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1308 PD: Using farm records effectively for business and financial management

A.J. Brannstrom Published on 29 August 2008

Dairy farming is a complex business which demands accurate records and careful financial management. Both financial and production records are required in order to provide the information on which the farm manager can make critical decisions. Unfortunately, since farming is widely viewed as “a way of life” rather than a business, the financial management tools long available in other industries have not been universally embraced by producers.

History of farm accounting
In contrast to most other “industries,” agriculture does not have a long period of record keeping and analysis history. Subsistence farming was largely the rule throughout the 19th century. Most farms have traditionally been family owned and operated, and farmers have been guilty to some extent of leading a “lifestyle” rather than running a business.

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Prior to the 1920’s farm credit was relatively small. Most farm borrowing was done between generations. Farm loans, like residential real estate loans, were made on a short term basis (usually five year notes paying a simple annual interest payment with balloon balance due at maturity).

Harvard professors of accounting, Kaplan and Johnson, show that many of the financial management techniques in use today originated between 100 and 150 years ago in the textile mills, railroads and finally in the integrated industries like General Motors and DuPont. These systems were developed to provide managers the information they required to identify and correct weaknesses in the business and later to allocate resources between competing divisions. These financial management systems were developed out of necessity because organizations were much too large to manage from “the seat of the pants.”

There are many reasons why farmers’ financial management skills have been slow in developing. Despite greater reliance on debt financing, many farmers’ primary reason for record keeping is the satisfaction of Internal Revenue Service tax reporting requirements. Since cash basis accounting provides farmers very significant advantages in managing income tax liabilities, most farm record systems are designed around the income tax reporting function.

Accounting is one of the “least liked” tasks on the farm. In an article entitled “Farmer’s Perceptions About the Management of Their Farms,” John E. Carlson found that farmers admit to the importance of good record keeping, but rank it fourth behind field work, buying and selling (machinery and crops) and working on farm machinery. The same survey found that the average farmer estimated spending about one to 10 hours per week on farm record keeping during the winter and much less during the summer.

The survey also asked: Who has the major responsibility for doing the record keeping in your farm operation? Only 16 percent hired outside help. About half the respondents named themselves and 20 percent named their spouse.

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Carlson concluded, “Farmers saw farm management as important to the successful operation of a farm. They also indicated that it was a serious problem for many of them. Especially problematic were issues related to long range decision making and determining the best combinations of farm enterprises.” Although this survey was conducted 20 years ago, my sense is that the results would be similar if the survey were repeated today.

In summary, the historical structure of family farms, the record keeping requirements imposed on farms for tax purposes and the limited resources devoted to accounting have sometimes resulted in poor decision making and lost opportunities.

Information needs of the manager
Despite the small amount of time typically given to managerial planning, complete and accurate farm records, when effectively used, can help increase profits for the farm operator. Farm records, like their business counterparts, have four basic uses:

1. service tool
2. diagnostic tool
3. indicator of progress
4. forward planning

As a service tool the records system can provide income tax information for filing tax returns and Social Security reports, as well as providing a basis for tax management decisions. Further, the records system can provide a basis for developing equitable business arrangements for operating agreements, partnerships and corporations. Records also help in obtaining and effectively using credit by showing factors relating to the profitability, liquidity and solvency of the farm business.

As a diagnostic tool, records can help determine the absolute and relative profitability of the business by identifying the strengths and weaknesses of the business. Thus, the manager can see strong points and capitalize on them while recognizing weak points and taking corrective steps.

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The records system can be used as an indicator of progress from both the business management and financial management standpoints. As a business indicator, records can show the manager changes in size, productivity and efficiency, and organization factors unique to his business and farms similar to his. He can measure actual performance in comparison with budgeted performance or standards of performance for his type of business.

As a financial indicator, records help the farm manager and his lender to measure the changes in the financial condition of the business and to compare actual and planned performance. This needs to be done on a regular basis so problems can be worked on as soon as they develop.

Finally, records should be used as a forward planning device for short and long-term planning. Past records can be used as a basis for projecting cash flows. The manager can then compare actual performance with the plan. The records system can provide cost information and coefficients of production unique to his situation for budgeting in both the short and long run. He can project short and long term credit needs and repayment capacities.

Further, the manager can schedule purchases of inputs, compare various inputs as to costs and returns, select the kinds and sizes of enterprises, and determine capital generation capacities of different alternatives. In these volatile economic times, forward planning is becoming increasingly crucial; good computer tools are available to help with the task.

Types of records required
• Income and expense ledgers
An income and expense statement is required for tax purposes and can also perform other functions as a business management tool. Income and expenses should be recorded and totaled on a current basis for greatest accuracy and to provide a running account so problems can be identified when corrective action may still be taken.

• Depreciation
A depreciation record is required for tax filing purposes. It provides a list of all depreciable capital assets used in the farm business and can be used in constructing the inventory record and financial statement. Depreciation records are almost always kept to conform with IRS regulations and recently have had little relevance for financial decision making. It may be necessary to maintain a second set of depreciation records that better reflects true economic costs for analysis and budgeting purposes.

• Profit and loss statement
A profit and loss statement takes the income, expense, and inventory records and ties them together to provide the manager with information about his return to labor, management and equity capital for the year and over a series of years. Accurate measurements of feed and livestock inventories are vital to making correct accrual adjustments for calculating net farm income.

