The costs and income added to the production scheduling for the activity (the scale of the operation) determine the profitability of income-generating activities, as well as the need for subsidies or fees covered by users, in the case of projects not aimed at generating income.
Although the market, technology and sustainability assessments should have provided most of these parameters (product prices, investment costs, etc.), at this point there is still not a full understanding of the different parameters.
An important initial step is to verify and classify costs. Initial estimates about the costs of the various components of the investment should be reviewed; In addition, the investment costs, the operation and the general expenses, each require a different treatment.
A. Verification and classification of costs
The essence of the process of evaluating an investment aimed at generating income is based on comparing the benefits generated with the required costs. By definition, only those projects in which the benefits are greater than the costs, deserve to be implemented. This is true even in the case of investments not intended for income generation, social, environmental, or production support projects – knowing the costs is a prerequisite for calculating the value of the investment being considered and for calculating the amount needed annually to cover operating expenses.
For projects aimed at generating income, it is necessary to estimate both the investment costs and the different costs and income generated from the project operation.
It is easy for an applicant, full of enthusiasm about their proposal, to underestimate the costs of a project or to assign them to the wrong category; and this causes errors in the calculation of financing requirements. The process of preparing a project profile in the field places little emphasis on cost verification – best estimates are acceptable when working at the profile level. Therefore, as the first task in the formulation and evaluation process, applicants and their advisor should examine the previously identified costs, in order to:
- Determine if the initial costs have been assigned to the correct categories (initial investment, replacement of investment items, annual operations, overhead).
- Break down the overhead costs into their specific components, e.g. break down the overall estimated cost of a building into components such as: site preparation and access; the foundations, the construction per square meter; finishes (electrical and plumbing); furniture, etc.
- Identify costs not included above, e.g. technical assistance, training, legal or health requirements, mitigation of environmental impact, improvement of access roads.
- Verify the validity of the costs to be used in direct contact with vendors, transporters, engineers and other specialists in the area.
1. Investment and related costs
Investment is the primary part of any project. In fact, a project can be defined as an activity in which an investment is made now, in order to obtain benefits in the future. Investment is a type of expense, but it can be differentiated by the duration of its impact. If the market lasts for no more than one year, the cost cannot be taken into account as an investment, and should instead be treated as an operating cost.
Not all investments are in the form of physical assets, although investments in works and machinery are undoubtedly the most common. However, you can invest in less tangible things: for example, education, research and systems. When you buy a store, or other business, you often have to pay for the “business legacy” of the previous owner; that is, his network of business contacts. It is estimated that the relationship developed by the seller with his customers over the years is an asset that has a monetary cost.
Establishing a permanent crop (including labor costs) is also an investment. If small areas of permanent crops are replaced annually as part of an established cycle (for example, 5% of trees each year), the cost is often included as part of operating costs. Although this is not so important on a small scale, it is necessary to remember that the cost and availability of financing often differ according to its purpose. If significant areas of new crops must be established, or if a high percentage of existing plantations need to be replaced (e.g. as a result of buying a poorly managed farm), it becomes clear that the high costs required will cause operating budget problems. However, if the new plantations are treated as an investment instead (which they are), it will generally be possible to obtain longer-term funds at lower rates, and there may even be a grace period for payment of the loan. loan.
When estimating the costs of a physical investment, the following factors should be considered:
- The initial price of the assets (machinery, equipment, or materials) at your point of sale.
- The taxes imposed on that price.
- The transportation of the asset to its final location, including insurance, and, when the item must go through customs, import duties.
- Installation and, if necessary, testing of the item in its final location.
- Training of operators.
b. Economic life
Some investments will have a useful life longer than the project’s time horizon, especially in the case of works, construction, and heavy machinery. Others, like earth, do not have a predetermined useful life, and it is generally assumed that their benefits will last indefinitely.
However, many investments will need to be replaced as they wear out (but it is important to remember that they should never be replaced in less than a year or they cannot be considered an investment). It is, therefore, necessary to examine the useful life or economic life of each investment; that is, the number of years it can be used until it needs to be replaced.
Electronic equipment (computers, printers, telephones, etc.) is one of the shortest economic life categories – perhaps no longer than four years. In these cases, the economic life of the asset is mainly determined by the rate of technological change. A computer is usually replaced, not because it has stopped working, but because it is no longer compatible with the latest programs.
In the case of other investments, the economic life is closely related to the use and maintenance of the article, and the increase in the cost of repair as it deteriorates. A vehicle or truck, for example, may last a quarter century, but when a truck is used on rural roads in developing countries, the economic life of the truck will generally not exceed 6 or 8 years. Remember, this does not mean that the truck will no longer operate after this time. Rather, it means that the cost of keeping it running simply becomes too high to justify keeping it [9] . When this happens, most businesses decide that it is more convenient to buy a new truck and sell the old one.
