Underestimating Future Capital Costs
OPINION: It's easy to underestimate future capital costs in farming.
Farmers only need to look at their building or renovating of homesteads and cowsheds, irrigation development, and major repairs on farms to know how easy it is to get this wrong.
The writer would strike a dozen incidents of this every year including hefty over-runs from original estimates which when added up would equate to the value of 5,000-7500 lambs or 100,000 kilograms of milk solids.
Whose fault is all this? Well, it cannot be inflation because the official figure is only 1-2 per cent and it cannot be Inland Revenue because they hardly feature in this exercise. Nor can it be your bank because they will be guided much more by how much you want to borrow.
That only leaves you and the business carrying out the capital works. The rule of thumb for any capital project is to obtain three external quotes from three independent parties – probably anything more than $50,000 in farming today needs no less than three quotes.
Some quotes are fixed quotes with no allowance for over runs. Other quotes can be open-ended and nobody tends to take control of the over run costs. They are just something that gets added up at completion, which is far too late for you and I to do anything about it.
Some quotes also involve quality and others do not. We need to take much more interest in a quote from a party we do not know well. Look at how many house repairs arising from the Christchurch earthquake have had to be revisited repair wise – some several times. The official figure is somewhere between 30-40 per cent – this is ridiculous and terribly expensive, if not for you and I then for the country as a whole because it will increase insurance costs.
For any capital works of any size, we need a qualified party independent of the builder and insurance company to manage the project, work quality, time framesand progress – even a good farmer may not be a good project supervisor.
Many of us have had to deal with a quantity surveyor for the owner and another quantity surveyor for the insurance company with the gap often being substantial and away goes two to four years before the gap becomes workable.
An allowance for unforeseen expenses in our budget is not good enough, because nobody is responsible for managing it, historically the allowance has not been high enough and, thirdly, the allowance often makes no allowance for time lost.
We all need to spend much more time at the onset of these capital expenditure exercises. The fact that we may be out of our depth simply makes the focus and expert involvement at that point even more critical.
Capital budgeting seems to be a problem outside of farming too. Just look at the Fletchers estimates during earthquake repairs and the below provision figures are in the millions of dollars yet this organisation will have had full time costing and estimating experts but still it did not work.
It is fair comment that for a period building costs were increasing close to 1 per cent a month but the experts knew that. There is a world of difference between estimating a capital cost that will be spent over a three-month period compared with a capital cost that will be spent over a three-year period. Once again, the building construction costing expert would be well aware of this, but the time value of money is not well understood in the market place.
Sometimes there are penalties incurred during a big construction project if it is not completed by a certain date. This does not stop over runs, guarantee issues about the quality of the job, and it can mean real stress in the last few weeks or months for everybody on the ground in the project.
Does the Government have these problems? The short answer is, yes, but they have more money (yours and mine) and in many areas are looking at last year's actual cost and adding perhaps 5-10 per cent. Where do they have these problems is in education, welfare, health, and national superannuation.
The annual health insurance costs for a New Zealand family have been increasing each year by some 15 per cent. Even United States President Donald Trump is struggling with this cost. The rule of '72' suggests that, if this annual increase continues at 15 per cent then family health insurance costs will double every five years.
In Christchurch, we are close to seeing 200 building related companies go into liquidation with the total capital loss being of the order of $45-$50 million. This is despite there being a lot of work available and on top of this of course there is a lot of jobs having to be revisited.
Take your pick what brought this about - it could have been poor cash and people management, a company being under capitalised, not understanding the time cost of money and its recovery or the company might have subcontractors who were weak financially. Weak cash management would appear to be the core problem and the problem is people but so is the solution.
Mark Twain once said that his dealings with some people made him think that perhaps it would have been good if Noah had missed the boat, such is the human race.
For every building company that tips over there are a big number of good builders who take real pride in their work.
So what is the take home message from all this? Inflation cannot be blamed, people in the building related industry need better money management and cash is undervalued.
People who can forward budget well need gold treatment. The key is to focus ruthlessly at the beginning of the project and not end up shouting, swearing, and screaming at the end of the project. We need to take more responsibility up front in our forward capital budgeting planning, timing, and implementation.
Pita Alexander is an accountancy and agribusiness director at Alexanders.