/lb this would equate to $15/head. If you had a 640 acre pasture and put a water tank in the middle, the investment costs might total $12,000 (includes cost of trenching the waterline, the hookup fee, tank, and supplies). Now lets say the stocking rate is 1 Animal Unit Month (AUM)/acre. This would mean you could stock 213 750-lb steers for 4 months (640 acres x 1 AUM/acre / 4 months x 1 steer/0.75 AU). Thus, we would expect an increase in revenue of 213 steers x $15/steer or $3,195. The new annual water bill would cost roughly ($2.50/1000 gal + $15 monthly charge). If we expect 1 AU to drink 15 gallons of water per day, our steers would drink 640 AUM x 30 days/month x 15 gallons/day x $2.50/1000 gallons or $720 + $60 for a 4 month usage fee for a total of $780. We might have additional annual expenses with the new water tank such as the float or boards to keep livestock from getting into the tank of $100/year bringing our total annual expense to $880. Thus, the net annual return would be $2,315 ($3,195 – $880). So, it would take 5.2 years to pay off ($12,000 investment divided by $2,315 net annual return). A project that has a life expectancy of 20 years and only takes 5.2 years to payoff would have an IRR of 18%.

We interpret this project in the same way as if we invested $12,000 and would expect an 18% return over 20 years. The key to using partial budgeting is to make sure you estimate your investment costs and revenue as accurately as possible. There will al-ways be unforeseen expenses that will decrease the IRR, but it gives you a “gut check” to see if it would pencil out. You are more likely to pull the trigger on a project which brings a 15% IRR than you would one that brings 5%. Also, consider there might be some side benefits that might not be monetized.

Source: SDGC Newsletter