Overstory #221 - Economics and Farm Forestry
Understanding the economic tools used to assess the viability of a long-term project such as farm forestry is very important if a farmer is to make an informed investment decision.
Understanding these tools also allows:
- A farm forestry project to be evaluated against other investments, such as investing in the stock market or building a new dam;
- The cash flow of a project to be assessed;
- The financial aspects of the project to be analysed; and
- The economic risks to be highlighted right from the start of the project.
While it may be argued that an economic analysis only considers the monetary aspects of a project, it does allow farmers to weigh up the financial costs and returns against non-economic benefits such as aesthetics, wildlife, erosion or salinity control. For example, a farmer might choose to accept a lower return from a less profitable option (such as using native species rather than exotics) because of the value they place on the non-commercial benefits (such as biodiversity and aesthetics). In effect, an economic analysis can be used to assess the costs associated with providing the noncommercial benefits that are desired.
Although the true 'worth' of the farm forestry project may be greatly underestimated in a financial analysis, it must be remembered that it is simply a tool to help decision making. Therefore, before making any commitment, farmers should also consider the social and environmental benefits, risks and uncertainties associated with the project.
The good, the bad and the ugly
Farm forestry financial analysis can be thought of as a case of "The Good, The Bad and The Ugly":
The Good are the returns from timber and agricultural products and services generated by the project. Some of these are easy to estimate and value, while others present real challenges and may be best left out of the analysis all together. How do you put a realistic dollar value on the satisfaction a farmer gets from seeing their property improved or being able to pass on a better farm to their children? Individuals will have a feel for the importance of these benefits and should consider them when making the final judgement.
The Bad are the costs incurred as a result of the project. Because of the financial costs, including labour, are incurred at the beginning of the project, they are generally the easiest values to incorporate into the analysis. A farmer can quickly estimate the costs of buying seedlings or preparing the site for planting.
The Ugly are the problems associated with time and the impact this has on future costs and returns over the course of a long-term investment like forestry. Any investor knows that a dollar today is worth more than a dollar in the future because of the potential income that can be generated by investing this money. But this is further complicated by the fact that the rewards and risks become more uncertain the longer the investment. The DCF tool is designed to help with many of these issues and provide a framework for which to work through them.
There is little point in knowing that a farm forestry project is a good investment, unless it can be compared to other investment options such as putting money into the bank, the share market, buying a new tractor or continuing to farm as present. Most farm forestry analyses consider the current land use as the benchmark against which a farm forestry project is to be compared. "Is farm forestry more profitable than the agriculture I am currently doing?" If this is the question, then it is important to know what is presently being earned from the land so that this can be compared against the farm forestry project. This may seem simple, but because agricultural incomes rise and fall, the farmer should be cautious about settling on a figure. It is important to think about how costs and returns have fluctuated over the years, how they might change over time and settle on an 'average' figure to be used when comparing with the farm forestry project.
Agricultural income minus agricultural expenses (variable costs) will provide an Agricultural Gross Margin. This provides an indication of the profitability of the agricultural enterprise. Using an average gross margin is a good start, but it should also be remembered that the use of a gross margin is also limited in comparing agriculture to farm forestry as labour is generally not included in a gross margin, whereas it is generally included in the long term economic analysis of a farm forestry project.
Determining Costs - The "Bad"
Costing an operation is relatively simple. All that is required is a good "guesstimate" of likely present day costs of doing the job. Remember to include all costs from the start (such as ripping, mounding, planting and seedlings) through to the middle (pruning, thinning, pest control) and to the end (harvesting, roading). The cost of land is commonly not included in a farm forestry analysis, especially when trees are being integrated into the farming landscape, as it is presumed that the landowner already owned the land. If, on the other hand, land needs to be bought, this cost should be included as a cost at the start of the project and offset at the end by allocating a sale price for it.
Labour inputs and costs are often forgotten, but are very important in a farm forestry analysis as many of the jobs require labour, but little capital, such as pruning. It is important to try and fully cost out labour or at least record the amount of labour required. While a farmer may not cost their labour, at say $15 per hour, this figure will at least cover any unforeseen contract labour that may be required during the life of the farm forestry project. Likewise there will be a real cost associated with buying and maintaining equipment and machinery. Although any savings associated with utilising on farm labour or existing machinery is an advantage that may make forestry more profitable for farmers than investors the costs, however small, should not be ignored.
