Previous Page Table of Contents Next Page


Chapter 6
ESTIMATING COSTS AND INCOME


Costs and income, combined with the planned production schedule for the activity (the scale of the operation), together determine the profitability of income generating activities, as well as the need for subsidies or user charges in the case of non-profit projects.

Although the evaluations of market, technology and sustainability should have provided many of these parameters (product prices, cost of investment, etc.), at this point we are still far short of having total knowledge of all of the elements.

An important beginning step is to verify and classify the costs. Initial assumptions on the cost of different components of the investment should be checked out, and the costs of the investment, operation and general expenses each require a different treatment.

A. Verification and Classification of Costs

The essence of the process of evaluating an income generating investment lies in comparing the benefits generated to the costs incurred. By definition, only those projects in which the benefits are greater than the costs deserve to be implemented. Even in the case of non-profit investments, social, environmental or production support projects - knowing the costs is a prerequisite for calculating the value of the investment under consideration and for calculating the amount needed annually to cover operating expenses.

For profit-oriented projects, it is necessary to estimate both the costs of the investment and all those costs and incomes that stem from the operation of the project.

It is easy for an applicant, enthusiastic about his proposal, to underestimate the costs of a project or to assign them to the wrong category, which causes errors in the calculation of financing requirements. The process of preparing a project profile in the field lays little emphasis on verifying costs - best estimates are acceptable at the profile level. Therefore, as a first task in the process of formulation and evaluation, the applicants and their advisor should review all of the costs previously identified, in order to:

The contrasting costs of a project can be broken down into three principle categories:

a) Investments and their periodic replacement;
b) Production costs (which generally vary with the scale of manufacture);
c) General or overhead costs (which typically do not vary as a result of changes in the scale of production).

The following is a brief description of each category of costs.

1. Investment and Related Costs

The investment is the heart of any project. In fact a project can be defined as an activity in which an investment is made now in order to obtain a benefit in the future. An investment is a kind of expense, but it can be distinguished by the duration of its impact. If the impacts no more than a year, the cost cannot be considered as an investment and must instead be treated as an operating expense.

a. Types of investments

Not all investments take the form of physical assets, although investments in works and machinery are, undoubtedly, the most common. However, one can also invest in less tangible things: for example education, research and systems. When you buy a store or other business, you frequently will have to pay for the "goodwill" of the previous owner; that is, his network of commercial contacts. It is considered that the relationship, developed by the seller with his clients over the years, is an asset that is worth money.

Establishing a permanent crop (including the costs of labour) is also an investment. If small areas of permanent crops are being replaced every year as part of an established cycle (for example, 5% of the trees every year), the cost is frequently included as part of the operating expenses. While this does not matter at this small scale, it is important to remember that the cost and availability of financing will often differ according to its purpose. If significant areas are to be established in new plantings, or it is necessary to replace a high proportion of existing plantings (e.g. following the purchase of a neglected farm), it rapidly becomes apparent that the high costs involved will cause problems in the operating budget. However, if the new plantings are treated instead as an investment (which they are), it will often be possible to obtain longer term funds at lower rates, and there may even be a grace period on the payment of the loan.

When estimating the cost of a physical investment, the following factors must be considered:

b. Economic Life

Some investments will last longer than the life of the project, especially in the case of physical works, construction and heavy machinery. Others, such as land, have no predetermined useful life, and it is generally assumed that their benefits will last indefinitely.

However, many investments will have to be replaced periodically, as they wear out (but remember: never less than a year, or it cannot be considered an investment). It is therefore necessary to consider the economic or useful life of each investment; that is, the number of years that it can be used until it is replaced.

Electronic equipment (computers, printers, telephones, etc.) are one of the categories with the shortest economic life - perhaps no more than four years. In these cases, the economic life of the asset is primarily determined by the rate of technological change. A computer is normally replaced, not because it has ceased to function, but because it is no longer compatible with the latest programs.

