End-of-Year Allocations Absorbing the Support Centers
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1 End-of-Year Allocations Absorbing the Support Centers Successful businesses are managed. Producers cannot manage what is not measured. In order to manage each enterprise of an agricultural business, producers must have an understanding of each enterprise s contribution to the business, positive or negative. In other words, each enterprise should be separately evaluated so that the manager can determine its profitability. As discussed in the Transaction Log section of this curriculum, business transactions are broken down to Profit and Support Centers. See the Transaction Log section for clarification on this subject. Many of the production costs can be easily identified with a commodity or enterprise, like onion seed. It is obvious that onion seed should be paid for by the onion enterprise. However, there are other costs, like taxes, utilities, insurance, general farm labor, and machinery repairs. Which enterprise pays for these expenses? For those expenses that cannot be readily identified with the responsible enterprise, producers should allocate them. The allocation criteria should be logical and result in a reasonable charge to the responsible enterprises. Why Should I make End-of-Year Allocations? An enterprise can look profitable when only the direct expenses (seed, fertilizer, harvest expense) are considered. But what about the enormous overhead costs, like machinery cost, utilities, interest on loans, and labor? Absorbing these costs refers to the allocation of these indirect expenses to specific enterprises produced by the operation. How does a producer absorb those costs? Unfortunately, many producers absorb overhead costs with off-farm income (spouse s town salary). Since agriculture is normally thought of as a price-taking industry (little negotiation and/or variation in prices), the most cost efficient operations are the successful ones. Efficiency means making every dollar spent produce the highest profit margin possible. Efficiency does not always mean low cost; quality should be maintained, but only if it can be achieved efficiently. Sometimes, doubling the yield comes at triple the expense. The cost and benefit should always be measured and compared. As discussed in the Transaction Log Section of this curriculum, agricultural enterprises are best managed if evaluated separately. Also, the true impact of a certain enterprise cannot be determined until all costs have been absorbed. Duckworth, Brenda, Stan Bevers, Rob Borchardt, and Blake Bennett. Department of Ag Economics, Texas Cooperative Extension, Texas A&M University. May 2003.
2 How do I allocate those hard to charge costs? Throughout the year, all transactions have been recorded, including non-cash expenses like depreciation and management labor. Now, the allocation process can begin. If an operation has both cost and support centers, the support centers should be allocated first because support centers are complete ; they are not responsible for any other costs. Visualize 3 stairs. Support centers are on the bottom step, cost centers on the middle step, and profit centers are the top stair. Costs step up those stairs- from support centers to cost and profit centers; cost center expenses step up to profit centers. All costs eventually are absorbed by the profit centers. To begin allocating costs, the producer must first determine a scheme for allocation. Are three profit centers equally responsible for the Machinery & Equipment Support Center costs? If so, the cost would be split equally three ways (33% to each profit center.) Does one enterprise use the machinery more than the others? Considering the Labor Support Center, is one profit center more labor intensive than the others? Maybe Onions should pay 20% of labor, tomatoes are responsible for 20%, and corn should pay the remainder (60%). When deciding on an allocation scheme, the manager should first know what kinds of costs make up the support center. Larger costs should have more weight in the decision. Different criteria can be used for each class if the allocation is more realistic, but consistency over the years is important. Keep it simple. Examples of allocation criteria Machinery & Equipment is often allocated based on acres (if the machinery is used the same amount per acre). If a producer has 2 acres of cantaloupe, 4 acres of corn, and 50 acres for cattle, the criterion could be a modified per acre allocation. Since the crops use the machinery much more than cattle, the entire machinery cost may be allocated to the crops. Therefore, the cantaloupes would receive 2/6 (33%) of the total support center cost and the corn would receive 4/6 (66%). If the cattle do use some of the equipment, the allocations may be altered slightly so that the cattle share some of the cost, but most is still allocated to the crops. Labor is more difficult to allocate. The most correct way to absorb labor costs when hired employees work on all enterprises is to keep timesheets. Timesheets break down each day for an employee by enterprise. At the end of the year, the manager would total all labor hours and charge the responsible enterprises. However, this is not a realistic method of absorbing labor costs for everybody! L6.2