Another cost that is often ignored is the time and resources taken to access information and gain new farm forestry skills. These costs, known as 'transaction costs', while sometimes difficult to value, can have a large impact on the economics of the project. The most obvious 'transaction cost' is the cost involved in sourcing accurate, reliable and up-to-date market information for farm forestry products and services. Transaction costs can be accounted for by including the cost of joining a growers group or by calculating the time involved in attending courses, seminars or field days.
Determining Returns - "The Good"
It is the prospect of rewards that drives farmer investment into revegetation and forest management. The rewards come in many forms and although some are difficult to measure or have ill-defined market values, it is worth considering what value you would place on them.
Estimating the effect on agricultural returns
When planting out a block or belt of forest an estimate of grazing returns from within a stand of trees can be included in the analysis. Grazing under a forest might provide valuable off-shears shelter or-act as a nursery paddock for calving cows. These are direct returns to the grazing enterprise as a result of the trees. A grazing gross margin can be used if the grazing under the trees is still considered part of the overall property's enterprise.
In southern Australia, grazing returns under trees can be estimated from the crown cover of the trees, and therefore light, reaching the pasture (see Figure 1). Other agricultural returns may include cropping or hay production in the early years. The value of a good shelter block might be accounted for as an increase in lambing percentages or a reduction in stock losses. Most farmers could put a reasonable value on these returns whereas trying to predict the affect of shelter on wool, milk or meat production is going to be more difficult.
Estimating the value of other benefits from trees
There has been many attempts at estimating the economic value of the environmental benefits of trees. One report from the Murray Darling Basin titled, "Cost-sharing for on-ground works" (1996), estimated that for one hectare of farm forestry planted on the Liverpool Plains, where dryland salinity is an important issue, the farmer can expect the following returns from trees:
- $10/ha/yr from increased production;
- $5/ha/yr from lowered water table benefits;
- $2/ha/yr from less soil erosion;
- $5/ha/yr from increased land values; and
- $4/ha/yr from increased amenity values.
In practice the environmental benefits of trees (salinity and erosion control, wildlife, aesthetics, land values etc) may be difficult for a farmer to value, unless there are "buyers" who are prepared to fund revegetation for these reasons. A project that is eligible for up-front funding because of its environmental values will be cheaper to establish. By using this lower cost in the analysis the farmer is effectively accounting for the "sale" of environmental values. Any products sold from the site in later years would be more profitable because of the grant received at the start.
Estimating timber returns
Although uncertainty in production and future markets makes estimating timber returns a difficult task, any information gained from measuring trees, and talking to the possible purchasers is extremely helpful in making a good "guesstimate".
Timber is sold by volume and is expressed in cubic metres (m) (1 metre by 1 metre by 1 metre = 1 mJ). In any market there will be quality grades that have different values and possibly different risks. A high quality sawlog might be valued at $80/mJ as it stands in the forest, whereas a pulp log may be worth only $5/mJ. Whereas the sawlog can be always sold for pulp if the sawlog market evaporates, the reverse is most unlikely.
Prices for timber are either quoted as mill door prices or as stumpages. The mill door price accounts for the costs of harvesting and transporting the log to the mill, a stumpage price does not, but represents the return to the grower.
Farm forestry cash flow
Once the costs and returns have been estimated, the project's cash flow can be calculated. Using a spreadsheet this is relatively simple as all anticipated costs and returns for each year can be incorporated then summed to provide a total cost and a total return each year. The net cash flow is simply yearly returns minus yearly costs.
Once the cash flow of the project has been calculated, future financial commitments over the life of the trees can be ascertained by considering when payments are due and returns are expected. This simple information is often ignored by those more interested in the final figure, but the net cash flow of a project can be an extremely important guide for investment decisions and help in building a sound understanding of the financial viability of the farm forestry project.