In the case of other investments, the economic life is strongly related to the use and maintenance of the item, and the increasing cost of repair as it gets older. A car or truck, for example, can last a quarter of a century, but when a truck is used on rural roads in developing countries, the economic life will not generally be more than 6 to 8 years. Remember, this doesn’t mean that the truck can no longer run after that time; rather that the cost of keeping it on the road simply becomes too high to justify keeping it[8]. Most businesses decide around this time that it is cheaper to buy a new truck and sell the old one.

The replacement cost should be recorded in the year that replacement takes place. So, if you have to change the old truck in the sixth year, you should register the cost of the new truck (let’s say, US$35,000) in that same year.

c. Salvage value and residual value

Frequently, when an asset is replaced at the end of its economic life, it still has value. Doubtless, the six year-old truck still is worth a lot, maybe 20 or 35% of its initial cost, depending on the tax structure of the country. This value is called the salvage value and it should be recorded as an income in the year it takes place, in the same way that the cost of the new truck is recorded as an investment cost. A few investments have almost no salvage value. These may include electronic equipment, fixed goods (such as wells, water catchment tanks, etc.) or permanent crops at the end of their useful life span.

It is also necessary to take into account, especially in the case of investments having very long economic lives, that they may possess a significant residual value at the end of the project life time. The residual value is what an investment is worth when the period analysed ends. For many assets this value is not enough to be worth recording, especially if it is in the distant future. However, when dealing with large assets such as buildings and land, the residual value will often be significant and can influence the profitability of the project.

To understand the importance of residual value, it is worth remembering that the project began without any resources, but it used loans and other sources of financing to obtain the goods it needed. During the period analysed, income from the project is applied to the payment of the loan. Before ending the analysed period, the cost of these goods has generally been completely paid for. However, in the case of land, buildings, etc., there still remains a great deal of value in these assets and that value must be recognized when the project period expires.

Nevertheless, it is very important to distinguish carefully between the annual cash flow and the financial rate of return (total profitability) - see Chapter 9. The buildings and other goods represent a value, but not an income. So you cannot claim residual values when dealing with cash flow, but you can include residual values in the calculation of profitability.

d. Depreciation

The subject of depreciation is always raised by students studying the RuralInvest methodology. Inevitably someone always asks why the cost of depreciation is not included in the calculations.

The answer is simple: depreciation is purely a tax-related measure, defined by the ministry of finance, internal revenue service or the treasury of the country in question, specifically in order to offer fiscal benefits to investors. The tax authorities dictate the manner in which a person or company making an investment can use the cost of that investment to reduce their taxes each year. This amount is the depreciation, and often has little relation to the actual life of the asset. It also changes from one type of investment to another, normally to support government policies towards certain sectors or activities. When a company charges depreciation in its accounts, it does not actually set aside funds for replacement of the asset, it merely reduces its tax burden.

As a result, the concept of depreciation is of relevance in a financial analysis only where taxes are being taken into account. Under RuralInvest taxes are given little importance, as the purpose of the analysis is to determine if the project is effective and sustainable, not to maximise after-tax earnings.

Given that the calculation of taxes normally is not a high priority among those who analyse rural investments of small or medium scale, you can leave the concept of depreciation aside until the project generates enough profit and calls for a mature consideration of tax matters.

2. Recurring Costs

Investments are not the only costs that a project faces. Once the project is under way, there are costs that must be met 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 general expenses.

a. Production Costs

These are all costs directly attributable to the process of production. For example, in the case of a small workshop producing clothing, the cost of raw materials (cloth, buttons, etc.), packaging materials, and the electricity used to operate the sewing machines and irons are production costs.

Labour is also considered a production cost if it is directly related to the output of the garment workshop. In fact, any cost that changes directly in relation to the production volume is a production cost. The estimate of these costs is dealt with in greater detail below.

b. General Expenses

These include any cost that does not normally vary according to the level of production. So, continuing with the example of the clothing workshop, we can identify as general expenses the salary of the workshop manager, the lighting of the building, and the salary of the truck driver, because these items do not change according to the level of production. General expenses may also include property taxes, insurance policies, telephone bills and accounting services.