3 A manager can likely estimate which enterprises were most labor intensive. It is important that the manager consider the time frame the labor was employed if seasonal. Weekly timesheets might be an alternative if the manager does not have a good feel for how his labor dollars were spent. General and Administrative like utilities, taxes, and professional fees are charged to the G&A support center. This is the most difficult support center to allocate because there is no direct link to production. A per acre allocation can be used, but another good criterion may be based on total direct costs (before any allocations). For example, let s say an operation has $1,000 in direct expenses. Of this $1,000, tomatoes accumulated $250 for direct expenses, like seed and chemical. Corn accumulated $500 for direct expenses, and cattle accumulated $250. The allocation would be: 25% to tomatoes ($250/$1,000)*100 25% to cattle ($250/$1,000)*100 50% to corn ($500/$1,000)*100 Transferring/ allocating support center costs to profit centers Once the criteria are chosen, actually transferring the cost is simple. 1. Find the Allocation Worksheets section of this curriculum. 2. Fill in responsible enterprises. * Note that if an enterprise did not use any machinery, it should not share the cost responsibility. 3. Calculate monthly totals for the support center being allocated on the transaction log. 4. Determine the percentage of total based on chosen criteria (use allocation worksheets to aid in this process.) 5. Do calculations. 6. Take end calculations, respective of responsible profit center, and record on the income statement worksheet under the Allocations section. 7. Repeat for each support center until there all support centers are zero. After all costs are absorbed, enterprise analysis can begin. L6.3
4 End of Year Allocations Lesson Plan I. Purpose A. Provide some background on full absorption costing, including explanation of support centers. B. To teach the process of allocating or absorbing those costs not previously charged to the responsible enterprises. II. Descriptions/ Highlights A. The accounting format is step-up-accounting where income & costs are separated into centers representing how they should be absorbed by the products sold. Transactions that can be directly linked to an enterprise at the time the transaction is made should be immediately charged to a Profit Center. B. Before any allocations are made, all costs should be entered, including non-cash transactions like management labor and depreciation. These non-cash transactions should be recorded to the Income Statement Worksheets. 1. Management Labor is the amount paid to the owner/ operators of the business. Most producers do not write themselves a check specifically for labor; however, most do write personal checks out of the farm account, assuming there is more than one account. These personal checks written from the farm account can be considered payment. In other words, the transactions recorded in the Personal section of the transaction log can be considered management labor. If no personal expenses are paid from the business account, then an amount should be assigned. Remember, the owner s time IS worth something. What would it cost to hire someone to do what the producer does? After all, producers are usually farming/ ranching to make a living- not only because they enjoy it! 2. Depreciation is the cost of an asset, allocated back as a business expense over the economic life of the asset. L6.4
5 C. After all entries are recorded, it is time to allocate/ transfer costs accumulated to the support and cost centers. There is a specific process by which to allocate cost center and support center costs. 1. Support centers should be allocated first because both profit and cost centers are responsible for absorbing the support centers. For example, the Machinery & Equipment SC accumulates costs like tractor fuel, repairs, and depreciation. All profit and cost centers that use the tractors or other machinery represented should share in absorbing those costs. 2. Cost centers (if any) are absorbed next. Occasionally, one cost center is partially responsible for the costs in another cost center. For example, if a rancher keeps heifers from his calf crop, and the cow enterprise is set up as a cost center (keeps calves through stocker phase after weaning), then costs from the cow enterprise are transferred to both the stocker profit center and to the replacement heifer cost center. D. The allocation/ transfer process is simple once all transactions are recorded correctly. Logic is the most important tool in this process. The center being absorbed should be examined. 1. What kinds of transactions make up the center? 2. What is a logical criterion for their allocation? For example, if you were about to allocate the Irrigation cost center, you would think first about which enterprises benefited from the irrigation. Why are you irrigating? Is it to make your corn grow? Although your cows may also benefit from the irrigation after the corn is harvested (graze the stalks), the primary reason you have the irrigation is to make your corn grow. Would you have irrigated if the corn production were not affected? Certainly, you would not irrigate just so the cattle would have more stalks to graze! The corn should absorb all costs in the irrigation center. - To transfer costs from one center to another, record the entire accumulated amount of the center to be absorbed on the responsible center s income statement worksheet. L6.5
6 Then, record the same amount as a negative number to the absorbed center, thereby zeroing out that center. The only reason a producer should have a support or cost center where all costs accumulated there are absorbed by a single enterprise is in order to separate that information for further analysis. In our irrigation example, the producer may have wanted to know how much was being spent just on irrigation. Of course, this is assuming repair, fuel, utilities, etc. associated with irrigation can be segregated. Most often, we set up cost and support centers because those costs are not easy to charge at the time of purchase. For costs such as these, there are allocation worksheets to aid in the allocation process. Step 1. Determine the method and select the corresponding allocation worksheet. Step 2. List the responsible enterprises/ centers. Step 3. Fill in the criterion. Step 4. Do the math, and examine for reasonableness. Step 5. Increase the expenses, according to the allocation worksheet, of the responsible centers; zero out the absorbed center. (The net total effect is zero. You are simply moving the cost from one location to another.) ** Only Profit Centers should remain at this point; all other centers should have a zero balance. III. Potential Speakers A. Extension Agents B. Certified Public Accountants IV. Review Questions A. True or False. Businesses can be effectively managed from a whole-farm Income Statement. L6.6
