Increase PROFITS and reduce fixed costs
In the December 2019 Pula Imvula we discussed and emphasised the different types of costs namely fixed, overhead and input costs. We also indicated a few measures to control these costs, but the emphasis was mainly on input or production costs.
In this article we will be looking more specifically to fixed costs and will discuss depreciation in a bit more detail, being a specific type of fixed cost.
Farmers are production orientated and are not to blame for that, but the results are that we then forget about the fixed costs and to manage them especially in difficult times. To refresh our memories. Fixed costs are those cost incurred when running a business but need to be paid even in times of hardship and when nothing was produced. Fixed costs are fixed, and it is also very difficult to allocate a true fixed cost to a specific farming enterprise. Examples being for instance loan repayments, insurance on buildings and vehicles and machinery, accounting fees, bank charges, training costs, depreciation. Even your salary (living costs) can be considered a fixed cost – you must live even if there is no production.
In general, fixed costs are greater with crop production than with livestock farming. This is due to the higher value of all the vehicles, machinery and equipment needed for crop production. For example, the fixed cost of a tractor valued at R1 million could be as much as R8 000 per month. The fixed costs involved could be depreciation, insurance, license fees, and the storing costs (cost of a shed) of the tractor.
According to the formula PROFIT = INCOME - EXPENSES (or costs), it is obvious that to reduce costs is the only way to affect profits positively. Thus, costs must be managed. When considering this equation consideration is quite naturally to pay attention to production costs whilst we tend to forget about fixed costs. However, when a famer finds himself in dire straits regarding his/her finances it is most of the time due to high fixed costs especially the repayment of loans. Remember, fixed costs must be paid even if no rain has fallen and there is no crop.
Thus, these costs must also always be managed, in view of the aim to always keep these costs as low as possible. How can this be done?
Also keep in mind all assets deteriorate over time. They have a finite useful life and must eventually be replaced. A tractor, while working, has normal running costs to keep it going. The question is however ‘what happens when the tractor needs to be replaced?’ Will you have the funds available or will you have to borrow money with all the risk and additional costs involved?
The cost of the deterioration of an asset over time is known as depreciation. The theory behind depreciation is that you must save the annual depreciation cost every year to enable you to replace the asset when needed to be replaced. In practice we unfortunately know very few business owners who do this and when the asset needs to be replaced there is a shortage of funds and borrowing becomes a necessity. In farming it is at times quite understandable that money is not saved. How can one save money when for instance during a drought you must buy feed for your livestock?
HOW TO KEEP COSTS LOW
A few examples of questions to consider.
- Are you not maintaining too high a standard of living in view of your farm profit?
- Do you consider the possibility to adapt your lifestyle or are you in competition with your neighbours?
- Do you manage your living costs strictly according to a budget or do you buy impulsively?
- Before taking up a new loan, do you consider your cash flow properly and the need for perhaps another or a new tractor? Remember, the more vehicles and machinery, the higher the license fees and/or insurance and depreciation and storage costs.
- Do you limit the number of loans you take up?
- Do you negotiate a lower interest rate to be paid on a loan?
- Do you pay your payments in time?
- Do you consider repaying a loan in a shorter time?
- Do you ever consider sub-contracting actions instead of buying your own harvester?
Legally, according to accounting practices, depreciation is considered a cost and can be subtracted from your business profit. This practice is widely used by accounting officers to reduce profits and then also taxes to be paid to government. Different ways to determine depreciation for different types of assets have been devised based on the principle that all assets do not depreciate at the same tempo. A tractor used every day will have a shorter lifespan than one only used for ploughing during the relevant season.
Thus, it is important to remember to also manage the fixed costs and production costs of your business to increase profits.
Publication: April 2020