In reality, the separation between production costs and general expenses is not always clear. Any cost will change if the scale of production increases enough. If it the business is very successful, for example, the workshop might need a new, larger building, or it might need to hire department managers. On the other hand, is the cost of labour really tied to the scale of production? For example, can you send the workers home in the middle of the day, without pay, if the workshop has orders only for half of the normal number of shirts? Only where workers are paid "piece-rate" - that is per shirt produced - can labour really be said to be a production cost.

Deciding whether an expenditure is a production (i.e. variable) or overhead (i.e. fixed) cost can be helped by the following "rule of thumb": Any costs that increase when the level of output increases (or decreases) by 10% will be variable costs. Costs that remain unchanged, however, will be overhead or general expenses.

3. Training Costs and Technical Assistance

The assignation of costs for training, education and technical assistance frequently cause confusion; however, the same rules apply here as for physical goods. Any expense for experts and training that only occurs once, or that is repeated only at long intervals, is an investment.

If, on the other hand, the expense is repeated annually or more frequently - as is typically the case for agricultural extension services or specialized technical advisors - it is considered a recurring cost. However, the cost of such services generally is not closely related to the output of the project. For example, the monthly visit of the veterinarian to visit a cattle herd would not be likely to increase to a frequency of every 3 weeks just because the farmer increases the size of his herd[9]. As a result, the costs are recorded as a general or overhead expense and not a production cost.

Incremental Costs and Income

In some cases a proposed investment will build upon an existing activity - for example adding an irrigation system to an existing production operation, or upgrading machinery in a food processing plant. In these cases it is important to distinguish between total costs and income, and those that are additional or incremental to the project. Including all costs, including those presently paid, or all incomes, including those presently received, in the calculations for the new project, will give a wrong impression of the profitability of the proposed new activities. The question of incremental project activities is discussed in more detail in Chapter 9.

B. Assigning Costs and Income by Activity

In the identification stage (project profile) the simplifying assumption was made that the investment will result in a project with constant activities during the entire period analysed.

For example, an investment in a poultry operation may be initially be supposed to produce a certain number of birds per year, every year of the project, without any change. However, real life is not so simple. The truth is that in many cases, and for many reasons, project activities are not constant every year.

One aspect that often changes with time is the efficiency of the production process. Yields improve and losses are reduced. In the poultry operation, the rate of hatching is likely to improve after the first year, while greater experience in poultry management may well result in faster growth among the birds, and hence quicker production cycles, as the years go by. By year five it may be possible to complete a broiler cycle (chick to saleable bird) in only 7 weeks, as opposed to the 10 weeks required at the start.

Another change may arise from new or modified project activities. The poultry project may commence turkey production as from year four, thus adding a new activity. A dairy plant may wish to experiment with ice cream and yoghurt production, but not until the butter and cheese operations are well established and running smoothly.

Still another possibility is that the costs and income associated with the activity will not remain constant. Growth and mortality rates for chickens, and hence the costs and income from a poultry operation, may well differ between the summer and winter months. Tomato production in the dry summer months may result in higher costs (irrigation), but higher yields, lower losses (fewer pests), and better prices in the market, than the rain-fed tomato produced on the same land in the wetter winter months.

In all of these cases, it is not possible to talk of a constant pattern of production. Rather, production patterns will change over time, and perhaps seasonally as well.

When dealing with activities in which the production cycle extends over more than one year (for example, tree crops or dairy cattle) such changes in the production model over time are not only possible, they are inevitable. A plantation of avocados presents different costs and incomes as a function of its stage of development. As the tree grows from a sapling to a mature tree, the amounts of fertilizer, labour requirements for harvesting, and of course the income from the yield of fruit, will all change.

And if different plots are planted, or young stock purchased, in different years, the result will be a series of very complex changes, as the project will consist of a mix of new, young, and mature animals or plants which changes from year to year. As a result, in the detailed analysis of productivity it is essential to clearly define the changes in the costs and income of the project with the passing of time. This is the purpose of using blocks.