7 False. Each enterprise must be evaluated individually before the business can be effectively managed. B. True or False. It is acceptable to have a balance in the support centers after all allocations are made. False. The support center should have a zero remaining balance. C. True or False. The same allocation criteria should be used to allocated all support centers of the business. False. Each support center may use different allocation criteria; the chosen criteria should be reasonable and consistent year to year for comparability. L6.7
8 End-of-Year Allocations Absorbing the Support Centers Overheads Introductions Effective management can only be accomplished if information is separated into responsible enterprises. The commodities being produced by the business must pay for the expenses generated by their production. The Transaction Log is designed to separated cash transactions by profit or support center. Those costs that can be identified with a commodity or enterprise should be recorded in the profit center section of the transaction log. The costs that benefit more than one profit center are recorded in the support center section of the transaction log. Once all cash and non-cash transactions are recorded to the Income Statement worksheets, the allocation process begins. Since the support centers are complete (all costs are recorded), they should be allocated first. Steps for completing the allocation process: Step 1. Determine the method and select the corresponding allocation worksheet. Step 2. List the responsible enterprises/ centers. Step 3. Fill in the criterion. Step 4. Do the math, and examine for reasonableness. L6.8
9 Step 5. Increase the expenses, according to the allocation worksheet, of the responsible centers; zero out the absorbed center. (The net total effect is zero. You are simply moving the cost from one location to another.) Record these transactions on the Income Statement Worksheets in the Non-Cash Transactions column on the Allocation of line. L6.9
10 End-of-Year Allocations Absorbing the Support Centers Case Application The Doe operation has 3 support centers, Machinery & Equipment, Finance, and Labor. Throughout the year, costs associated with each of these support centers have been accumulated on the corresponding transaction log form (cash) or directly to the income statement worksheet (non-cash). Total amounts to be allocated to the 5 profit centers are: Machinery & Equipment $5, Labor & Management $18, Finance $2, Mr. Doe decided to keep it simple and allocate support centers based on proportionate amounts of direct expenses. The direct expenses accumulated in the profit centers were those expenses that could be easily charged at the time of purchase, like seed, chemical, etc. (See the income statement on the Total Expense line, just above the Other Income/ Expense line.) Notice the following profit center direct expenses: Table 1. Total Expenses % Calculation % of Total * Cows $4,100 $4,100 / $7,508 55% Cantaloupe $1,210 $1,210 / $7,508 15% Corn $520 $520 / $7,508 7% Onion $440 $440 / $7,508 7% Tomatoes $1,238 $1,238 / $7,508 16% Total $7,508 $7,508 / $7, % * Percentages changed slightly to reflect reasonableness. The Doe s allocation worksheets are shown below. According to the Machinery & Equipment allocation worksheet, the M&E support center accumulated $5,619, of which $3,629 was noncash depreciation expense. The allocations were as follows: Cow/calf 55% = $3, Cantaloupe 15% = $ Corn 7% = $ Onions 7% = $ Tomatoes 16% = $ % $5, The above allocations result in the entire $5,619 being transferred to the responsible profit centers. Therefore, the remaining balance in the Machinery & Equipment support center is zero. L6.10
11 To illustrate how the income statement of each center is influenced, see the cantaloupe and machinery/equipment income statement worksheets below. Notice that $ is recorded in the Non-cash transactions column on the Allocation of M&E line as an increase of expenses on the cantaloupe worksheet. Each responsible enterprise s income statement was treated similarly. Notice also that the M&E worksheet reflects the total amount ($5,619) as a negative number so that the balance in the support center is reduced to zero. This process was followed for all support centers. Mr. Doe is a good manager and has carefully examined these allocations for reasonableness. The first thing he noticed was that the cattle received a very high allocation of machinery & equipment costs. Normally, cattle utilize equipment much less than crops, but Mr. Doe realized that he used a good deal of gas checking on his cattle and he made some repairs to his stock trailer. He also remembered that the shredder, hay bailer, hay trailer, stock trailer, etc. are primarily used by his cattle operation and a proportionate amount of depreciation should be charged to cattle. Mr. Doe also noticed the huge amount of labor expense ($10,117) his cattle must pay. Of the total expense charged to cattle, only $2,752 was due to hired labor (John Doe, Jr.) Family consumption (personal expenses paid by the business) can be thought of as management labor and resulted in $7,365 being charged to the cattle enterprise. See the Income Statement by Enterprise for a summary of total allocations to the profit centers. Notice that if the enterprises were evaluated without the allocations, each one would have reflected a profit. The onion profit center would have contributed $7,060 to the total farm profit of $11,061. If only the cash transactions were absorbed, the business would have had a profit of $1,709. Even without depreciation and management labor, absorption of all costs makes a difference. The table below summarized how the allocations, both cash and non-cash, affect each enterprise s net income. Table 2. Cow/calf Cantaloupe Corn Onions Tomatoes Total Income 4,836 3,400 1,333 7,500 1,500 18,569 Expenses 4,100 1, ,238 7,508 Profit/Loss 736 2, , ,061 Cash Allocations 5,144 1, ,496 9,352 Profit/Loss (4,408) ,405 (1,234) 1,709 Non-Cash Allocations 9,360 2,553 1,191 1,191 2,723 17,019 Real Profit/Loss (13,768) (1,766) (1,033) 5,214 (3,957) (15,310) L6.11
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