I had a professor in college who said, "There are lies, big lies and statistics." In my profession, I equate statistics to accounting allocations.
For several years, I helped manage a plastic packaging and printing company. We used sophisticated accounting software that allocated costs down to the penny for every job. A manager once tried to tell me why a job with a 45% profit margin was better than the job I wanted him to run, which had a profit margin of only 20%.
On the face of it, a 45% profit margin is substantially better than 20%. However, as with statistics, we need to have all the facts. The 45% job was a run of 10-mil plastic (1⁄100" thick) with low costs. It would run for two hours and generate $1,000 of gross income, with $450 going toward our margin. The 25% job was for 50-mil plastic and would also run for two hours but would generate $5,000 of revenue and $1,000 of gross margin.
Which would you rather have? I think most businessmen would choose the $1,000. However, the manager wanted the $450, since his performance was based on how "profitable" his jobs were. It took me several months to get my point across that our profitability was related to bottom-line income per machine hour, not the profit percentage. Almost all of our jobs of thicker material provided a lot more money per hour than the smaller jobs with a better "profit" percentage. It all depends on how you allocate indirect costs.
How Does This Apply to Farming? Each year, a farmer runs a margin analysis on which crop should be planted. One year, it might be corn; another year, soybeans. The estimated gross revenue minus direct costs of production and estimated indirect costs (machinery, compensation to the owner, office overhead, etc.) equals the total contribution per acre.
Gross revenue and direct input costs are generally accurate. The area where I see many errors is the allocation of indirect costs. For example, many farmers figure the indirect cost of machinery by dividing the estimated cost for the year by number of acres. But should each crop be allocated the same amount of machinery cost per acre? Many crops require several extra passes over the field to cultivate, spray, etc. These crops need to be allocated more machinery cost per acre versus a crop that might be no-till and require only one or two passes. By allocating the same amount of machinery cost for each crop, the farmer might either substantially overstate or understate the true cost.
Let’s say the farmer understates the cost by $40 per acre for one crop and overstates the cost per acre by $25 on another crop. If the first crop shows a gross margin of $100 and the second shows a gross margin of $80, the farmer will pick crop No. 1. However, when he prepares his final crop margin analysis after harvest, he might well find out that the crop returned only $60 per acre and that if he had planted the other crop, he could have made $105 per acre instead of $60 per acre. Allocated over 2,000 acres, this simple cost accounting mistake totals $90,000.
Another variable is the need for crop rotation for disease control, resting the soil or to replace or supplement various nutrients. Planting corn year after year, even if that is more profitable when the costs are isolated, might not be the best decision in the long term.
The bottom line for margin analysis is to make sure that your "more profitable" crops are really better than your "least profitable" crops. Do a careful analysis of your overhead items and make sure you are accurately applying these costs for each crop.
My partner says, "Accounting is the art of being excruciatingly exact about a lot of arbitrary assumptions." Let’s not make decisions based on isolated, arbitrary assumptions such as indirect cost allocations. Let’s not let an accounting "statistic" cost us money.
Paul Neiffer is a tax accountant with CliftonLarsonAllen and author of the blog The Farm CPA. He grew up on a wheat farm in Washington and owns a corn and soybean farm in Missouri. Contact him at email@example.com.
- March 2012