Want to make more money? Then read this.

If I put the term “opportunity costs” in the title of this article most people would roll their eyes and move on. But if you want to make more money, pay attention.

Most people dismiss opportunity costs as a theoretical concept economists use to confuse people who live in the real world. By the end of this column you’ll understand that opportunity costs are real and that including them in your analysis gives you important practical information that can help you profitably grow your business. Ignore them, like most of your neighbors do, and you’ll get the results most of your neighbors get (they don’t pay themselves a competitive wage, they rely on off farm-income, etc.). Understanding and using opportunity costs is essential if you want to change that.

When you look up the definition of “opportunity cost” you’ll probably find something like, “the benefit that a person could have received, but gave up, to take another course of action.”  I got that definition from investopedia.com. Their definition isn’t wrong. It’s just not very helpful.

I think it is easier to understand why opportunity costs are essential if we define them a little differently. Rather than looking at the “benefit we gave up” what if we look at the cost of pursuing a course of action … the cost of pursuing  an opportunity. Let’s start with cattle and land.

One of the first things we address in the Ranching For Profit School is the difference between the land business and the livestock business. Whether you own land or not, your livestock must rent whatever land they graze. If they rent the place next door your livestock business will pay rent to your neighbor. If it’s your land they graze, your livestock will pay rent to your land business, and they’ll pay whatever rate you’d have to pay if someone else owned your ranch. The rent that our cattle business pays to our land business is an opportunity cost. By including this cost in our analysis, we know whether it makes sense to expand our business by renting more land.

There are two other important opportunity costs we need to consider: the value of our investment in livestock and our time.

Economists would probably tell you that the opportunity cost for livestock is what you could earn on the money you have invested in your herd if you put that money into some alternative investment. That’s accurate, but what do the economists expect you to do with that information? Sell the herd? Maybe if the alternative investment is better, you should sell your cows and start custom grazing. But let’s flip this around. By including opportunity costs in the calculation, you know if and when it makes economic sense to buy more cows. If the cow gross margin is good, and we’ve included opportunity interest in the calculation, it tells us that we should buy more cows, AND we should use the bank’s money to do it!

Figuring out what to charge for opportunity interest on cows is simple. We advise participants in the Ranching For Profit School to charge 10% of the opening value of their herd. If the herd is worth $700,00, the opportunity interest is $70,000.  It might seem like 10% is too high, but it is the perfect number for two reasons. First, we value the herd conservatively. Ten percent of the conservative value of a mature cow comes pretty close to the interest you’d pay on a loan for a bred replacement. The other reason we use 10% is because it is easy. We make no apologies for that! It may not be precise, but it is accurate enough to give us useful information.

The other opportunity cost we need to include is labor. If you want to know if your ranch is really profitable, you’ve got to include a fair salary for yourself … unless your spouse is happy to continue subsidizing your hobby with off-farm income! If this is a real business you will pay yourself a fair wage. That way you know three things: First, if something happened to you, you would be able to pay someone else to do the work. Second, if you expanded, it’s likely you will need more help. By including this cost, you will know if you can handle it. Third, if you don’t include all of the costs of doing business, you cannot set a meaningful profit target. Without a meaningful target, how can you possibly build a meaningful plan?

Here’s the final kicker on opportunity costs. If you leased your ranch to someone else, sold your cows, invested that money in something else and lay in a hammock all day long, how much money would you make after paying property taxes and insurance on your ranch? Shouldn’t that be your minimum profit target? Wouldn’t it be kind of embarrassing to make less by having all of your money tied up in cattle and working your life away, than you could make laying back in a hammock all day long?

I’m not suggesting that you’d want to sleep all day long, but I’ve always figured that you should make more doing something than you can make doing nothing. As Stan Parsons advises, “If you want to be a cowboy get a job!”

 

Note: Stan Parsons’ book, If You Want To Be A Cowboy Get A Job! is being republished as an e-book and will be available soon. Stay tuned for details.

