Setting realistic prices in the marketplace

Pioneer brand products financial controller Jason Morris outlined a simple tool to calculate the true cost of contracting services.

Morris says to set realistic pricing requires an understanding of costs, overheads, profit, area based charging versus hour based charging, inflation, competition and the impact on price of the combination of cost, time, inflation and competition.

“Price setting is part art and part science,” he told delegates to the Rural Contractors conference. The art part includes value, competitive advantages and customer expectations. The science is the costs, overheads and profit expectations.

“Rural contracting is a machinery intensive activity. Are your prices greater than your costs?” Morris asks. “Do you know your costs?”

Estimating machine costs – depreciation, repairs and maintenance, insurance and storage – is difficult, but is necessary to arrive at a proper pricing structure for the job.

To that you need to add fuel costs, labour costs and overheads (admin, workshop facilities, staff training, etc).

Morris worked through the following example at the conference, and although a fairly lengthy exercise, a worthwhile task to help you calculate the true cost of contracting services.

The example is for maize silage harvesting, in-field transportation and stacking – working out the cost per hectare and determining the profit margin.

Calculating forage harvester costs

The first component to cost is the forage harvester. There will be machine fixed costs, which do not change as machine sees more use. As an example, assume a Claas 900 with 700 hours of use per year (3,500 hours over five years).

Depreciation per hour – Assuming a cost price of $700,000 and an expected residual value of 26 percent, being $180,000, depreciation is $520,000 over the five-year life of the machine, or $148.57 an hour.

To calculate the interest, add the cost of the machine ($700,000) to the expected residual value ($180,000) and divide by two for the average value ($440,000). Assuming an interest rate of 10 percent, annual interest costs will be $44,000, or $62.86 an hour

Storage and insurance costs valued at two percent of the machine’s value comes to $14,000 a year, or $20 per hour.

Fuel, oil and lubrication costs per hour. Morris says a rule of thumb for tractor fuel usage in litres per hour, under normal working conditions, is the PTO power in kW divided by four – in this example, actual fuel usage is 100 litres per hour for the Claas 900, at $1.84 per litre, excluding GST, as diesel was in June, fuel costs per hour would be $163.47. Oil and lubrication comes in at $24.52 an hour (the rule of thumb that is applied for power machinery is 15 percent of fuel costs).

Repairs and maintenance can be assessed for normal use at around three percent of the engine-operated machinery’s replacement price or five percent of an implement’s replacement price per year. This percentage will likely increase if the machine is worked for longer hours or is subject to harder-than-average use. In this example R&M would be $35,000 annually, or $50 an hour.

Labour costs are not just the hourly rate. The cost includes general time (staff meetings, training, downtime, admin duties, etc) ($10 an hour); holiday pay eight percent of yearly total ($1.60/hour);  statutory holidays (11 days) plus sick leave (five days) and bereavement leave (three days) add another eight percent in total ($1.60/hour);  ACC = two percent, based on current rates (40 cents); and KiwiSaver at one percent (20 cents).

Adding the extra costs to the hourly labour rate of $20, labour costs are $33.80 an hour.

Add these all together, and you’ll find your Claas 900 forage harvester costs $503.22 an hour to run.

In-field transportation and trucking costs

Let’s assume a cost for the truck and trailer of $125,000. Owned for 10 years and operated for 1800 hours a year – total 18,000 hours.

With a cost price of $125,000 and a residual value of 10 percent ($12,500) depreciation works out at $112,500 over 10 years, or $6.25 an hour.

Using the same formula as the forage harvester to calculate interest, we find it’s $6875 a year, or $3.82 an hour.

Storage and insurance works out at $1.39 an hour, repairs and maintenance at $2.08 and fuel, oil and lubrication at $47 an hour, assuming 25 litres of fuel an hour at $1.63 a litre.

The wage cost is per the harvester example: $33.80.

This gives a total hourly cost of $94.34 for the in-field transportation and trucking.

Stacking costs

We’ll assume the cost of tractor is $250,000. Owned for 10 years and operated 1500 hours per year – total 15,000 hours

Depreciation is $11.67 an hour, interest $10.83, storage and insurance is $3.33, repairs and maintenance $8.33 and fuel (17 litres an hour at $1.63), oil and lubrication $31.96. Wages: $33.80.

A total of $99.92 an hour for stacking.

What’s the cost per hectare?

So, in this example, by adding the totals together, maize silage harvest and stack would cost $697.48 an hour.

Assuming the harvester can harvest 1.5 hectare per hour, it works out at $335.48 per hectare, assuming three trucks are needed per hectare, in-field transportation will be $283.02 per hectare (three trucks carrying 21 tonne each, assume 63 wet tonnes per hectare harvested. Factoring in time from depot to field and field to stack, assume one hectare per hour), and stacking at 1.5 hectare per hour works out at $66.62 per hectare. The total cost to harvest a hectare works out at $685.11.

Morris says the price to harvest and stack from Pioneer Brand Forages 2008-2009 catalogue is $879 a hectare. Less costs of $685, it provides a margin of $193.89 to cover overheads and profit margin.

So, what’s the profit?

Overheads include office costs (invoicing and bill payments), admin wages, advertising, other vehicle costs, non machine allocated R&M – office, depot, incidental staff costs and various other non direct costs. These need to be allocated to ensure profitable pricing.

Overheads will differ based on size of operation. A method of allocating overheads is based on proportion of income generated by each activity. For example, if your total overheads are $250,000 and income for maize silage harvesting and stacking is 35 percent of your business, then $87,500 should be added to the annual costs of this activity – if you harvest 1000 hectares, it works out at $87.50 a hectare. This gives a profit of $106.39 a hectare. Take 33 percent tax out of this, leaving $71 per hectare profit.

If you harvest 1000 hectares then your profit is $71,000. This is a return after tax of eight percent. Is this a fair reflection of your time and effort, risk, and significant investment in machinery or would you be better off with your money in the bank?

Area based charging is the traditional method, however, it fails to take into account factors influencing workrate – crop yield, difficult soils, haulage distance, field shape, etc.

Time based charging is probably not a reality, but time does need to be considered when setting prices.

What happens to profit if it takes a shorter or a longer time to harvest: In this example, if the harvest rate drops to 1.2 hectares per hour your profit drops to two percent. Conversely, if the harvest rate rises to 1.8 hectares an hour, the profit rises to 12 percent.

So what does the future hold?

Morris says to expect higher inflation and lower unemployment, which will put pressure on wages to rise. Fuel costs are steadily increasing. Interest rates are likely to hold firm until end 2008 and CPI expectations are a peak of 4.7 percent third quarter 2008.

The big question is, are your prices keeping pace with inflation or are you losing margin? Do the maths. You’ve got the formula, work it out.