Written April, 2016
Fine-tune Management Decisions with Enterprise Accounting
Farmers are used to calculating profits each year for their entire farm. But where do these profits come from? Most farms and ranches produce more than one product. By dividing the farm operation into separate lines of production the contribution of each one toward overall profit can be evaluated.
The various sources of farm income can be divided into "enterprises" or "profit centers". Each crop produced and each species of livestock raised can be considered a separate enterprise. Usually, these correspond to major commodities such as soybeans, corn, hay, swine, beef, or dairy.Sometimes one crop can be divided into multiple enterprises that require different production methods or target special markets. An example would be dividing corn production into yellow corn, white corn, sweet corn, popcorn, and seed corn. Likewise, livestock enterprises can be divided into production phases. A cow-calf operation may divide its costs and returns into a breeding phase (up to the weaning date of the calves) and a finishing or feedlot phase. A farrow-to-finish hog operation may analyze the farrowing, nursery and finishing phases separately, to find out which one is contributing most to overall profit. Raising replacement dairy heifers can be analyzed separately from the milking herd.
Allocation of income and costs among enterprises is done most conveniently when financial transactions are first entered into the accounting system. If a hand record book is used, each crop or type of livestock will have a separate column or page for recording revenue and expenses. A computer based system will typically ask for a code number that corresponds to the relevant enterprise, or provide a drop- down list of enterprises that the record-keeper has defined in advance. Some checks may need to be subdivided when they are entered, such as one for a bill that includes herbicide for both corn and soybeans.
Not all costs can be conveniently assigned to a specific enterprise. Examples are farm property taxes and liability insurance premiums, legal and accounting fees, and vehicle registrations. These are collectively referred to as overhead expenses. They can be allocated among enterprises at the end of the year, either in the same proportion as all other costs, in the same proportion as each enterprise’s contribution to gross revenue, or according to some other logical formula.
Some types of overhead costs are best allocated according to use. For example, fuel, repairs, depreciation, and machinery lease payments can be summed and divided by the total crop acres farmed to come up with a cost per acre, which in turn is multiplied by the number of acres in each crop enterprise. A more precise allocation would take into account the hours or days each machine is used on each crop, but that would require very detailed records. The cost of wages and benefits paid can be allocated based on an estimate of how much time hired employees spend on each enterprise.
Sometimes one enterprise produces a commodity that is utilized in turn by another enterprise. The most common example is home- raised feed. Corn or hay that is fed on the farm should be valued at its opportunity cost, that is, the price for which it could have been sold minus transportation or other marketing costs saved. That value is then assigned as income to the corresponding crop enterprise and an expense to the livestock enterprise that utilizes the feed. Total profit is not affected, because the two values cancel out for the whole farm.
Another example of an internal transaction is the value of manure produced by livestock and applied to crops. It can be valued based on the potential cost saving from the commercial fertilizer it replaces. This value would be designated as a cost to the crops and as income to the livestock, with the hauling costs assigned to livestock.
When livestock operations are broken into phases, the value of the young stock transferred should also be entered as an internal transaction.
For example, the value of weaned calves would be income to the cow-calf enterprise and a cost to the feedlot enterprise. In effect, one enterprise is "selling" the product to another enterprise.
Realistic transfer values should be used to avoid biasing the profit estimates in favor of one enterprise or another.
Larger farming operations may want to track expenses of certain "cost centers." Cost centers provide services to other enterprises on the farm, but do not generate any revenue themselves. Common examples are the farm’s line of machinery, a feed mill, or an irrigation system. The cost per hour, acre, or ton of service provided can be tracked and compared with the cost of obtaining the same services from an outside source, such as a custom machinery operator. The unit cost can then be charged to each profit center based on its corresponding level of use.
Most whole-farm accounting programs also have the ability to perform basic enterprise analysis. Considerable care should be taken to clearly define the enterprises to be analyzed and to set up the chart of accounts in such a manner as to make it easy to assign income and expenses properly. The accounting system must also allow internal transactions between enterprises to be made.