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9 Comments


  1. Some very good comments and ideas. However, I always twinge a little when one assumes that any investment outside of Ag in the stock market, housing etc., is a slam dunk huge return. I’m curious to know what these guaranteed investments are.

    Reply

  2. Hi Dave.
    As always, a fascinating topic. I found myself tripping over one tiny little part, the line where you say,

    “AND we should use the bank’s money to do it!”

    Funny thing about that: I frequently sit with very successful small business people who all tell me the same thing: Never, ever use your own money.

    But here’s the rub: I had a nice chat years back with recently-deceased Bud Williams where he told me that one of the most important goals I could set for myself was to become self-financed in the cattle business, as it would result in a 10% improvement in my bottom line. Personally, I enjoyed using borrowed money when I was young, perhaps because I didn’t have any of my own money. Now, in my sixties, I can’t imagine having a cattle note hanging over me. Plus, my wife would throw a fit.

    Any thoughts?

    Reply

    1. John, thanks for the comment. I think that borrowing money boils down to two things:

      1. What are you going to use the money for? Will you put it in something that makes money or something that costs money? (Kiyosaki’s classic, Rich Dad Poor Dad, is a great read on that.) Related to what you are going to use it for, is how risky that thing is. If something is low risk and profitable, it is a financial no-brainer to borrow money to do it. However, once someone if financially comfortable, the next dollar they make isn’t as valuable to them as the last dollar was. At some point the marginal value of the next dollar you make is less than the marginal cost of the hassle and stress that it takes to make it.

      2. The bigger issue is perspective. Is the note hanging over you or is it giving you an opportunity to grow? Is it tying your hands or liberating you so you can build you business. Had Kathy and I not borrowed money, we would not have been able to buy Ranch Management Consultants from Stan. We didn’t feel like the loan was a burden. We were grateful for it because we knew it was a launching pad to pursue a dream! (Please don’t call me Rocket Man!)

      I wonder sometimes, as we get older … I think you and I are about the same age (young old men?) … and as we become more secure financially, if we dream smaller. Things that seemed like adventures to us when we were younger seem like risks to us now. Maybe that’s why borrowing feels like a burden rather than a blessing. Maybe.

      Reply

  3. Dave,
    My father-in-law worked as a railroad conductor for 43 years. For the last 25 years of that career, he also ranched on the side. He started by purchasing a 200 acre irrigated farm where he preconditioned calves to turn out on leased grass in the summer. He then purchased a small ranch, and later sold the farm and the small ranch to purchase a much larger ranch with an irrigated farm on it. His original land purchases increased by about 25% while he owned them and his current ranch has increased by 150% in 20 years. He agrees he could have made more money over the same period by investing in the stock market. His argument is that ranching is what he is motivated to do and many of his friends who made the same wages never saved any appreciable amount of money because they weren’t focussed or disciplined. He is 78-years-old, has been retired from the railroad for many years, is in great shape, works hard, and still loves his work of being a full-time rancher. Many of his compatriots are deceased or in a nursing home, but he wakes up every day with a mission. I also believe being focussed on a goal kept him from falling into some of the same pitfalls (multiple marriages and alcoholism) that many of his coworkers of his era of railroaders were plagued with.
    I guess he is a hobby rancher since he gets a good retirement, but I don’t know many people who have become as wealthy as he is playing golf or fishing. Also, I have seen many families sell their fixed agricultural assets just to lose the money on poor investments.
    I guess it is the same argument that can be made for buying a home. While measured strictly by the numbers, it is a poor investment, but when considering that most people would not be motivated to invest that much of income into any other appreciating asset, it turns out to be most families greatest area of savings.
    My questions; How do you measure intangibles like motivation to invest in a given area of interest? And, also having money in a fixed asset verses a more fluid asset where it is more easily eroded?

    Reply

    1. Thanks for your comment and question.

      Notice that I didn’t follow the classic definition of opportunity where you’d ask “What could I get if I invested the money tied up in this thing and put it somewhere else?” I asked, “What will it cost to expand?…too borrow money to buy more animals or to rent more land?”

