Partial Budgeting Tool Unlocks Equipment Decisions

The price of a 310-PTO horsepower tractor climbed by 3% between 2023 and 2025, according to estimates compiled by University of Illinois' Farmdoc team every two years. That's modest compared to the 2021 to 2023 time frame, when the price of the same tractor jumped 32%.

But, with corn, soybean and wheat prices muddling below many farmers' break-even levels, price tags on equipment are forcing farmers to think more carefully about decisions that would have been no-brainers in 2021 and 2022, when incomes hit records.

"Working capital has contracted over the last year," says Russell Morgan, a farm business adviser and consultant. "There are many farmers that have -- I wouldn't call it a shortfall -- but certainly tighter working capital."

Between recent upgrades and tight finances, many farmers are forgoing large capital expenditures such as machinery purchases. The Association of Equipment Manufacturers reports that year-to-date combine sales as of August were 42% behind 2024's sales. Sales of tractors with more than 100 horsepower were down more than 26% year-to-date, while 4-wheel-drive tractor sales were almost 40% lower.

But, equipment doesn't last forever, and repairs have trade-offs, too. While some farmers have arrangements with their dealerships to upgrade their fleets every year, others face the repair-or-replace choice on a piece-by-piece basis. Farmers may be reluctant to buy when finances are tight, but sometimes it's worth the investment, Morgan explains.

USE THE RIGHT METRIC

One of the most commonly discussed metrics in finance is return on investment (ROI), but Morgan cautions it's often misused. "It's abused. It's used wrong," he says. Unlike other common but ambiguous buzzwords, such as sustainability, return on investment has a very specific definition.

The return on investment is a ratio expressed as a percentage, measuring the profit generated by an investment relative to its initial cost.

Seed and fertilizer salesmen often misuse ROI because they're trying to illustrate that their products generate a large return, but Morgan stresses that those items are operating expenses, not investments.

"Investment typically refers to a capital investment, something that's going to be around for more than one operating cycle, like a tractor or building," he says.

Calculating the ROI for a tractor, for example, starts with comparing the net financial benefit it provides against the total cost of ownership over a specific time period, which is typically one year.

Morgan says the net annual benefit requires estimating the positive impact (gains) and subtracting the negative impact (costs) the new tractor has on the farm's profit each year. The positive impacts gained from factors such as enhanced technology, improved fuel efficiency and time savings may be difficult to quantify. Not fully capturing these positive attributes may result in a negative ROI calculation given that farm machinery typically declines in value over time.

For example, if a farmer's total initial investment is $300,000 with a net annual financial benefit of $30,000, the ROI would be 10%.

Morgan says ROI as an analytical tool has limitations. It's great at comparing two investment ideas to determine which provides more profit potential -- such as a CD with a 4% interest rate and one with a 5% rate. But, it's not that useful in making decisions about a single investment, such as the choice to either buy a new tractor or fix the current one. It also doesn't address the amount of risk the operation can tolerate.

PARTIAL BUDGETING BRINGS PERSPECTIVE

Partial budgeting is an old methodology, but it's tried and true, Morgan explains. It focuses on the incremental costs and benefits associated with a single action, such as upgrading or making repairs to equipment, rather than the farm's entire financial picture.

To start, he suggests outlining easily quantifiable parameters and dividing them into four quadrants. In the top left, list the parameters that add to revenue, such as higher yields because of better technology. On the bottom left, list the parameters that would decrease expenses, such as lower maintenance costs. Then, add them together. This is the positive impact of the decision.

On the top right, list anything that would reduce revenue. Morgan says that category doesn't always apply to equipment but can if the new machine is less versatile or results in the loss of custom-farming business, for example. In the bottom right quadrant, include parameters that add to costs, like interest, depreciation or insurance. Add them together to get the negative impacts.

Finally, subtract items on the negative impacts from the positive. For example, if the positive impacts of the choice total $100,000 but the drawbacks amount to $50,000, the net impact is a positive $50,000.

"That looks like a positive decision, but that's where an economist says, 'It depends,'" Morgan says, explaining that there are factors that aren't easy to quantify that need to be considered, as well. If the decision reduces your management time overseeing labor, for example, that's a net positive, which may be hard to translate into dollars and cents. If the new equipment includes technology beyond your management capacity or requires labor that you don't have, that's a negative factor.

"These are things that are near impossible to put dollars on, but it does impact the dollars," he says.

Morgan suggests writing all of the nonquantifiable aspects in the quadrants, too, so that you can look at the full picture.

KNOW YOUR RISK

If the decision to buy a new tractor looks like a net positive, also consider the impact on the balance sheet, your working capital and your debt-to-asset ratio. Every farm operation is different. "How one management team would interpret the same scenario might be different than how another management team would do it, because they have different aversions to risk," Morgan explains.

Even though a new piece of equipment can increase the value of your assets, the prospect of increased debt can weaken your ratio. Bankers generally consider a debt-to-asset ratio of 60% as vulnerable or high risk.

"Your lender might look a little more askance at your situation" if your ratio goes too high, Morgan says, advising farmers to leave themselves wiggle room in case something negative happens.

"It may be better to hold on to that machine for another year even though it looks like it can make money. Employ proactive management as opposed to reactive management," he says.

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