Economic Analysis of the Dairy Farm - Babcock Institute - University ...

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Economic Analysis of the Dairy Farm: Recommendations for Preparing Net Worth & Farm Income Statementsfrom a fire not used to rebuild. Insuranceproceeds from crop damage are included in cashincome.In addition, do not include as cash incomesales of assets used in a trade or business thatare rare but ordinary in nature such as land ormachinery. The sales of assets used in a tradeor business that are part of the customaryoperation of the business such as breedinglivestock are included as cash income.The NFIFO formula is shown below. Thefarm's total output is the total farm revenue.The cost of producing that output is the totalfarm expense. Subtraction of the two yields thenet farm income from operations (NFIFO).Total Farm Revenue– Total Farm Expense= Net Farm Income From OperationTotal farm expense does not include a chargefor unpaid family and operator labor andmanagement, or a return to the equity capital.Therefore, NFIFO is a return to thesecomponents of production and the business'sprofit. Do not confuse the profit with theretained earnings.To calculate net farm income, add the raresales of assets used in a trade or business (suchas machinery and land) to total revenue beforesubtracting total expense. However, do not addsales of the once-in-a-lifetime items to totalrevenue when making this calculation.Adjustments to cash incomeThe adjustments to cash income to obtaintotal farm revenue fall into two categories.1) The change in the value of current assets'inventory. Change equals the value at theend minus the value at the beginning of theaccounting period.2) Non-cash income from the change in theinventory of raised breeding livestock.The first half of the formula for the calculationof net farm income can now be identified as:Cash Farm Income+ Change in Inventory+ Non-Cash Income= Total Farm RevenueChange in inventoryTo produce a balance sheet, the physicalchanges in inventory must be multiplied by aprice per unit. The question is “what price?”Example: Given the following facts, whatprice per bushel of corn should be used whenpreparing a balance sheet? The production costis $90 per ton (usually unknown), the marketprice at the beginning of the accounting yearwas $110, the price at the end of the accountingyear was $85, and the long-run average price is$95.The answer to the question "what price?"depends on the reason for holding the inventory.There are usually two reasons given for holdinginventory, for future feeding or sale.Inventory held for feedInventory held as input for another enterpriseon the same farm should be valued at its longrunaverage price. In addition, the price at boththe beginning and the end of the accounting yearshould be the same as the usual price (long run)of this product/input.This valuation method insures the farm'smajor output's return will not be affected byfluctuating prices of internally produced inputs;especially those internally produced inputswhose cost of production has not changed. Theinvestment in capital, both material and human,is usually too great to cause a significant changein the level of a major output based on thecurrent "market" value of one of the internallyproduced inputs. Some substitution may occur;however, this is usually limited because of thetransportation and in/out costs.Example: If the cash price of corn hadincreased to $150 per ton in the spring of 2001.This alone would not cause livestock farmers toliquidate their herds, instead they could obtain alarger return on corn (in the short run) by sellingthe corn at market price than by feeding it totheir livestock. Nor would may livestockfarmers sell their corn and buy another energysource. If only the price of corn is considered,this would seem profitable, but this transactionalso has other costs and those costs generallyoutweigh the potential savings.4 Dairy Updates 2001
Economic Analysis of the Dairy Farm: Recommendations for Preparing Net Worth & Farm Income StatementsInventory held for saleIn the case of inventory held for sale, thereasons for selecting a valuation method are notas compelling. Some individuals argue that thistype of inventory be valued at its current marketprice. Others argue that until the inventory isconverted to cash, it should be valued at cost ofproduction. However, as mentioned above, thisis usually unknown and the long-run averageprice must be used as its proxy.Any adjustment in the price of inventory heldfor sale should be executed between accountingperiods, not during an accounting period. Thechange in equity this adjustment will causeshould result in a change in the valuation'sportion of the statement of equities.Accounts receivableMost farm operators do not have a largeamount of accounts receivable. The accountsreceivable (that are collectable) should berecorded on your balance sheet. The change inthis value from the beginning to the end of theaccounting period is listed as an inventorychange, because accounts receivable areconsidered current assets.Livestock held for saleIn most cases, the expenses associated withthe increase in value of feeder livestock areincluded in the cash expenses. This means theincrease in value of the livestock must beincluded as part of the income stream if a propermatching of income and expenses is the goal.The value of all these changes are summedand added to the cash farm income. Thisadjustment, based on the beginning and endingbalance sheets, is the first step in convertingcash basis farm records. The logic being thatthis increase in inventory could have been soldfor cash to bring the inventory to the same levelas it was at the beginning of the accountingperiod. The opposite argument holds fordecreases in inventory.Non-cash incomeRaised breedingSometimes production by an enterprise is anecessary asset in the production function of theenterprise. Breeding livestock is a goodexample. These assets fall into much the sameclassification as the inventory change; however,because they are non-current assets they areusually called "non-cash" income.The reason for including them here and notas a capital expense adjustment is that the saleof breeding stock (IRS Form 4797) is includedas cash income. Further reasoning is that theseassets could have been sold for cash to maintaininventory levels. This would have kept thenumber of livestock at the end of the accountingperiod at the same level as they were at thebeginning. This follows the reasoning usedearlier on inventory changes.The FFSTF had three recommendationsconcerning the treatment of raised breedingstock.1) The preferred method is to determine thecosts associated with raising breedinganimals, and capitalize and depreciate thatcost. They realized that this approach wouldnot work, because it was written into TheTax Reform Act of 1986 and raised suchoverwhelming objection that it was laterrepealed.2) To use one of three methods for adjustingtotal income for the change in the quantityof breeding stock. The FFSTF emphasizedseveral times that only the change in thequantity of breeding stock multiplied by theselected price must be included in totalrevenues. Any change in the price of thebreeding stock be disclosed in the statementof owner's equity. The prices used by thethree methods are:a) Quantity-based market value,b) Base value, andc) Base value with full revenue recognition.Base value is a stipulated value, roughlyapproximating the cost of raising the animal.Changes in the quantity multiplied by thebase value are included in total income.Business Management No. 203 5
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