However, the use of blocks is not necessary in all cases. Most non-income generating projects, as well as lacking changes in income, tend also to have simple patterns of production, where many costs are fixed, and activities are few. As a result, blocks are used exclusively for income generating projects.

1. The Concept of Blocks: The Basic Unit of Analysis

A block is defined as any grouping of plants, animals or other production units that share the same costs and income per unit of production. An activity (for example the production of maize) may be the same as a block, but not always. Thus, summer maize may fall into a different block from its winter counterpart, if the costs and income per hectare are different, although it may be the same variety of corn in both cases. By the same token, a blouse and a shirt manufactured in a garment workshop may be quite different, but both may be considered in the same block, if the two pieces require the same amount of materials and labour and if they are sold at the same price.

The blocks don’t always have to group physical things. For example, in an eco-tourism project, the block might be visitor/nights, while in a transportation project, the block might be passenger/miles. Once again, however, a visitor/night in a double room would not be in the same block as a visitor/night in a single room, because the income (and possibly the costs) would not be the same.

The unit of production, whether it be a hectare of citrus trees, a dairy cow, or a hotel room, may not stay always in the same block. A calf might be in a block of newborn cattle for its first year, but it will then move to the block of juveniles in the second year, before entering the mature dairy cow block in its third year. After that, the animal might stay in this block until it is sold in its tenth year.

Although the concept of blocks might seem complicated at first, it is a powerful tool for identifying and fine tuning the production patterns when changes take place from year to year. It is particularly useful for investments dealing with permanent crops, breeding animals and dairy production. The main problem for the user lies in the exact definition of the blocks in a specific case. The following points might help in determining what is or is not a block:

2. Determining costs and income per block

In order to construct a model of the overall performance of a project over time we need to know three pieces of information about each block. These are:

As we have seen, if the project is simple (without any change of characteristics during the period of analysis) the blocks will be equal to the products (that is, tomatoes may have only a single block), and annual production levels may remain constant from year to year.

Each block requires these three tables. Thus a perennial crop with blocks for each stage of its growth and production requires several sets of tables. For this reason, before considering blocks in further detail, we must carefully examine two key associated parameters: the unit of production and the production cycle.

a. The Unit of Production

The definition of the unit of production is critical because it will determine the manner in which costs and income are measured. In many cases, the unit of production of a block or product is obvious. Generally, crops are measured by hectare, acre or other measurement of area. In this case, the use - and cost -of inputs (fertilizers, labour, etc.) can be calculated per hectare, and so can the yield at harvest. In the case of large animals, the unit may be the head, the breeding female, or the Livestock Unit.

However when dealing with other activities, the nature of the unit of production is not always so clear. In this case one must follow the rule that the unit of production is the most convenient unit for estimating costs and income. For example, in the case of an aquaculture project, the unit could be the entire stock of fish, the pool or tank or even the individual fish, depending on which measure is more convenient when thinking of costs and income. If the farmer is more used to thinking of feed per tank of fish, then the tank is the obvious choice. However, if he or she thinks instead of the costs per fish sold, the individual animal may make the better unit.

A word of warning here: The larger the unit of production the less easy it is to make changes in the production level. If the unit of production selected for a proposed fish farm is the tank (with an average of 5,000 fish), then you will be constrained to increases (or decrease) production levels by 5,000 fish at a time, or starting using fractions of a unit of production (0.5 of a tank, if a new tank will have only 2,500 fish). Size may not be a problem if the project uses standard sized units, but an overly large unit of production can be very inconvenient.

In the case of agro-industrial products or handicrafts, the unit of production is frequently equal to the unit of sale; the piece of clothing, the kilo of cheese, the box of jars, etc. When dealing with services (hotels, transportation, etc.) the unit of production might be the passenger (or passenger/kilometre), the guest or the hour of machinery service. But remember: Once the unit of production has been selected, all costs and income must be expressed in terms of this unit.

