“Good enough” cost accounting

Jul 17

If you have read or listened to anything at all about winery cost accounting, you have probably heard it said: "If you don't know the true cost of your wine, how can you know how to price your wine?" Or maybe, "If you don't know the true cost of your wine, how can you know if your winery is profitable?"

My sense is that these are questions that keep accountants up at night, but not business owners.

In my experience working with winery owners, what I have witnessed is this:

The art of pricing has very little to do with "the true cost of your wine."
Winery owners are much more concerned about cash flow than any profit number shown on a financial statement.

The price of your wine is not determined by the cost of your wine.

Allow me to draw a parallel with accounting firms.

In the world of accounting firm owners, there is some controversial discussion about timesheets. Staff hate them. Firm owners cling to them. Thought leaders question their value.

Generally speaking, modern firms are moving away from billing their client by the hour and are moving towards fixed pricing, or what's called value pricing. This leads naturally to the question: If we are no longer billing by the hour, then is it also time to get rid of timesheets?

One reason that some firm owners are reluctant to let go of timesheets is that they want to use the time data to calculate out what it is costing them to deliver on each project or client. They want to make sure that each client is profitable, and exactly how profitable.

Ron Baker, author of Implementing Value Pricing and many other books on pricing, argues that the question should not be: "What is it costing us to serve this client?" But rather the question should be: "How much money did we leave on the table?"

We intuitively know who our best clients and worst clients are. If we are using fixed pricing, we generally know which clients we priced too low and which we priced well.

In other words, if we want to optimize pricing we should be asking about the value delivered and what the customer is willing to pay—not getting lost in the weeds of cost accounting.

In many ways, timesheets in the accounting industry are the equivalent of "true cost" accounting in the wine industry.

The difference is that winery owners are not accounting firm owners. When left to their own devices, winery owners generally avoid the weeds of cost accounting because, well, they are winemakers and not accountants.

Winery owners know intuitively that doing the cost accounting work will not help them price their wine. They do not wait for their accountants to sharpen their pencil and model out all the costing data so that they can then add a carefully determined standard markup percentage based on desired profit margins...and then slap the result on the price tag.

My experience has been that winery owners generally follow their nose, use their intuition, and implement value pricing principles naturally. Winery owners set prices based on the quality of their product and what the market will bear.

In fact, in many cases, setting a higher price on a particular wine is part of the way that winery owners communicate the value of the wine to their customers. Pricing the wine is actually part of how the value of the wine is created in the eyes of your customer.

Granted, I am speaking here about boutique wineries who make premium wines and sell them directly to customers. If your winery's business model is built around three-tier distribution and having the lowest price point possible, then there is a much greater need to examine the costs. By contrast, boutique winery owners are usually pursuing a strategy of limited product, unforgettable customer experience, and premium pricing.

"Good enough" cost accounting

I am not arguing that wineries do not need to know the overall gross margin they are getting from wine sales. I am only arguing that you do not necessarily need to calculate the gross margin on every individual SKU nor even on every individual vintage. You do not necessarily need to know the gross margin on your white wines versus your red wines. You do not need to know the gross margin on using one type of tank versus another.

You know intuitively how you want to balance your portfolio of reds versus whites, this varietal versus that varietal. You know intuitively which wines are more expensive to make.

The child psychologist Donald Winnicott famously made the argument in favor of "good enough" parenting. In the same way, I want to make the argument for "good enough" cost accounting.

The cost-benefit analysis simply does not come out favorably when small winery owners try and follow all the rules of GAAP in their cost accounting.

Why is cost accounting for wineries so difficult?

"True cost" accounting for wineries is notoriously difficult. The difficulty comes from several things. The multi-year production cycle is probably the most complicating factor. But there is also the fact that wine lots are not kept distinctly separate due to blending and topping... How much cost do you assign to the pinot noir vs the pinot noir rose? Even if you can keep track of the direct materials assigned to each lot, what about the cost of production labor? How is that assigned to various lots? What about other cellar costs, such as lab and analysis, additives, supplies, barrels, winery equipment, utilities, etc?

It's important to note that cost accounting is a process of modeling. It is not something that can be directly measured. You can measure directly how much cash you spent on purchasing grapes in a given year. But it is an exercise in modeling to determine the cost of the "juice" that goes into each bottle of finished wine, and then the total cost of that bottle once packaged and ready for sale. The model depends on multiple variables, operations on those variables, and the order in which those operations are performed.

It’s not simple.

At this point, you might be asking: If "true cost" accounting is not worth your time (or your accountant's), what's left? Do I need cost accounting at all? Can I just write of all my costs as incurred and call it good?

Unfortunately, no.

The IRS requires that you put a dollar value on your inventory.

The IRS requires that you report the value of your inventory on your tax return. This is true even for wineries that meet the revised small business threshold (currently at $26 million per year in sales). You cannot simply deduct all of your grape and bottling costs as expenses in the current year.

The IRS requires that you use a method of accounting that clearly reflects your business income. If you did not report any inventory value, you would be missing a key asset on your business's balance sheet. Not reporting this asset means that you would be overstating your expenses and therefore understating your income (and understating your tax liability). This is a situation the IRS wants to avoid.

To make life a bit easier on small business owners, the IRS has simplified what needs to be included in the value of inventory. For businesses doing under $26 million in annual revenue, you are allowed to use the “non-incidental materials and supplies" method of inventory costing, under Section 1.162-3 of the internal revenue code. This means that you do not need to fully "load" your inventory. You can include only "hard" costs: grapes, bulk wine that you purchased, bottles, corks, and other packaging. You do not need to worry about "full absorption costing"—where all of the indirect costs are allocated into your inventory.

Capitalizing only direct materials costs to inventory is the first step to simplifying your wine costing process. The second step is letting go of the notion that you need to cost out each wine lot and SKU separately. We use a simplified costing method based on average costs that eliminates the need to track individual wine lots while still meeting IRS requirements.

This simplified method provides an overall gross profit margin percentage that you can use to make decisions about your winery's financial model and answer a few key questions faced by winery owners:

Can I keep my operating costs within my overall gross margin?
Do I have enough capital available to get the flywheel turning? That is, to make several vintages of wine and build up my inventory so that I can have the product I need to make the sales I am planning for.

Neither of these questions is answered by "true cost" accounting.

A few other thoughts

Even though it is not required by the IRS, there are times when it makes sense to include more than just direct materials in your inventory value.

First, it is common practice for a bank to offer a winery a line of credit based on the cost value of their inventory. If you want to achieve the maximum credit line, you will want your inventory value to be as high as possible. This means including indirect costs and production labor in your inventory value.

Likewise, if you are in the process of selling your winery, you may want to make your balance sheet as strong as possible. Again, this means including all possible costs in your inventory.

In both of these situations, you are delaying posting costs to the profit and loss statement. This means that the net income shown on your financial statements will be higher. This is good when looking for a loan or planning an exit strategy—and not so good at tax time.

It is possible to create a book-to-tax adjustment so that lenders and other viewers of financial statements can see the full value of your inventory and yet you are still maximizing your tax situation.

And, yes, it is possible to include these costs in inventory while still using our simplified, average-cost approach.