The Real Cost of Depreciation
Oct 10, 2011
Here is an interesting concept for you to consider, from Moe Russell of Russell Consulting Group:
A standard rule many use when estimating depreciation cost is 10% of equipment and 5% of facilities. Some disagree with that and say, 'The tractor I purchased ten years ago is worth more now than I paid for it, so there is no depreciation."
What many forget is that depreciation is the allocation of funds to replace equipment worn out in the production process. What the tractor is worth is not the issue, it is what it cost to replace that tractor that defines depreciation.
More importantly, when we replace equipment, we seldom replace it with like items; we often upgrade to newer technology, larger equipment or different features. Since depreciation is the allocation of funds to replace equipment, it follows that the real cost of depreciation is the cost of what you replace with upgraded equipment.
Several years ago, Chris Barron and I did a study and looked at depreciation three ways on four items of equipment. The first way was to use the equipment for a specified number of years and then line it up and sell it for cash (have a sale). The second was to replace the equipment with new equipment but with the same horsepower and size (replace). The third was to upgrade to newer, bigger equipment (upgrade).
Following are the results of our study:
Item Have a sale Replace Upgrade
Tractor 3% 9.5% 14.2%
Combine 4.4% 8.8% 13.8%
Planter 3.1% 1.3% 23.8%
Sprayer 9.3% 14% 18.8%
Average 5.0% 8.4% 17.6%
Bottom line: If you are going to stay farming, 10% depreciation is not enough.