DEFINING BLOCKS ON A COFFEE FARM

A family has just bought a 20 hectare coffee plantation, consisting of 11 hectares of mature plants, 5 ha of old bushes, and 4 ha of coffee planted one year before. Although the plants are dispersed around the farm, all of the areas with mature coffee plants are bearing fruit and using resources (agro-chemicals, etc.) on a fairly uniform level; that is, all share the same characteristics of costs and income. The old bushes are over 25 years old, and give lower yields than the mature plants. They also require more agro-chemicals to control diseases than the younger

plants, so they form a different block. The newly planted bushes, which require care but, as yet, bear no fruit; constitute a third block. Of course, no plant is identical to its neighbour, and no area of the coffee farm is exactly the same as any other. However, the three blocks form groups of broadly similar plants. In the table below is a summary of the blocks in the first year of the project.

BLOCK

UNITS

CHARACTERISTICS

New plants

4 has.

Low maintenance costs, without yields or income

Mature plants

11 has.

Medium costs (including costs for harvesting). High yield and income.

Old plants

5 has.

Relatively high maintenance costs, Yields and income only moderate.

To determine how each block changes from year to year, more information is needed about the characteristics of the blocks and the family’s plans:

a) The family decide to replace half of the ‘old plants’ block in each of the first two years of the project (that is 2.5 has. per year);

b) The ‘new plants’ block contains plants in both their first and second year of life. That is to say, the costs and income associated with plants in these two years are similar[11];

c) All of the areas within the ‘new plants’ block when the farm is purchased are in their second year of life;

d) None of the mature plants will move into the block of old plantings within the next five years.

Under these assumptions, we can predict the number of hectares of coffee plants in each block over the first four years of the project:

BLOCK

Hectares
Year 1

per block
Year 2

per project
Year 3

Years
Year 4

New plantings

4

2.5

5

2.5

Mature plants

11

15

15

17.5

Old plants

5

2.5

0

0

Total

20

20

20

20

How did we arrive at the second table? The first year is the same as the first chart. But in the second year, we take away half of the old plants, leaving only 2.5 has. in the block and establish in its place 2.5 has. of new coffee plantings.

However, these new plantings are now the only ones in their block because the 4 ha of previous ‘new plants’ being already in their second year, have "graduated" to the block of the mature coffee plantings. The mature coffee plants now number the original 11 ha plus the new 4 ha. Note that the number of units (hectares in this case) in a block can change and need not be equal to that of the previous year.

In the third year of the project the rest of the old areas (2.5 has.) is replaced, leaving the ‘old plants’ block empty. In its place a further 2.5 ha is added to the ‘new plants’ block. This block now consists of 5 ha because the other 2.5 ha planted the previous year are not yet old enough to graduate to the mature block. The mature coffee block thus continues with 15 ha. The reader can work out the area of plants per block for the fourth year of the project on his own.

b. The production cycle

The definition of the production cycle is important for the same reasons as the definition of the unit of production (above) - it determines the way inputs and yields are measured. When we speak of three 50kg sacks of fertilizer per hectare, we refer to the entire growing period of the crop, or production cycle, not per week or every 5 years. However, to properly understand the production cycle we need to know two things about it: how long it lasts (its duration) and how many cycles there are per year (its frequency).

Duration of the production cycle: The duration of a production cycle is simply defined as the period necessary to complete the production activity. For most annual crops, it is the time between land preparation and harvest; perhaps 12 - 14 weeks for short cycle crops, such as vegetables. Grain and legume crops such as rice, maize and beans will generally require longer.

In some cases, however, this simple definition must be modified. Remember that all analyses in RuralInvest (except working capital) are undertaken on a yearly basis. Thus costs and incomes from an activity can not be calculated on a longer base than one year. As the production cycle is a key parameter or input in calculating these costs, the production cycle must not exceed 12 months either, even if the life of the entire activity - for example, a fruit plantation - spans 20 years or longer.

Beyond agriculture, a different problem can be encountered in trying to define the duration of the production cycle. Many activities, such as handicrafts, agroindustry, transportation, tourism and other businesses continue operating throughout the year, without a clear beginning and ending point for production. In this case several options are available. One alternative is to select the entire year as the production cycle. However, many costs (salaries, electricity, telephone, etc.) are typically paid monthly so it may be more convenient to define the cycle as one calendar month. Alternatively, if the plant or workshop delivers the product for sale on, say, a two weekly basis, it might make sense to select two weeks as the product cycle duration. In the end, the choice may not matter very much, as long as the period is convenient and you are consistent in always measuring the inputs and outputs over the same period for each activity.

