One of the major steps in going from cash-basis records to accrual-basis records is tracking inventory.
People tend to get hung up in inventory because the accounting is not as straightforward as “check = expense” and “deposit = income”. Intuitively, farmers get how it works, but it is the accounting that makes it difficult.
Most of the farmers I’ve meet have a good understanding and feel for how much money they have in a group of pigs and the cash they need to bring in on it to make their payments. The big thing to remember is “cash flow does not measure profitability;” so you need to be tracking inventory if you want to measure profitability.
Over the next couple of blogs, we will focus on the most important aspects of inventory for farmers: tracking processes and cost allocation.
There are two types of inventory tracking processes that I’ve seen farmers use: periodic and perpetual.
Periodic inventory tracking is really just counting sheep, literally (and will make you just as tired). You go and physically count what you have on-hand. Physical inventory counts are important because they give you two solid numbers to use in your sales formula. The cost of goods sold formula looks like this:
Value of beginning inventory + Value of Purchases – Value of Ending Inventory = Cost of goods sold
“Value” is a relative term in farming since the commodities market is constantly changing. When we are looking at physical inventory, it changes values to units:
Bushels at 1/1/19 + Harvested 2019 bushels – Bushels at 12/31/19 = Bushels sold in 2019
You can use algebra to calculate any aspect of this formula; you just need three numbers to start. The reason you want to have hard beginning and ending inventory numbers is because bushels harvested and sold are subject to “documentation error.” Having two numbers that you are confident are correct helps point you in the right direction when yield monitors and/or settlements are not making sense.
You always want to have at least one good count a year and done around the same day every year. The days of the counts should be as close to the cut-off date of your financial information as possible. In addition, you will want to do as many counts as you would like to have accrual adjusted financial information; quarterly statements means four inventory counts annually. I like to think of them as “walk-abouts” or “mental vacation days” if that seems like a lot.
Perpetual inventory tracking is a little more involved but has the same core concepts. Perpetual inventory helps you track inventory throughout year so you always have some idea of what you have on hand on any given day. You can track it manually but usually I see farmers using software when tracking inventory perpetually. Going back to our formula, perpetual inventory works on the premise that:
Bushels at 1/1/19 + Bushels harvested to date – Bushels sold to date = Inventory at date
Your best bet is to invest in some sort of inventory tracking software if you want to have monthly accrual financial statements. Even though you are tracking your inventory with software, you will still want to do at least one inventory count every year due to “documentation error.” Think of it like changing the oil -- you gotta do it if you want the engine to run smoothly.
Do not be disheartened if you want to track inventory but don’t think your numbers will be good because you haven’t done it in the past. You need to start somewhere and the first count is the most important one. Be sure to talk to your CPA or Accountant if you are interested in accrual financial statements. A lot of CPAs and Accountants have experience doing inventory counts so they would probably help if you asked.