Hayenga, Wayne A.

English

Texas A&M University

to - 5 - ')
L-l092
INVESTMENT ANALYSIS·· PARTIAL BUDGET METHOD
VVayne A. Hayenga*
Should I make this investment or not? How
many times have you asked yourself this as you
considered some change in your business that would
require an unusual capital expenditure? When a
decision will be made that affects only a part of
the business~ the partial budget method is an appro-
priate tool.
Types of Investment Decisions
A partial budget considers all receipts and ex-
penses that change if a decision is to be made to
change a part of the business. Examples of situ-
ations where a partial budget is appropriate
include:
• purchase of new machinery
• leasing of machinery
• construction of a new building
• adding a new product, service, crop or live-
stock enterprise
A partial budget is an excellent planning tool.
Several advantages and disadvantages of this anal-
y is method are listed below.
Advantages
• It is a quick method of investment analysis.
• It shows results of projected changes clearly.
• It can be done easily for several alternatives.
• 0 detailed forms or procedures are necessary.
• It is not necessary to consider all costs in the
business-only the costs and returns that will
be changed by the investment under consid-
eration are considered.
• It isolates the impact of a change.
Disadvantages
• It does not account for the time value of
money invested.
• It may oversimplify the problem.
• Data may not be readily available.
• It does not show the effects of the proposed
investment on the firm's financial situation.
.Extension economist-agribusiness, The Texas A&M Univer-
sity System.
38.16
• It is difficult to identify all components of a
business that may change.
• It does not indicate benefits of increased
managerial flexibility or point out increased
managerial problems.
The Method
Partial budgets include only the changes in costs
and returns that will be affected if a change is made
in a business. The added costs and reduced returns
are summed together, and they are subtracted from
the added returns plus reduced costs. This net
change is the expected profit or loss from the pro-
posed change.
Example I shows a partial budget to compare
the cost advantages and disadvantages of purchasing
an $18,000 combine to harvest 150 acres of grain
sorghum and 150 acres of wheat, to custom hiring
the work. Be concerned with the process rather
than the data in the example.
Step 1. Added Costs. Calculate the added costs
of the proposed change. Which costs will increase
and how much? What new costs will be incurred?
In the example, added costs include depreciation,
interest, repairs, taxes and insurance, as is usual
for machinery investments. l Also, operating ex-
penses of fuel and labor will change in this example.
Step 2. Reduced Returns. Many business
changes may require you to give up a usual source
of income. Expanding one enterprise may force
you to reduce the available resources for other
enterprises thereby reducing sales of one product.
Compute the .receipts that will be given up when
the proposed change is in effect and enter the
amount in the budget.
In this example there are no reduced returns.
Step 3. A dded Returns. New income that will
result from the proposed change should be entered
under the heading.
lAn easy way to remember the fixed costs of depreciation,
interest, repairs, taxes and insurance is with the acronym
DIRT!.
a Agricultur I Ext n n Service. T e exas A M University System. John E. Hutchison, Director. Coli ge Station
Here it is proposed that the farmer will do 200
acres of custom work at $5 per acre which will bring
in $1,000.
Step 4. Reduced Costs. Proposed changes often
eliminate some costs presently being incurred. Costs
that will 'be eliminated or reduced are entered in
this section of the budget. In this example the
farmer will not have to custom hire combining of
wheat and grain sorghum, thus saving $1,500.
Step 5. Net Change in Income. This is the
final summation of the above entries. The cate-
gories of benefits are on the right side, (B), of the
example form. On the left side (A) of the form
are the costs of the change. If the benefits (B) are
greater than the costs (A), the proposed adjustment
will be profitable. If (A) is greater than (B), how-
ever, the result is a loss of income.
The example shows the cost of owning a. com-
bine in this particular instance would be $1,025
more than hiring custom work.
Examples II and III are other uses of the partial
budgeting technique. Example II evaluates a
change of a minor product line in a farm supply
store. Example III considers adding a repair service
to an electrical equipment sales operation.
Conclusions
Partial budgeting is an excellent managerial
tool to help evaluate the financial considerations
of changes in a business. The results should be used
as a guide in conjunction with other management
tools to reach a decision. Remember that with
partial budgeting, as with all management tools,
the assumptions in the process should be prudently
evaluated.
Example I
Partial Budget Worksheet
Proposal: Purchase an $18,000 combine to harvest 150 acres of grain sorghum and 150 acres of wheat
versus custom hire the work.
Added Costs
Depreciation1
18,000 - 4,000
10
Interest2
18,000 X .08
-2-
Repairs3
Taxes3
Insurance3
Fuel3
500 acres X $.50 jacre
Labor3
15 days at $25jday
Reduced Returns
A. Total Additional Costs
and Reduced Returns
$1,400
720
600
135
45
250
375
NONE
$3,525
Added Returns
Do 200 acres custom work
at $5 per acre
Reduced Costs
Custom harvesting costs
150 acres wheat
150 acres grain sorghum
B. Total Additional Returns
and Reduced Costs
$1,000
750
750
$2,500
Net Change in Income (B minus A) -$1,025.
lStraight line depreciation with a $4,000 salvage value.
2Interest on y:! the investment at 8%.
3Estimated.
Example II
Partial Budget Worksheet
Proposal: Remove large animal veterinary equipment line from farm supply store and put in pet
products line.
Added Costs
New display counter
Depreciation
Electricity
Interest
Reduced Returns
Profits from veterinary
equipment sales
($20,000 sales @ 10% net)
A. Total Added Costs
and Reduced Returns
$200
50
25
$2,000
2,275
Added Returns
Profits from sales of pet products
( 8,000 sales @ 30% net)
Reduced Costs
Labor savings from setting up and
delivery of veterinary equipment
Warehouse space from storage of
veterinary equipment available
to other lines (value)
B. Added Returns and
Reduced Costs
$2,400
300
$400
3,100
Net Change in Income (B minus A) +$825
Example III
Partial Budget Worksheet
Proposal: Add repair service to electrical equipment sales operation.
Added Costs
Labor
Lights, heat, etc.
Advertising
Tools and equipment
Reduced Returns
A. Total Added Costs
and Reduced Returns
$8,800
600
300
2,000
NONE
$11,700
Added Returns
Repair services sales
(labor 1,200 hours @ $8/hr.)
Profits on parts
($15,000 sales @ 28%)
Reduced Costs
B. Added Returns
and Reduced Costs
$9,600
4,200
NONE
$13,800
Net Change in Income (B minus A) +$2,100
Partial Budget Worksheet
Proposal:
Added Costs
Reduced Returns
A. Total Added Costs
and Reduced Returns $----
Added Returns
Reduced Costs
B. Added Returns
and Reduced Costs $----
Net Change In Income (B minus A) $ _
This Fact Sheet is one in a series on investment analysis. Others in
the series include Investment Analysis-Break-Even Method (L-I093, Texas
Agricultural Extension Service) and Investment Analysis-Capital Budget-
ing Methods (L-I091, Texas Agricultural Extension Service).
Educational programs conducted by the Texas Agricultural Extension Service serve people of all ages regardless of socio-economic
levels, race, color, sex, religion or national origin.
Cooperative Extension Work in Agriculture and Home Economics, The Texas A&M University System and the United States
Department of Agriculture cooperating. Distributed in furtherance of the Acts of Congress of May 8, 1914, as amended, and
June 30, 1914. .
5M-3-74 AECO 1


Investment Analysis--Partial Budget Methods.

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Investment Analysis--Partial Budget Methods.

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