Frequency of the production cycle: We mentioned previously that RuralInvest uses an annual basis for almost all calculations. So it is not enough to know how long each production cycle lasts; we must also know how many cycles are completed in the year under analysis. For activities that are continuous throughout the year, the answer is simple: the duration of each cycle (in months), multiplied by the frequency of the cycles (also in months) will add up to 12. Thus, if the production cycle of a rural shop lasts one month, there will be 12 cycles per year.

However, not all activities continue throughout the entire year. In agriculture and other types of activities based on natural resources, there will often be periods in which no production is occurring. Although the production cycle of a crop may last 4 months, it is not at all guaranteed that there will be three cycles a year (producing 3 cycles x 4 months = 12 months). Even two cycles may depend upon the availability of irrigation. By the same token, a vegetable processor might define his production cycle as one month, but his or her plant may only operate for 5 or 6 months per year, due to the lack of raw materials in other months.

c. Estimation of volumes and quantities

Even with a very careful estimation of the amounts used or generated in the process of production, mistakes frequently occur in these measurements. Below we consider two factors that often cause errors in the estimation of input and output quantities.

Waste materials and losses: One factor which is frequently overlooked in estimating quantities is that of losses, damaged goods and waste, all of which are a normal part of many production operations. If 8 tons of green or sweet peppers are harvested in the field, it is highly unlikely that all 8 tons will be sold. A certain percentage will be rejected as too small or bruised, another percentage will be damaged in transportation to the point of sale, etc. It is very important to take these sorts of losses into consideration if you want a reliable estimation of costs and income. Losses can also occur with respect to inputs. If you are bottling wine, it would be wise to assume that some of those bottles will be broken, and order a small additional quantity to cover such breakages.

Another example is the conversion of fruits and vegetables in a processing plant. Take, for example, a vegetable processing plant making pickles. We can imagine that each bottle of finished product requires around 120 grams of cauliflower, as well as carrots, zucchini, and other vegetables. However, it would be a bad mistake to estimate the requirement for cauliflower by multiplying the projected number of jars of pickle by 120 grams. In reality, about 40% of each cauliflower will be lost, as the stalk, leaves, and damaged sections are discarded as the cauliflower is prepared. In order to end up with 120 grams of cauliflower ready to use, you would thus need to buy approximately 200g for each jar of pickle.

Self-supply/auto-consumption: Another element that may cause confusion is that related to the source of inputs or the destination of products. Sometimes a project makes use of inputs that are not paid for, typically because they come from the same persons or families as own the project. This is called self-supply. A very common example in many rural activities is the use of unpaid family labour. Other ‘free’ inputs can include raw materials for processing, or even water, can also often be found. It is important to realise that these inputs, even if not paid for, still have a value. Even if he was not paid, a day’s labour provided by your brother could have earned him a wage working on a neighbouring farm.

Similarly, if outputs are consumed on-farm (or by the owners of the project) without being paid for - for example grain is eaten, or kept for seed rather than being sold - this is auto-consumption. Here the reverse applies. Even though the family did not pay for the crops or animals they eat, they still had a value, one that could have been gained by taking the crop or animal to the nearest market.

The occurrence of either auto-consumption or self supply can lead to important differences in the results obtained from the two principal project measures used by RuralInvest. These are discussed in more detail in Chapter 9, but in cash flow analysis, ‘free’ inputs and consumed products are ignored, as the analysis deals only with cash. However, in financial terms, they must be taken into account, because financial analysis tries to account for all costs and benefits with a market value, even if it isn’t paid. After all, if you consume something instead of selling it, you do not reduce the profitability of the operation, but you do affect your capacity to generate cash flow: a key aspect for the bank or financial agency when considering the possibilities of a loan.