• Cash flow
A cash flow record provides a history of how cash moves in the business and can also serve as a device to project cash flow in future periods. The record of actual cash flow can be a monitoring device to measure actual performance against planned performance.

• Production
Production records for the individual crops, livestock and other enterprises are essential for the manager to evaluate his performance as a production manager. Accurate measurements of input quantities consumed and outputs produced in each enterprise allow for construction of meaningful enterprise budgets.

• Enterprise accounts
Enterprise accounts are vital records to help evaluate the performance of each of the several enterprises making up the total farm business. At a minimum they should be broken down between the crop and livestock enterprises. Ideally, each enterprise should be in a separate account. Enterprise accounts can help farm managers see which of their enterprises make the most profit, determine which production methods within an enterprise perform economically under the individual farm conditions, and help determine what level of output is economically appropriate for each enterprise.

• Feed
Feed is one of the largest inputs for livestock enterprises. Almost all home-grown feeds have a farm gate value. Managers should be very concerned about feed utilization and efficiency in the various livestock enterprises. A good record of purchased and farm-grown feed is essential for the manager to make economically sound decisions about the livestock program as well as to properly credit crop enterprises for their share of input into the livestock enterprise.

For example, using appropriate transfer prices, corn could be “sold” to the dairy cow enterprise which “buys” the corn from the corn enterprise at its “farm gate price.” This concept of transfer pricing is often misunderstood in farm accounting. Farmers tend to view crops harvested and in storage as free goods which are then transferred to the dairy enterprise which is “where the farm profits are made.” The obvious fallacy of this logic is that the actual costs of producing the crops are not recognized and tend to make the dairy enterprise look much better than it actually is.

• Labor
With labor costs going up and greater scarcity of competent farm help, more attention must be paid to effective labor use in the business. Constant study of labor use can make fewer hours accomplish the same task. Time study records can help provide this information. Also, labor records are needed for Social Security purposes, Workmen’s Compensation, W-2 forms, etc.

• Equipment
Larger, more expensive, complicated equipment, with its high fixed costs plus large operating costs, calls for special analysis on many farms. It may pay managers to keep an individual set of financial records for these types of machines. This information can serve as a guide to when to buy, sell and trade equipment, as well as the basis for making decisions about appropriate rates to charge for doing custom work.

• Experimental
With exploding technological developments, managers are continually faced with decisions concerning whether new technology can be profitably used in their business. Records of trial projects in crop and livestock enterprises can provide a guide to the physical as well as financial performance of that technology for a specific farm situation.

• Production – Field records
Increased concerns about ground water contamination and chemical carry-over make an accurate record of chemical and cultural practices on each field absolutely essential. As farm sizes continue to grow and the number of potential chemicals available for disease and insect control increases, even the sharpest memory will fail. Field records will be a valuable tool for the manager to analyze the effectiveness of fertility and weed and disease control programs.

• Production – Livestock records
Most successful dairymen have recognized the importance and value of good production and breeding records for the dairy herd. More than half of Wisconsin’s herds belong to the Wisconsin Dairy Herd Improvement Association.

Those who choose to be on “official” records are visited once a month by a fieldman from the cooperative. The fieldman gathers breeding information and production records from the farmer and generates a production roster listing each cow in the herd, her current production level, estimated total lactation production level and estimated breeding dates.

• Forward budgeting
A pro forma farm plan is a basic planning and control document necessary to judge the progress of the operation throughout the year. This planning document should be done on a quarterly basis so that variances in target receipts and expenses can be monitored and corrected in a timely manner.

• Long-range budgeting
When the business is just starting, or when it is contemplating major alternative investments, long run budgeting is necessary to determine if the proposed alternatives can be economically successful. Several computerized simulation models have been written to help farmers and lenders do long range financial planning.

Once a strategic decision has been made to make a significant capital investment, detailed transitional plans are needed to forecast the cash flow requirements of the plan between the current period and the long range goal. Again, this process is greatly assisted by computer software.

Conclusions
Dairy farm management is becoming an increasingly complex task. Dairy farms are larger and more capital intensive, and they are increasingly competing in a global market. Price changes have been frequent and abrupt in response to changes in supply and demand. New technology has resulted in other changes.

As production processes grow more complex, more time and managerial skills are required to handle the non-routine tasks. Major modernization projects can easily depress the return on assets (ROA) and return on equity (ROE) during the construction and start-up process while the economic benefits may not be measurable until a few years later.

No two dairy farms are identical, and correlating profitability with specific production practices is a challenge.

Farm owner/operators are unique in that, in many cases, they must play the roles of both senior management and laborer. It will be difficult but increasingly important for them to spend more of their time in the management role since that is where the decisions critical to the success of the business will have to be made. Farm management is a planning, decision-making and problem solving process. The problems generally fall into three categories: what to produce, how much to produce and how to market. Problem solving is a continual process. The challenge facing farm managers in the future will be to effectively utilize computers and the Internet to develop a management information system to meet these problem solving needs.

As dairy farms continue to grow in size and complexity, the importance of managerial accounting techniques will also increase. Obviously the needs for greater financial management skill will be acute in the years ahead. PD

—Excerpts from 2008 Kentucky Dairy Conference Proceedings

A.J. Brannstrom, MS, MBA, Faculty Associate, University of Wisconsin Center for Dairy Profitability

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