Cost Accounting Made Easy

by Peter Callan, Extension Agent, Farm Business Management, Northern District
Cost accounting is used to evaluate the overall costs associated with conducting business.  It is easy to allocate “big ticket” expenses (e.g., fertilizer, seed, feed, livestock supplies) between a farm’s enterprises (e.g. dairy, crop, beef, etc.). This gives the producer a rough estimate of production costs for an enterprise.  However, it is extremely difficult to allocate operating costs (e.g., labor, fuel, supplies, repairs, etc.) between individual crops and enterprises on a farm. A cost accounting system enables the farm manager to determine the exact cash production costs for enterprises and specific crops grown on that farm.

My sister-in-law has developed a cost accounting system that is a simple and fast way of allocating costs on the 200 cow dairy, 1800 acre cash crop farm and dry bean processing business operated by her and my brother.  She has “trained” my brother to categorize expenses on billing statements received each day in the mail when he comes into the house for his dinner. This easy task takes a maximum of five minutes. If my brother does not perform this simple assignment; he does not have the opportunity to eat his dinner that evening!  The system works because my sister-in-law is an excellent cook and my brother carries a large “tire” around his waist.  The first step in developing a cost accounting system is developing a chart of accounts.

chart of accounts is a listing of the names of the accounts that the farm has identified for recording transactions in its record keeping system.  The chart of accounts is sub categories for major income and expense categories.

The producer has the flexibility to customize the chart of accounts to best suit the needs of the farm, including adding accounts as needed. For example, repairs are a category that summarizes equipment, silo and real estate repairs and shop supplies. The repair category can be broken down into sub accounts.  Equipment repairs can be assigned to repairs by the piece of equipment.  Likewise real estate repairs can include repairs made to barns, driveways, houses, etc.  Shop supplies are a “catch all” category for the various items used in the farm shop, e.g., nuts and bolts, welding supplies, oil filters, tools, etc.  Livestock producers may wish to break down feed expenses into the following sub categories: calf feed, concentrates, minerals-salt, forage purchased, hay purchased, nutritional work, forage testing, and silage inoculants.  The most important concept in any record keeping system is the ability to find what you are looking for when you need it.

The key to developing a chart of accounts is identifying the sub categories which will enable the producer to make more informed business decisions on a timely basis. On many farms, labor is the largest expense.  Now more than ever, the accurate allocation of labor expenses between crops and enterprises is the key to determining the most profitable uses of labor on a farm.

There are two types of labor records that are kept in a cost accounting system.  Federal and state laws require employers to report wages paid to employees.  In order to meet the state and federal reporting requirements, employers will record the following information for each employee: gross wages, state and federal income taxes withheld, employer and employee social security and Medicare taxes.  The second type of labor records allocates labor between the farm’s enterprises.

My sister-in- law has developed a simple system to allocate labor costs between the dairy, cash crop and bean processing enterprises on her farm.  During the first full week of January, April, July and October, she totals the number of hours worked for each employee.  Then she distributes the number of hours that the employee worked between the farm’s three enterprises. For example, 100 percent of the milker’s hours are allocated to the dairy enterprise.  Depending on the time of year, the herdsman may work 100 percent of the time with dairy while during the summer and fall he spends part of the day working in the fields.  In addition, my brother fills out a time card during the first week of each quarter which lists the number of hours that he spent working that week between the three enterprises.  Then my sister-in-law summarizes the total number of hours worked on the farm that week and calculates percentages which show the distribution of hours between the enterprises during that quarter. Thus at the end of the year, the records for the four quarters (January, April, July and  December) are totaled to determine the percentage of total wages paid that should be allocated to the farm’s enterprises.

There is a simple way to allocate expenses (labor, repairs, shop supplies, tools, etc.) that are spread across all the farm’s enterprises.  First, the categories of farm income (milk, calves, cull cow, hay, corn, wheat, custom work, government payments, patronage dividends, etc.) are totaled to determine gross farm income.  Then the income is distributed between the farm’s enterprises to calculate the percentage of total income that was generated by that enterprise.  For example, on a dairy and cash crop farm, the ratio could be 70% dairy and 30% cash crop.  This allocation can then be used to distribute expenses between the enterprises.  On a cash crop farm, the acres of each crop grown are totaled to determine the total crop acres. Remember, if a hay field is cut three times during the season, total hay acres will be calculated as follows:  acres in the field X 3 cuts = total hay acres. For example, assume that there are 1,000 crop acres and shop expenses are $12,000 for the crop enterprise.  $12,000 (shop expense) / 1, 000 acres = $1.20 shop expense per acre. By accurately distributing labor, shop supplies, tools and repairs between the farm enterprises and crop acres, producers will be able to calculate accurate production costs. Likewise, understanding a farm’s cost structure can be helpful in the decision making process to replace “tired iron” in the farm’s equipment inventory.