When estimating costs, is it important to consider the value of auto-consumption or self supply? Normally, you should identify the cost (for self supply inputs) or the price (for auto-consumption of outputs) at the nearest market - adjusted by the cost of transportation, if it is at some distance - and use that figure for the financial analysis.

3. The importance of the project’s first year

The first year in the life of any project is the most delicate and risky period. If a project is going to fail, in nine out of ten cases, it will do so in this period. Why? Because the first year of a project is the least secure; the employees are as yet unaccustomed to their duties; the management is less experienced; the suppliers and banks are more cautious; the buyers are less accustomed to the product.

More important, however, is the fact that during the first year of its life, a project typically lacks the reserves to absorb any setbacks or unexpected events. The lack of adequate resources for financing activities such as the purchase of raw materials, the payment of salaries or the cost of transporting finished product to the market can easily throw a new project into bankruptcy. To reduce this risk, it is necessary to deal with the first year of a project’s life differently from other years.

4. Estimating the need for working capital

The lack of adequate operating funds has probably condemned more small projects to failure than any other factor. It is always necessary to calculate the needs for working capital; that is, the funds needed for the project to pay its expenses in cash, until it has accumulated enough cash reserves to rely on its own resources. Many small projects begin operations relying on income from sales to pay their bills. But they have forgotten that, in the real world, it may take many months to obtain the payment you expect. However, especially when dealing with a new business, the gasoline station, project employees, and the feed or fertilizer salesman, will all demand to be paid in cash.

In general, working capital is required to cover all project expenses incurred as cash payments, from the moment the expenditures begin until the funds are received from the sale of the finished goods or products. The stages of this period include:

a) Preparation for production, including activities such as: buying inputs (even if not yet delivered), preparing the soil; training employees; contracting the transport, etc.

b) The production period. This may be a short period (making a shirt, the production of a kilo of cheese) or long (growing a crop) but it can never be longer than 12 months, for purposes of calculating working capital c) Storage. You may be able to make a shirt in a few hours, but perhaps the finished shirts are only shipped to the wholesaler once a month. Sometimes, non-perishable products can stay in storage for months waiting for better prices.

d) Transportation and distribution. This may be a short period, but in the case of crops or other products for export by ship, it could mean a wait of several weeks.

e) Waiting for the buyer to pay. While selling in a market generates immediate cash, this can be the longest wait of all. Supermarkets frequently delay payment for up to 60 days and large agro-industrial plants sometimes follow the same policy.

f) Clearing payment. Cash is immediately available, but do not forget that banks frequently demand several days before crediting a cheque, and perhaps weeks if the payment comes from another country.

g) Accumulating reserves. Working capital will be needed not only to cover the periods described above, but also while the project is accumulating enough surplus to allow any operating loans to be paid (if you have one), and then reserves equal to the entire working capital needs.

The combination of all these factors can bring about a delay of many months, or even years, before the project ceases to require borrowed working capital.

5. Cash Flow

In the previous discussion, it was proposed that once the project begins selling its output and receiving income, it will be able to establish working capital reserves. However, this is not always true.

Some production processes are constant and thus working capital is readily accumulated. For example a workshop making shoes may face the same expenses every month, and can gradually build up working capital reserves from the margin earned each month (once money starts to flow in). Other business, however, are seasonal; in other words, there are only sales of the product during certain months, or the volume of production varies significantly from month to month. In other cases, you may have more than one product, each having its own costs, income and working capital needs.

For example, let us look at the production of a single product; tomatoes. We know that to produce one hectare, we will need $500 in local money in working capital to cover the four month period, from land preparation in February to the end of the harvest in May. As we have used up all our resources installing the irrigation system, we take a loan for the $500. However, when we sell the tomatoes in May and June we will earn $800, leaving us with a profit of $300 towards the working capital in our next cycle (less the interest paid on the loan). Unless we need the money for other purposes, we will need a loan of only $200 next time.

