Accounting for inventory in any business is tricky and the cannabis business is no exception. For producers, processors and retailers like yourselves, it is the main driver of profitability.
I once had a client who owned a cookie business. She had a large market and her cookies were in high demand. Her sales were climbing, yet she was making less and less. When we delved into the calculation of her costs, everything seemed in good order. She had accounted for labor, materials, supplies, space, equipment, all of the “ingredients” to making her cookies. Each cookie cost $.79 and she sold them for $1.50, around a 47% gross profit. But as I investigated more, I discovered that she packaged the cookies in twos, so in fact the cost of her cookies was double what she thought, at $1.58. Selling them at $1.50 had her losing $.08 right off the bat and as her sales increased, so did her losses.
Now that may seem like a novice mistake for some of you. But you can see how a small mistake in calculating the cost of your inventory, could lead to disaster.
So what’s the secret to accounting for inventory in the marijuana industry? A complete understanding of everything that goes into creating the product that you sell. It’s different for each category of sales. A producer has to consider the cost of land or space where they grow plus seeds, water, nutrients, labor to maintain and harvest, packaging for sale. Can they include the cost to maintain an office where orders are taken and bookkeeping is done? Probably not. What about product testing or the cost of software to track the inventory? Absolutely.
Processors have a different set of costs. A producer of edibles must include the cost for each ingredient, the labor to produce the product, the cost of space and equipment, packaging for sale. What about the fee you paid for a booth to promote your product at a trade show? No, sorry, that can’t be included because it is not a cost that goes directly into the making of your product.
In theory retailers have it the easiest because they are not producing anything, they buy their products ready for sale. But many retailers repackage flower into individual or smaller quantities. If so, they need to capture the costs of repackaging to know what kind of gross profit they are making on sales. In addition, they often have a large variety of products, so understanding cost of sales in a retail setting is very challenging.
I keep referring to gross profit and it is an important term. Gross profit is simply your total sales minus your total cost of sales and is usually expressed as both a number and a percentage (cost of goods sold divided by sales). You want the gross profit number to be high and the percentage to be low. Gross profit is what is used to pay the rest of the expenses for your cannabis business.
Lastly, and probably most important of all, is that IRC Section 280E prevents the deduction of any expenses related to illegal activities for federal income tax purposes. Because marijuana sales remain federally illegal, this IRC section applies to all companies in the cannabis business. However, it does not preclude the taxpayer from deducting cost of goods sold. So the more costs you can reasonably justify as being partially or fully attributable to the total cost of your products, the less your taxable income will be.
Good inventory management systems can be a huge help in determining the cost of inventory, however even with the best of systems, it’s imperative that you have a thorough understanding of every cost related to inventory and account for each. Be sure to devote the time and resources to this important piece.