Due to minimal profits, many producers own and operate equipment that is literally held together by “duct tape and baling wire.” Some of this equipment is used every day on the farm.  Thus it is not feasible to hire a custom operator to perform the tasks. Many operators are wondering when they should make the decision to replace this piece of equipment.  For example, the following scenario occurred on a dairy farm:  the dairyman owned a tractor with 14,000+ hours that was used for loading the mixer wagon.  The repairs to keep this tractor operating had been mounting for the past three years.  The spouse developed a sub category in the farm’s record keeping system which tracked the repair bills for this worn out tractor for the past 3 years.  When this couple met with their loan officer, the spouse was able to show the loan officer that the annual repairs bills for the old tractor were more than the loan payments to purchase a newer model tractor.   Even though milk prices had dropped to the lowest levels in 30 years, the loan officer thought the purchase of another tractor was a wise investment because the spouse had records to justify the purchase.

In my opinion, the income and expenses for enterprises (e.g. dairy, beef etc.) and crops should be analyzed over a five year time frame. Numerous producers apply lime and potash to their fields once every three years.  Thus the lime and potash could be considered an “investment” in the field because the cost will be spread out over a three year period. However, the lime and potash expenses will be listed in the farm records during the year they were paid. Consequently, there may be significant variations in fertilizer expenses during the years when three year’s worth of lime and potash was applied to the fields. In the past three years, there has been significantly volatility in grain and fertilizer prices. A five year average will provide a more realistic assessment of the enterprise’s and crop’s profitability because the average will take into consideration the impact of drought on crop yields and the variability of crop prices and input costs.

Numerous producers believe that a cost accounting system will enable them to accurately calculate production costs for their farms’ crops and enterprises.  For these producers, the big question is how to implement a cost accounting program which meets the needs on their farms?  They feel that cost accounting systems will be time consuming.  How will they ever start the process?  Will this system work on their farm?

There are several quick and easy steps to implement a cost accounting system.  First, the record keeper purchases a box of 50 manila folders and a box of paper clips.  One folder will be used for each vendor and buyer (e.g., milk cooperative, grain, livestock, etc.)  which the farm does business with. The folder will hold billing statements and sales receipts from that business.  Paper clips will keep statements together in the order that they were received in the mail. Next, the producer creates a chart of accounts which will provide the information that is needed to make accurate and timely decisions. When the expense invoices arrive in the mail each day, the farmer roughly allocates the expenses to the chart of accounts.  For example, a $5,000 potash bill may be split between crops as follows: 50% corn, 20% beans and 30% hay.  In this case, the fertilizer expenses would be broken down as follows: $2,500 corn crop, $1,000 beans and $1,500 hay.  This is a more precise distribution of fertilizer costs among crops because previously the entire bill was listed under the broad category of fertilizer expense.  When  developing the chart of accounts, the producer may wonder if an elaborate computer record keeping program is needed for a cost accounting program for his farm.  The answer is NO!

A cost accounting system can be implemented using both computer and manual record keeping programs. The creation of a chart of accounts is the starting point for a cost accounting system.  How many accounts does the producer need to make informed decisions?  On many farms, producers use computerized record keeping programs that have the potential to create a chart of accounts with numerous categories.  As a lender, I have worked with producers who had record books.  The record keeper, usually the spouse, developed a simple chart of accounts which provided the information needed to make informed management decisions. On numerous occasions, the record keeper was able to read the numbers from the accounts faster than I was able to enter the information on my calculator.  My sister-in-law strongly encourages producers to start out small with a limited number of accounts.  As the record keeper becomes comfortable working with the cost accounting system, additional accounts can be added to meet the needs of the business. The key to a record keeping system is the ability to find what you are looking for when you need it.

Supposedly Benjamin Franklin said,  “Drive your business, let not your business drive you.” In an era of declining profit margins, cost accounting enables producers to precisely calculate their costs of production because all cash expenses are included in the production costs. Cost accounting provides a financial picture of the current operation and serves as planning tool for future decision making.  Best wishes for a safe and profitable new year!

Article courtesy of Virginia Cooperative Extension

Link photo courtesy of Ken Teegardin

 

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