Dairy Profitability

Accrual versus Cash basis: What does it mean and why it’s important to dairy farming

by Rebecca White

What is accrual and cash based accounting?

From www.accountingcoach.com :

“Under the accrual basis of accounting, revenues are reported on the income statement when they are earned. (Under the cash basis of accounting, revenues are reported on the income statement when the cash is received.) Under the accrual basis of accounting, expenses are matched with the related revenues and/or are reported when the expense occurs, not when the cash is paid. The result of accrual accounting is an income statement that better measures the profitability of a company during a specific time period.”

For example, if you received a shipment of feed in October, 2010 but the bill doesn’t get paid until February, 2011, on a cash basis, that expense would be considered part of 2011 but on an accrual basis, it would be considered part of 2010’s expenses.

Why does it matter? For a business analysis, it’s important to match the expenses with the related income.  The money you spent on feed to make milk in October may not have come out of your checkbook until February, but those expenses need to go with the matching income. In other words, how much money did it take to make money?

Milk checks also need to be accounted for on an accrual basis.  This can be confusing since you receive December’s milk income in the middle of January.  Also, when it comes to milk checks I have often seen dairymen record the net milk price as income rather than the gross milk check as income. Hauling and marketing should be considered an expense.  Your gross milk income should be reported as your income and even though your net check has already taken out the hauling and marketing expenses, on an income expense report, they should be considered an expense.

But why does it matter?

“The only thing a cash-based system truly reports is how much cash is left, but it misses much of the explanation of how and when it was obtained or spent….A cash-based system may seem easier to maintain because all accounting events are tracked by the flow of cash in and out of the business. It’s essentially a checkbook.”

If you only look at the cash based approach to your dairy’s accounting system, you are missing an opportunity to analyze your business and see the true picture of your dairy’s profitability.

Still not convinced that an accurate business analysis is important? Ask your lender- he thinks it’s important. When you want to borrow money, they will look at financial ratios and analyze them to determine if they will grant you a loan. Accurately analyzing your business allows you to make improvements and create a stable lending opportunity.

Example

Below is an example showing just milk income and feed expenses in August on a cash or accrual based accounting system.  Even with this very simple example, there can be a huge difference between the methods. If you track Income Over Feed Costs (IOFC), the accrual basis is the only way to know how efficient you are at producing milk during that month.