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Depreciation and farm machinery, a rule of thumb

Hidden profit robbers, Part 1

Since machinery is a depreciating asset, the author recommends minimizing that investment and maximizing investment in appreciating assets.

In my farm financial talks, I usually ask, “What’s the biggest cost in owning any piece of machinery?” In this case, I’ve already given you the answer but surprisingly some people don’t seem to be aware of that. In my 16 years of consulting farmers, I’ve noticed the old expression “guys (and gals) love their iron” is very true. Iron in this case means machinery, including all sizes of trucks and SUVs. Of course, machinery is necessary but what is the right amount for your farm? Excess machinery capacity as well as unused or little used items result in higher than necessary depreciation costs and loan payments (if applicable).

Why it matters: Excess machinery capacity results in higher than necessary depreciation costs and loan payments. There is a rule of thumb — the capital investment for all grain farming machinery should be around $300 per acre.

Since machinery is a depreciating asset, I recommend you minimize that investment and maximize your investment in appreciating assets like land (over the long term). So, what’s the right amount of machinery? Of course, only you can decide for your own operation, but there is a rule of thumb for grain farmers.

The capital investment for all grain farming machinery (at fair market values) should be around $300 per acre. If it’s less than that you’re in excellent territory but you’re probably running older machinery, which is prone to breakdowns at inopportune times. If you’re in the $500 per acre territory (or higher) you probably have newer equipment that you’re proud of. To calculate this number, add up the value of all your grain equipment, including all trucks related to that enterprise (at fair market values), and divide by the number of cultivated acres. If you are in the right area ($300 to $400 per acre), you will also be spreading the capital cost over the optimum number of acres and you shouldn’t have excessive or insufficient capacity.

The hidden profit robber

Depreciation is the hidden profit robber, since it’s a non-cash cost that doesn’t affect your bank balance. However, it has a huge effect on your profitability. Let’s look at an example for a new combine. Assume the new machine costs $750,000 and fair market depreciation for the first few years is 20 per cent per year, so in the first year alone the depreciation cost is $150,000.

In late August 2020, the cash price for No. 1 CWRS wheat is $6.25 per bushel in northern Alberta, so it takes 24,000 bushels just to cover the depreciation costs. See the table for the total depreciation cost over five years. On top of that, you have input costs and fixed costs before you finally have some profit for yourself. New pickup trucks are the real profit robber. A new one-ton truck, all decked out, can cost up to $100,000. At a reasonable depreciation rate of 20 per cent that is $20,000 in the first year alone.

The Canada Revenue Agency (CRA) has its own depreciation schedules for tax purposes, called capital cost allowance (CCA), ranging from 20 to 30 per cent for most farm equipment. The CCA rates usually do not reflect actual depreciation in the marketplace (i.e. they are higher than the market rates thus creating lower equipment values than actual market prices).

The CCA rates are attractive to farmers since they significantly lower their income taxes payable. In good years, I hear farmers say, “I made good money this year, so I’ll buy some new machinery to lower my tax obligations.” If some pieces actually needed replacing that is a good plan, but if it’s only to lower taxes it’s not a good plan.

Here’s an idea for reducing your depreciation costs. A couple of farmers that I met over the past year told me they buy good used machinery instead of new. They had to travel some extra miles to do that but it was worth it. They told me they bought good used combines that were three to five years old in the $400,000 to $500,000 range. So, let’s look at the depreciation situation in this case. At a cost of $500,000 and a 20 per cent depreciation cost, the first-year cost is $100,000. That equates to 16,000 bushels of wheat versus 24,000 in the above example. Quite a difference!

Another idea if you are buying new is to hold onto the piece longer (if possible). As the machine gets older, the depreciation cost is much less than a new one. Here’s an example from my own experience. I generally keep my vehicles for 15-plus years to minimize the depreciation cost. In 1997, I bought a slightly used car for $14,000 and kept it for 17 years, until it had 450,000 kilometres, and then gave it away. My depreciation cost was just over $800 per year.

A good way to gauge your depreciation management is to look at your net worth value from year to year. Net worth equals assets less liabilities at fair market values. If net worth is increasing at a respectable rate, year over year, you are probably controlling depreciation fairly well. However, you may be able to improve your net worth even more by applying some of the above-mentioned ideas.

Thanks to Allan Sawiak, tax partner at KRP Group in Edmonton, for his input for this article.

In future articles, I’ll talk about the high loan payments (principal and interest) on new machinery and other profit robbers on farms.

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