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 $700,000, 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!”