      It might make financial sense to sell out and do something else…maybe… although land, depending on where you are has been a pretty good investment with a few notable exceptions (anyone remember the 80’s?). But does it make emotional sense?

      I think there are two ways to approach questions like this…
      1. The first is black and white, where we’d ask, “Financially, what is the best decision?” and then ask “Do I want to do this?”
      2. The other approach is to ask, “What do I want to do?” and then, “How can I make this work financially?” Either approach is fine, but I find the second more exciting.

      I don’t think very many of us are in ag to maximize ROI…we’d be pretty happy with a healthy ROI and the emotional benefits we get from doing what we love.

      Some things aren’t so easily measured in cold, hard cash (e.g. the value of doing what I love, the riskiness of an investment, the limitations of having money tied up in fixed assets, the value of having reserves). I use two processes to evaluate questions that involve more than money (as most questions do). If you’d like me to send you information on those processes email me at pratt@ranchmanagement.com.

      Reply

  4. Hi Dave,

    A couple follow up questions:

    How do you come up with a “fair wage” for the cattle business calculations?

    How do you deal with the cattle price cycle in the cattle business calculations?

    How do you handle the cost of your homestead in the land business calculations?

    Reply

    1. Good questions.

      Let’s start with a fair wage. If I was to hire you to do what you do, what would I have to pay? Or if you were to hire someone to replace the work you do, how much would you have to pay. There is no precise answer to that question…horse shoes and hand grenades—close is good enough.

      You can also look at time you spend working in your business ($10/hour work) and the time you spend working on your business ($100/hour work).

      2nd..dealing with fluctuating cattle prices. High prices or low, we rarely change the conservative values we use for livestock…If I think a mature bred cow is worth $1,200 in a low market and $2,400 in a high market…I’ll go with the $1,400. For opportunity interest I’ll take 10% of that number…now, if the fluctuation is
      more than that I might use a slightly higher number when the market is up…but again, we are talking horse shoes and hand grenades…let’s just get close. While the numbers are important, the more important thing is the thinking that led to the numbers and their implications.

      Finally, the cost of your homestead…simple. The cows only have to lease the grass. They don’t have to pay for the scenery, the minerals, the wildlife values or your home…all they have to do is rent the grass…so, if you were to continue to live where you live, the question is, what could you rent the grass to someone else for?…or what would it cost to rent the neighbors?

      Reply

  5. Hi Dave, thank you very much for today’s breakfast for thought.
    Two points before sharing it:
    First, a material one: I guess you mean “700,000”, not “700,00” as the total value of the herd.
    Second, a conceptual one: you say “The rent that our cattle business pays to our land business is an opportunity cost”. I’d rather say that it is the rent it usually doesn’t pay. It should pay it, or at least it should be acknowledged in our cost analysis. The same goes for our cattle an our own effort. Usually, opportunity costs are not billed, they are virtual, so to speak. We afford them, most of the times unknowingly, and very seldom consciously: “It’s mine, it doesn’t cost me a penny!”
    Thanks again,
    Marcos Giménez-Zapiola
    Buenos Aires, Argentina

    Reply

    1. Thanks. No matter how hard we look for typo’s, it seems that one (or more) always slip through. Thanks for the correction…it was supposed to be an opening inventory $700,000.

      On your second point, you wrote, “I’d rather say that it is the rent it usually doesn’t pay. It should pay it, or at least it should be acknowledged in our cost analysis.” That’s a fair way to think about it…and ABSOLUTELY!!! it should be included in the analysis … if it’s not, the cost analysis isn’t really telling you much….all you can deduce from it (without opportunity costs) is, “If I keep subsidizing my ranch with free land and labor and money, this is the result.” I don’t care if someone subsidizes their ranch. It’s their money, not mine … but wouldn’t you think they’d want to know how much their hobby really costs them? …. hmmm … Maybe not.

      Reply

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