However, if the project will cover several different activities - say tomatoes, squash and beans - the situation becomes more complicated, because we must know the relation between the costs and incomes of each activity. The only adequate solution in these cases is to calculate exactly how much we must pay in expenses and how much we will receive in income for the three activities combined: this is the monthly cash flow.

With the generation of a cash flow chart the working capital needs become clear. In the following chart, we can see the monthly production costs for tomato, mentioned above, during the period from February to May ($125 per month, or a total of $500). Income from the sale of tomatoes starts with $400 in May and is followed by a further $400 in June. However, these amounts may not be received until late in the month, so they are only credited in the next month (that is June and July). All income is best credited in the next month, as expenses in a month may well become due before the income is received.

There are further complications. In May the project will also face costs of $100 arising from the start-up of squash production. Thus borrowing requirements will reach a maximum of $600 before income starts to come in from the sale of tomatoes. Even then, the project will still be short $300 until the next month, when the remaining $400 from the tomatoes enters the bank.

The chart also shows that the total amount received from the sale of tomatoes ($400 + $400, or $800) is not enough to pay both the working capital loan for the tomatoes ($500) and, at the same time, cover the costs of squash production ($350). So, although the project breaks even in July, it will need still more funds to cover continuing production costs for the squash in August. If the working capital loan for the tomatoes was paid-off in July, the project would have to borrow further funds. Rather, it is necessary to wait until September before clearing the working capital loan. On the positive side, the combined profit from the tomatoes and the squash will be sufficient to cover the costs of the beans, although available cash will be reduced to only $350 by the end of the year.

Some readers may ask why the costs and income from beans for the months of January through April do not enter into the calculation. If you think about it, the answer is clear: the production cycle for beans doesn’t start until September. If the project commences in January, as it does in this example, it is impossible to have costs (or income) for beans in the early months of the year, as they could not have been planted the previous September!

The chart shown here is simplified and lacks some of the elements that would have to be considered in a real analysis. For example, the costs shown above reflect only the production process itself. Any project will encounter other costs - both general and fixed - that need to be paid during the first year of operation (like electricity, real estate taxes, family sustenance, the manager’s salary, etc.). Therefore, an extra row is normally inserted below to include general costs. But remember: only include cash expenditures in the cash flow.

It might be that the net income predicted for the end of the first year is negative (for example, owing to perennial crops that do not yield in the first year) or, although positive, isn’t sufficient to cover the costs in the second year (as in the example above). In these cases, working capital loans would be needed in a second and perhaps even a third year. However, in general it is not necessary to lay out a cash flow for each year. If costs and income in the second year are similar to those of the first year, you can simply repeat the working capital needs of the first year in the second.

It is not usually necessary to prepare cash flow projections for projects with one simple activity, or for very small projects. However, for those with multiple activities, or for larger projects, they are usually essential. In any case, RuralInvest provides a completely automated cash flow projection, so the monthly cash flow chart is generated directly once the data on costs and expenses have been entered for each block.

ACTIVITY

COSTS AND INCOME BY ACTIVITY OR BLOCK

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sept

Oct

Nov

Dic

Tomato:

Costs per month


125

125

125

125








Income per month





400

400







Squash:

Costs per month





100

100

100

50





Income per month








600





Beans:

Costs per month

50








50

50

50

50

Income per month


150

150

150









Montly balance
cumulative total

0

-125

-125

-125

-225

300

300

-50

550

-50

-50

-50

0

-125

-250

-375

-600

-300

0

-50

500

450

400

350



[8] Also considering the cost to the project of having a truck out of service while it is awaiting spare parts.
[9] However, the cost of inputs and materials used by the veterinarian - medications, drugs, etc. - can be considered as production costs, because they will change according to the number of animals treated.
[10] The need to estimate annual changes in production levels per block derives directly from a basic decision in RuralInvest to assess project performance on an annual basis (a standard practice in the financial world). Six monthly or even quarterly analysis periods could also be used, but would require considerably more work. In fact, monthly changes are recorded for the first year to determine working capital needs.
[11] In reality, coffee bushes do not pass directly from newly planted to mature in their third year, but the example has been simplified.

Previous Page Top of Page Next Page