Is Opportunity Interest, Real Interest?
An opportunity cost is the lost benefit of choosing a different option. The opportunity cost of going to college is losing out on four years of wages; the true cost is tuition plus lost wages. At the Ranching for Profit School, we include opportunity interest as a cost on owned livestock herds, because there is capital tied up in those animals that could be used elsewhere. Many wonder if this opportunity interest is real or just something added into the equation to make you feel bad about your business?
During the school, we start a fictional ranch from scratch with no money, no livestock, no land, and no time. Yes it’s on paper in a hotel conference room, but it is a valuable exercise. Maybe it’s more real life than we want to admit with the parameters of no money and no time! To quickly start a ranching business from scratch you would rent a ranch, borrow money to buy some cows, and hire someone for the labor. Let’s briefly look at those four items:
- Rent a ranch: pay a flat rate rent for the grazing and improvements
- Borrow money: pay 10% interest on borrowed money
- Buy cows: generate some income with calf crops
- Hire labor: pay market value wages
- And of course pay all other operating costs
During the school’s fictional ranch exercise, it is easy to see where some ranches have subsidized their operations with unpaid labor and free land rent. While working through the exercise most people agree with accounting for those two items. However we get push back on the 10% opportunity interest because bank interest rates have been in the single digits for many years, or perhaps the livestock were paid off so there was no money owed on livestock at all. So why charge opportunity interest?
Charging opportunity interest emphasizes that your money should work for you. If you borrow money, you pay interest for use of that money. If you use your own money, you surrender future interest earned. By figuring opportunity interest into your economic decisions, the business account should accumulate that extra cash. Over time that can be reinvested into the business or taken out as owner profit distributions. Charging opportunity interest makes it clear where the money is made: the cow enterprises, the land investment, or the money itself. Remember, an economic analysis includes all costs, not just cash costs. The value of the grazed feed, the full value of the labor, and the time value of money are needed to complete a full analysis. One more important reason to use opportunity interest is that when a profitable business is structured to include all costs, it is a signal to expand the business when the opportunity arises. If opportunity interest is omitted, but borrowed money is needed to expand, the analysis is incorrect.
I believe that you will get what you look for; if opportunity interest is figured then your business will keep improving to meet those goals. Figure a poor rate of return in, and you will get just that, disappointment. Figure a really high rate of return, and you will make steps to get there. Bud Williams says profit is a cost of production, and I couldn’t agree more that it should be considered first. For most of us in agriculture, it will require a paradigm shift to focus on profits and money management first, before the day to day labor activities. Many ranches who have shifted their paradigms to consider opportunity costs when making decisions, have profits to show for their efforts.
As a business owner, we also need to understand the difference between projections and actuals. We teach economics vs finance in the class; the opportunity interest is an economic cost, and the actual loan payment is finance. Projections and excel spreadsheets are wonderful for dreams, discussions, and decisions. But I am more concerned with what actually hits the bank account, because that is where the rubber meets the road. A lot of times there is a disconnect between what we think is going on and what is actually being deposited in or spent from the bank account. Factoring in opportunity interest will help us meet those projections by making money work for us. The next Ranching for Profit School with openings is in Kennewick, WA in late September. Join us if you want to challenge your paradigms and meet others who also want Healthy Land, Happy Families, and Profitable Businesses.