Accounting for long term investment periods - "The Ugly"
Discounted Cash Flow analysis is a process that involves financial discounting as a means of comparing costs and returns that occur over a long investment period. It is really an economic tool to deal with time. It is interesting to note that it was a German forester, Martin Faustmann, who in 1849 developed the DCF analysis technique for the very purpose of economically evaluating forestry projects.
In order to judge the viability of the project, the costs and returns incurred in different years need to be discounted to a present day value so they can be compared.
As already stressed, the discounted cash flow process is only one of many tools on which to base a decision and when judging the financial viability of two enterprises as different as farm forestry and agriculture solely on the NPV figure, many issues may be ignored:
- Agriculture may not be as profitable, but the returns are annual. Farm forestry has large cash "spikes", both positive and negative.
- Likewise, the labour requirements for the farm forestry project will have "spikes" during the planting, pruning and harvesting periods. Therefore it is a good idea to calculate returns per hour invested, for both agriculture and farm forestry.
- Agricultural markets are relatively well known in the short term. Farm forestry markets are unclear and uncertain.
- Landholders have the skills and confidence in agricultural production. New skills and technologies may have to be learnt and understood to successfully produce a commercially viable farm forestry product.
Risk and Uncertainty
As the figures used are the best available "guesstimates" today, some, if not all will be incorrect or change over the life of the project. Therefore it is important to change some of the key variables to test what effect they have on the final result. This is called a "Sensitivity Analysis". In the process a worst-case scenario should be considered and a judgement made as to whether the risks involved are worth carrying.
Risk is largely a personal perception. While one person may see a particular project as very risky another may believe the markets, climate and production will all be in their favour making it a very profitable venture.
In addition to testing different scenarios, risk can be accounted for in the DCF analysis by:
- Increasing the value of labour;
- Using higher costs if the exact cost of an operation is not adequately known;
- Being conservative about tree growth rates and timber yields;
- Being conservative with stumpage rates; and
- Using a higher discount rate to reflect a greater conservatism in the use of money.
This edition of The Overstory was adapted with the kind permission of the authors from the original:
Reid, R. and P. Stephen. 2001. The Farmer's Forest -- Multipurpose
Forestry for Australian Farmers. RIRCD Publication No. R01/33.
Copies of this publication can be purchased from:
Australian Master TreeGrower Program
Department of Forestry
The Institute of Land & Food Resources
The University of Melbourne
Victoria 3010, Australia
Tel: 61 3 8344 5011; Fax: 61 3 9349 4172
About the Authors
Rowan Reid (B. For. Sci., M. For. Sci.) is a Senior Lecturer in Agroforestry and Farm Forestry at the University of Melbourne and the developer of the Australian Master TreeGrower Program (MTG). More than 80 MTG programs have been conducted across Australia involving more than 1600 farmers. In 2000 the program was awarded the $10000 Eureka Prize for excellence in environmental education. Rowan is also a tree grower himself and has recently made furniture out of 16-year-old eucalypt trees he planted and managed on his Otway Ranges farm. He can be reached at: Rowan Reid, Senior Lecturer, Agroforestry & Farm Forestry, Department of Forest and Ecosystem Science, The University of Melbourne, Victoria 3010. Email: firstname.lastname@example.org
Peter Stephen was a Research Fellow with the School of Resource Management at the University of Melbourne, Australia at the time of writing. He has been involved with farm forestry extension throughout Australia for the past decade of which the last four years have seen a wonderful association with and coordination of the Australian Master TreeGrower Program. Peter has also worked overseas in a number of countries, but principally in India on farm forestry extension, community forestry and rural development.
Related Editions to The Overstory
- The Overstory #200--The art of farm silviculture
- The Overstory #177--Ten percent multipurpose tree cover for every farm
- The Overstory #121--Getting Started in Farm Forestry
- The Overstory #112--Farm Forestry Extension
- The Overstory #98--Integrating Forestry into Farms
- The Overstory #88 - Revegetation Planning for Farm Forestry
- The Overstory #73--Buffers, Common-Sense Conservation
- The Overstory #67--Optimising Commercial Timber Potential for Farm Forestry
- The Overstory #59--Choosing Species for Timber Production and Multiple Benefits