A sound machinery replacement strategy can bring big savings

Equipment expenses will always be a big part of your cost of doing business. But understanding your purchase options and developing a sound replacement strategy can bump up your profitability.

In a study by William Edwards, extension economist at Iowa State University, machinery costs accounted for 35-45% of total production costs. While the study focused on the costs of producing corn and soybeans on 60 Iowa farms, the results also have implications for forage production, says Edwards.

"Since seed and chemical costs are probably less with forages, machinery costs become an even larger percentage of total production costs," he says.

Moreover, the study found that about two-thirds of the variation in machinery costs came from differences in ownership costs, including depreciation, interest and insurance.

"Yet many producers give less attention to machinery costs than other cost areas because the cash expenditures tend to be made infrequently," says Edwards. "And once the investment is made, depreciation and interest become non-cash costs and are less noticeable."

There isn't one simple equation that will let you calculate the best time to replace equipment. But here are several important factors to consider:

Minimizing costs. According to Edwards, the standard rule for minimizing the long-run cost of depreciable assets is to make a change when the annualized total cost of owning and operating the machine begins to increase. For a tractor or forage harvester, that happens when repair costs begin to increase faster than depreciation and interest costs are decreasing.

He projects that, for a new 190-hp tractor that costs $93,000 and is used 400 hours per year, this point could occur around the 11th year of ownership.

"But as we all know, repair costs are rarely that predictable and can vary greatly from year to year," he says. "Being able to anticipate when large repair costs will be needed is a key consideration in when to replace a machine."

Reliability. Since timeliness is such an important component of farming and operating a forage harvesting business, the general reliability of a machine is a major consideration. For custom operators, downtime can be especially critical.

New technology. A faster, more-efficient bale wrapper or higher-capacity chopper may make some of your existing equipment less profitable by comparison, and, in time, obsolete.

Need for more capacity. If business is going well, and your annual acreage is increasing, the need for greater capacity may dictate buying or trading up, equipment-wise. Conversely, if the number of acres you're covering has significantly dropped, you may want to look at smaller machines that could reduce your overall equipment investment.

Current market considerations. Depending on the volume of equipment sales in the previous year, there may be an excess supply. And that could mean deeper discounts on dealer lots. And when the farm economy is below average, bargains may also be available in used machinery, says Edwards.

The extension economist cites several strategies farmers and custom operators can take in replacing machinery:

* Scheduled frequent replacements of key machines, based on years of ownership or hours of use. This is a common strategy for an operator who covers a large number of acres each year and who would be severely affected by extended downtime.

* Replacing one or two pieces of machinery every year. This keeps the cost of new equipment fairly constant from year to year.

* Replacing equipment when cash is available. This strategy keeps machinery purchases from cutting into profits used for family living or debt servicing. It also helps level out income for income tax purposes.

* Keeping machinery until it simply wears out. The least-cost approach in the long run, this plan nevertheless requires flexibility, since old equipment is less reliable.

Once you've decided to replace equipment, the next step is to figure out which purchase or lease option is the best for your operation.

Most farm equipment is still acquired through a conventional purchase plan. But leasing is becoming much more common. According to Edwards, there are two common types of leases. An operating lease requires fixed annual or semiannual payments for several years, after which the machine can be returned or purchased. A big benefit is that the lease payments are tax-deductible as ordinary operating expenses.

A second type of lease, called a finance lease, establishes the operator as owner of the machine and allows him to take depreciation deductions. The operator can still choose to keep the machine at the end of the lease period or return it.

"In effect, the finance lease is equivalent to a conditional sales contract with a balloon payment at the end," explains Edwards.

A lease ties you down more than a purchase, he notes.

"If you've signed a three-, four- or five-year lease on a piece of equipment, and then don't get as many acres as you expected in a season, you can't sell as easily. There may be a buyout clause, but exercising that will usually end up being rather expensive."

Another option, the rollover purchase plan, allows you to trade the machine for a new model after one year or one season. Often financed with a company loan that accrues no interest until the date of trade-in, this plan provides a safeguard against repair costs, since the equipment is always under warranty.

Edwards says lease and rollover plans both minimize the direct cash outflows needed to buy the use of a machine. "And you're getting to use a new machine, which should all but eliminate repair costs. The downside is that you build no equity through these methods."

As for the current machinery market, Edwards says that since sales were slow last year, some dealers may have extra equipment on their lots that they're willing to discount.

"There might be some deals out there," he says. "If you've got the financing, this may be a good time to buy." N