I am a member of the ranching community, so this article’s purpose is to empower ranchers on the business side of ranching. Financial institutions require ranchers to submit financial statements. There are two main important financial statements, the balance sheet and the income statement.
Inventory, supplies, and Cost of Goods Sold (COGS) are terms used in accounting. Most everyone is familiar with the terms inventory and supplies. COGS is somewhat vague. All three of those terms refer to items used and paid for, in your business. When you purchase a bale of hay, or a load of hay, which of these three terms should be used. The correct answer is, with inventory and supplies, it depends. COGS is always used with inventory.
Inventory
Inventory refers to items to be sold, or used in the manufacturing process, by your business. Inventory items are not expensed when purchased. Normally, inventory goes into a storage area for safe keeping. Note, inventory to be sold, means items that are purchased by your business and sold to another business. Items that are purchased by your business and used by your business are not inventory, but prepaid supplies. If your business uses items in the manufacturing process, for items to be sold, those items are considered raw material inventory. Inventory items are expensed when sold. Inventory items are charged to a revenue stream.
Supplies
Supplies are items used, or consumed, by your business. Supplies are not directly traced back to a product. Supplies may, or may not, be expensed when purchased. If supplies are purchased in bulk and stored for safe keeping, those supplies are considered as assets and thus classified as prepaid supplies and not inventory. Supplies are expensed when used. As supplies are consumed they are expensed to overhead.
Cost of Goods Sold (COGS)
Cost of Goods Sold are items purchased for resale. When inventory is finally sold and expensed, it is expensed to COGS. There is a matching revenue account. The net difference is “Gross Profit”. Supplies are expensed as used. Expensed supplies are considered part of your overhead. COGS is paired with inventory and not supplies. Note, overhead expenses are not COGS. For cost control purposes, it is far better to classify items as inventory rather than supplies. Do everything possible to keep overhead down. Feed should be a reimbursed cost and not overhead. COGS is an account used when items, opposed to expenses, are purchased that will be totaled and expensed later, when sold. Cost and expense are not the same. A cost is an asset. An expense is an expense. The purchase of a new truck is a cost. The purchase of fuel, for that truck, is an expense. When a gas station purchases gas to resale that is a cost. When that gas station pay the electric bill that is an expense.
Perspective
Now just to let you know, I struggled with these three terms, from the expense point of view. I always thought when a check was written, that was to pay for an expense. That is not true. When a check is written for Inventory that is just an exchange of assets. Both your checking account and inventory are assets. Asset accounts do not involve your temporary accounts, which are revenue and expenses. Now, when a check is written for supplies that may or may not be an expense. It depends if your supplies are prepaid supplies, an asset account, of something you use right then.
Merchandising, Service, or Manufacturing
Business entities are classified as, merchandising, service, or manufacturing. Some businesses fall into two or all three of these classifications. The ranching industry is very complex. There are many different types of ranching operations. Many ranches fall into the service and manufacturing business classification.
Cattle buyers that go to a livestock sale barn, CattleRange.com, or other marketing sites to purchase cattle wholesale and sell retail, would be classified as a merchandising business.
Many ranchers do custom work for their friends and neighbors. Custom work is classified as a service business.
The cow/calf rancher is classified as manufacturing. Those ranchers raise calves to sell. The general public may not realize it, but there are significant input costs involved in raising calves. These input costs are part of the “Work in Process” (WIP). As the calves are sold the WIP account is transferred to a COGS account. Some ranches raises heifers or bulls for sale to other ranches. There is a process involved in raising animals. Part of the process includes feeding. That feed would come from inventory. Some ranches raise stocker cattle. They purchase the weanlings small, feed them for several months, then resale them. Once again, there is a process involved. The maintenance costs for those animals should not be expensed until they are sold. That feed would come from inventory. Both of these examples involve a process.
In this example, no process is involved. Some ranches keep Longhorn steers on their ranch for tax purposes and they like the way they look. There is no revenue stream for those Longhorn steers. The maintenance costs for those permanent fixture steers should be expensed. That feed would come from prepaid supplies inventory and expensed as fed or expensed when purchased.
Fly Spray Example
For a practical understanding, let’s take the case of fly spray, purchased in bulk and stored in the barn, is a prepaid supply. The fly spray I keep in my truck is an expensed supply. Finally, COGS does not involve writing a check. When I take a bottle of fly spray from my prepaid supplies, I charge it to WIP (Work in Process). WIP is also an asset account. The fly spray cannot be expensed directly to COGS – Calves, because it will be months before the calves are sold. When the calves are sold, the WIP account is transferred to the COGS – Calves account. By charging the fly spray to WIP, I am able to keep it off overhead and can finally expense the fly spray to the COGS – Calves account when the calves are sold.
Work In Process (WIP)
I have several COGS accounts: COGS – Calves; COGS – Heifers; COGS – Yearlings; and COGS – Bulls. Each one has a matching WIP account. The purpose of the WIP account is to keep a running total of all the items charged to each perspective account. As animals are sold, the prorated amount is transferred to the appropriate COGS account and expensed at that time. Remember, Gross Profit is the net of the animal’s sale price and that animals COGS. Remember, variable costs for the animal go from WIP to COGS. Fixed costs are part of your overhead and are subtracted from your total Gross Profit.
Capital Gain v. Ordinary Income
I don’t charge any variable cost items to cows because cows are not a revenue stream. Whenever I do sell a cow, which is considered to be selling a fixed asset, resulting in a capital gain or loss depending on the difference in the book value and the selling price. That capital gain is not ordinary income. My calves, heifers, yearlings and bulls are current assets and the selling of those is ordinary income.
Input Costs to Raise Calves
So, what about calves? Ranchers know that the cow is responsible for raising her calf. Cow maintenance includes both variable and fixed costs, such as pasture lease, feed, herd health, mowing, herbicide, fertilizer, and water. Is the maintenance costs, of the cow, considered an overhead expense or part of the manufacturing process? Theoretically, the cows are manufacturing the calves, which will be sold before the year is up. Thus, any variable costs to maintain the cow should be charged to the calf. Also, the costs should not be expensed until the calves are sold. When the calves are sold, all of the costs put into those cows and calves should the expenses as COGS – Calves. The difference between calves proceeds and COGS is your Gross Profit. FYI, variable costs are costs that can directly be tied to the cows or calves. Those variable cost are expensed to, COGS – Calves. Fixed costs are costs that are not directly tied to the cows or calves. Fixed costs include items like depreciation, electric bills, pasture lease payments, etc. Fixed costs are considered overhead. Overhead is subtracted from Gross Profit. Variable costs like truck expenses, pasture herbicide and fertilizer, fence construction or repair, water line repair, cannot be directly tied to the cows or calves, and thus are considered overhead.
Maintenance costs for open cows, in the herd, are also expensed when the calves are sold. Open cows have all of the same variable costs as wet cows with calves, but no revenue. Remember, Gross Profit is revenue less cow/calf direct variable costs.
Conclusion
To have a successful ranch, proper costs tracking is important. Understanding the difference between inventory, supplies, and COGS is a must. Ranchers profit margins are small and expensing everything to overhead is just plain lazy. A lot of ranchers are subsidized by various other sources of income and think they are making a profit when in reality they are not. Ranchers love what they do and will continue until they go broke. Don’t be one of those ranchers who finally realize you can spend it all. Keep your ranch sustainable for your family and future generations.
Brett Bickham, Oct. 2020
Rule Accounting
Clifton, TX