The replacement value must be recorded in the year in which the operation takes place. So if the old truck is to be changed in the sixth year of the project, the cost of the new truck (eg US $ 35,000) should be recorded in that same year.
c. Salvage and residual value
Often times when an asset is replaced at the end of its useful life it still has some value. Undoubtedly, the six-year-old truck still has a high economic value, perhaps 20 to 35% of its initial value, depending on the tax structure of the country. This value is known as the salvage value and should be recorded as income in the year in which it occurs, in the same way that the cost of the new truck was recorded as an investment cost. The salvage value of some investments is almost non-existent. These may include electronic equipment, fixed assets (such as wells, water collection tanks, etc.), or permanent crops that are at the end of their useful life.
In addition, it is necessary to take into account, especially in the case of investments that have a very extended useful life, that they may have a significant residual value at the end of the economic life of the project. Residual value is the value of an investment when the analyzed period ends. For many assets this value is not high enough to be recorded, especially if it is in the distant future. However, when it comes to important assets, such as buildings and land, the residual value will generally be significant, and can influence the profitability of the project.
To understand the importance of residual value, it is worth remembering that the project started without resources, but used loans and other sources of financing to obtain the assets it needed. During the period analysed, the income of the project is applied to the payment of the loan. Before the end of the analysed period, the cost of these goods has been paid in full. However, in the case of land, buildings, etc. these assets still hold a large percentage of value, which must be recognised when the project period ends.
d. Depreciation
The subject of depreciation is an issue that always worries people who study the RuralInvest methodology. Inevitably someone always asks why the cost of depreciation is not included in the calculations.
The answer is simple: depreciation is a measure purely related to taxation, and defined by the Ministry of Finance, the Internal Revenue Service or the Ministry of Finance of the country in question, specifically to offer tax benefits to investors. Tax authorities dictate how a person or company making an investment can use the cost of this investment to reduce their taxes each year. This sum is depreciation, and generally has little to do with the useful life of the asset. In addition, it changes from one type of investment to another, usually to support government policies directed at certain sectors or activities. When a company charges depreciation on its books, it doesn’t really set aside funds to replace the asset, it just reduces its tax burden.
As a result, the concept of depreciation is relevant in a financial analysis only when taxes are being taken into account. In the RuralInvest system, little importance is given to taxes, as the purpose of the analysis is to determine if the project is efficient and sustainable and not to maximize net profits.
Because calculating taxes is not normally a priority among those analyzing small and medium-scale rural investments, the concept of depreciation can be put aside until the project generates enough profit and therefore requires serious analysis on tax matters. .
2. Recurring costs
Investment is not the only cost that a project must face. Once a project is underway, there are costs that must be covered annually (or more frequently). Costs that are not investments are described as recurring costs; that is, they occur year after year. This concept deals with two distinct categories: production costs and overheads.
a. Production costs
These are costs directly attributed to the production process. For example, in the case of a small workshop that produces clothing, the cost of the materials, (fabric, buttons, etc.), the packaging material, and the costs of electricity used for the operation of sewing machines and plates are included as production costs.
Labor is also taken into account as a production cost, if it is directly related to the production of the garment workshop. In fact, a cost that changes directly with production volume is a production cost. The estimate of these costs is discussed in more detail below.
b. General expenses
These include costs that normally do not vary by production level. Thus, continuing with the example of the garment production workshop, we can identify as general expenses, the salary of the workshop administrator, the lighting of the building and the salary of the truck driver, since these items do not change according to the level of production. General expenses may include property taxes, insurance policy, telephone bills, and accounting services.
In reality the separation between production costs and overheads is not always clear. Costs will change if the volume of production increases. If the business is very successful, for example, the shop may need a new, larger building, or hire department managers. On the other hand, it is worth asking, does the cost of labor really depend on the volume of production? For example, can you send workers home in the middle of the day, without pay, if the shop has received orders for only half the normal number of shirts produced? Only where workers are paid “per piece produced” – that is, per shirt produced – can labor actually be said to be a cost of production.
The following “rule of thumb” helps to decide whether an expense is a cost of production (that is, variable) or general (that is, fixed): a cost that increases when the level of production increases (or decreases) by 10 %, it will be a variable cost. On the other hand, the costs that do not vary, are taken into account as general expenses.
3. Training and technical assistance costs
The allocation of costs for training, education, and technical assistance often causes confusion; however, the same rules apply in this case as for physical assets. Spending on training and hiring experts, which occurs only once or is repeated only at separate intervals, is an investment.
If, on the contrary, the expense is repeated annually, or even more frequently – as is usually the case for agricultural extension services or specialised technicians – it is taken into account as a recurring cost. However, the cost of these services is generally not directly related to the project’s output. For example, the monthly visit that the veterinarian makes to the cattle herd will probably not increase to three weeks, just because the owner increases the size of the herd. Because of this, costs are recorded as an overhead and not as a cost of production.