The computer can quickly sort through all receipts and expenses, collect and organize those that belong to a particular enterprise, and present the results in total dollars per acre or some unit of output. Some programs also have a procedure for automatically allocating overhead costs among enterprises.
Most farm businesses use the calendar year as their accounting period. For enterprise accounting, though, it is more logical to summarize costs and returns over the relevant production period. For a specific grain crop this might start with fall fertilizer applications and end with final spring grain sales 18 months later. The costs and revenues for one year’s crop could stretch over three normal accounting years. In some accounting systems another digit is added to the enterprise code to indicate the year, such as a "6" for the 2016 corn crop. On the other hand, for a feeder pig finishing enterprise each group of pigs could be summarized separately, with an accounting period only 4 to 5 months long. In that case only a portion of the annual overhead costs should be charged to each group. Other enterprises, such as dairy, have continuous production, so the calendar year or any other arbitrary period can be used.
Tracking income and costs by enterprise helps identify the real sources of profits in the business, and provides factual data for either expanding or discontinuing certain activities. Different crop enterprises can be compared based on profit realized per acre. One word of caution is needed, however. Enterprise analysis does not identify or value any complementary or detrimental interactions between enterprises.
For example, corn may appear to be more profitable than a legume crop such as soybeans or alfalfa. However, growing continuous corn actually may be less profitable than a rotation containing other crops that contribute nitrogen to the soil, break up pest cycles, or spread out peak workloads. Where the presence of one enterprise significantly affects the performance of another, a whole farm approach must be used in which various crop rotations or even whole- farm plans are compared.
Some activities are intended to increase the net income received from a commodity after its production cycle has ended. These are known as “value-added” enterprises. Examples include processing milk, fruits, or vegetables into food products; sorting and packaging products by size or quality; and selling livestock as processed meat. Most processes that add value to products also add costs, though. The activities designed to add value can be analyzed as a separate enterprise. The price that the product could have been sold for without further enhancement can be used to transfer it into the value-added enterprise. In the end, the enterprise analysis will tell the manager if the value added to the product is sufficient to pay all the added costs incurred.
Marketing can also be considered a value- added enterprise. The grain enterprise analysis can be terminated at harvest, with the product being valued at its harvest time price and then transferred to the marketing enterprise. Items such as broker’s fees, options premiums, storage charges, transportation, and extra drying costs can be charged to the marketing enterprise. The final selling price, including any gains from hedging or purchasing options, constitutes the marketing revenue. The net income to marketing shows whether the manager added value to the product with his or her marketing skills or would have been better off simply selling the crop at harvest.
Comparing Land Units
Some crop producers rent land from multiple owners for different rental rates or under different types of lease arrangements. Some of these rented farms may be more productive than others. It is useful to compare the profitability of different land units, especially if their leases can be renewed or terminated yearly. Each farm can be considered a separate profit center. The same rules that were discussed earlier for allocating costs apply. If records allow, cost of inputs can be adjusted for each farm, such as when some units require higher rates of fertilizer application than others. In other cases the total cost for a certain input may simply have to be averaged across all crop acres. It is very important, though, that the quantity of product harvested from each farm be recorded accurately, in order to fairly assess and compare the profitability of each one.
Finally, an average profit per acre for each land unit can be found based on the income, expenses and number of acres of each crop grown on that unit. Farms that consistently show a net loss, or do not at least produce enough income to pay all variable costs plus the land rent, should be dropped from the land base. Some tenants rank all their rented farms by profitability each year, and try to replace the least profitable land units. The cost and income summary also can be used to estimate a reasonable rental rate for each farm.
Enterprise accounting has many uses. It takes extra effort, but the information it provides is well worth it. This year might be a good time to overhaul the operator’s accounting system to find out which enterprises are performing well and which ones are not.
William Edwards, retired economist. Questions?