ArchivesCannabis Archives — C. Lynn Northrup, CPA, CPIM
Tracking and managing the cost of growing cannabis is essential to maximize profitability. You are flying blind when the cost of growing cannabis isn’t matched with the yield harvested. Cost accounting can be confusing plus most cannabis business owners haven’t had the benefit of cost accounting training. Our objective is to explain, document, and clarify the steps required to develop good cannabis cost data.
Cannabis costs that should be tracked include:
- Labor required to grow and produce saleable product.
- Raw material including seeds, clones, and grow supplies.
- Grow equipment including lights and a hydro system.
- Cost of lighting.
- Packaging supplies.
These are direct costs and will be variable with growing and harvesting of cannabis products.
Direct costs of production results in more effective cost measurement. Inclusion of overhead costs using complicated allocation methods can produce misleading results. A direct cost approach captures just the variable costs of production and excludes selling expenses, office supplies, rent, marketing, and administrative costs. For the purpose of determining yearend inventory valuation allocation of overhead costs could be necessary depending on the valuation methodology that is used.
This direct cost approach should track the progress of production (grow) in specific units broken down into steps to match the cycle of the growing and harvesting process. Your grow schedule might look something like the following:
|Flowering||8 – 9 weeks||64|
|Harvest||1 – 3 days||3|
|Curing||1 – 2 weeks||14|
|Trimming Ready for Sale||5 days||5|
It is important to realize that plants in the cultivation process will have different maturity dates. Accordingly, tracking the progress of your production should be done using specific and consistent equivalent units of measure. In order to keep it simple, use an average yield per plant. Using this metric, you can convert your plants into equivalent units based on the stage of growth or percentage of maturity. Cultivation should be converted into equivalent and measurable units for the average yield per plant which can be used to measure your actual yield.
Assuming that one plant yields .5 pound in equivalent units at harvest maturity, this metric can be used to determine the expected yield for the entire cultivation. This is where you utilize the grow schedule to determine the number of plants at each stage of the grow process. Here’s is what it might look like:
|Plants||% of Completion||Equivalent units||Yield/ LBS.|
|Trimming Ready for Sale||30||1.0||.5||15|
|Total Current Yield||60||78|
If your total direct cost of per pound of yield is $1,000 then your existing inventory cost has a value of $78,000. This is an accurate way of tracking costs as it addresses only the costs of cultivation that are variable and excludes allocation of overhead.
Under ideal conditions, a cultivation can expect a yield of 500 grams or 17.5 oz. of marijuana per plant. This assumes that adequate space (6.5 feet), water, nutrients, and effective control of pests and diseases. Containers need to be 15 gallons in size for indoor cultivation.
This process can be utilized for keeping metrics on yield produced from your cultivation together with the direct controllable costs of production. The yield in pounds per plants and associated costs can provide a foundation for effective management and is one way to monitor efficiency of the cultivation.
According to the IRS pursuant to Treas. Reg. 1.471-11, cost of goods sold for producers includes direct material cost, e.g., marijuana seeds or plants; direct labor costs, e.g., planting, cultivating, harvesting, sorting; and indirect costs. Indirect costs may include repair expenses, maintenance, utilities, rent, indirect labor and production supervisory wages, indirect materials, tools, and cost of quality control.
Other Factors Impacting Yield
Light, nutrients, and genetics are all major factors that determine and affect cultivation yield.
Light can be measured in grams per watt providing an accurate measurement of production quantity as well as profitability. This measurement considers the amount of energy (watts) used to produce a gram of product. The higher the production output per watt, the greater efficiency that is produced. The calculation is determined by multiplying the total yield in grams times the total draw in watts to determine grams per watt. Square footage is also an important factor in determining efficiency and potential profitability. Therefore, yield per square foot is an important metric. It should be noted that some strains will yield varying amounts making it important to measure the yield per strain. Nutrients are another factor in determining yield and developing yield measurements compared to the cost of nutrients can help determine the most efficient combination to produce the best yield. Finding the best combination of yield measurement will be a process of experimenting to find the best combination of all the factors that produce the most efficient and profitable yield results.
Managing and valuing inventories in cannabusinesses is the key to increasing cash flow and lowering taxes. Cannabusinesses are restricted to reducing gross revenues by the cost of goods sold because of IRS Section 280E. Section 280E was enacted in 1982 and provides that no deduction or credit is allowed for any amount paid or incurred in carrying on a trade or business consisting of the trafficking in controlled substances within the meaning of schedule I or II of the Controlled Substances Act. The only way cannabusinesses can reduce their tax burden is by maximizing cost of goods sold (COGS).
The tax laws and regulation associated with cannabusiness are complex. Understanding these complex laws and regulations makes the job of valuing inventories and determining COGS of cannabis businesses a challenge. This is compounded by the cannabis industry being a collection of complex processes and types of businesses.
Cannabusinesses include cultivators or growers that grow plants and then harvest the flower from these plants. In addition to selling flower, it can also be processed into a variety of marijuana infused products (MIPs). Marijuana infused products are created by extracting distillate which is then infused into other cannabis products such as vape cartridges, edibles, topicals, wax, and shatter. These products are then packaged and sold through dispensaries. The tax laws and regulations for determining COGS and inventory valuation for growers and MIPs are different for dispensaries.
Cultivation or farming of cannabis needs to track the flower yield from indoor and outdoor grows measured in grams to develop a cost for the harvested flower. Marijuana infused products are the result of process manufacturing operations creating multiple varieties of products requiring different types of packaging. Costs are developed based on the recipes for these products, including packaging.
These products are then sold and distributed to dispensaries for ultimate resale to the consumer. Dispensaries, in many cases, are required to inspect, repackage, and check the quality of products before they can be sold to the consumer.
Most cannabis businesses are using Quick Books to accumulate costs supplemented by spreadsheets to calculate yield and the cost of distillate. The costs of cultivation and marijuana infused products include direct labor, material, and allocation of overhead. Allocation of overhead should be based on guidance from Section 471 and Section 263A of the Internal Revenue Code. It is critical to determine any allocation of overhead to be included in COGS in compliance with IRS codes and regulation, but also to maximize costs that offset gross revenue.
Accounting for cannabis products needs to be accurate. In some cases, ERP (Enterprise Resource Planning) systems are being utilized by larger operations. Dispensaries determine cost based on the actual cost of products purchased and associated freight. Inventory tracking is required, and many dispensaries utilize point of sale systems and inventory management systems to control and manage activity.
Based on my experience, managing and controlling inventory costs and the associated investment is one of the most challenging and critical areas of cannabusiness. First, inventory investment requires a significant cash investment. This makes effective purchasing and inventory management vital. Second, accurate and maximum determination of COGS reduces the tax burden created by IRS Section 280E. This means that inventory costing and management should be a top priority for all cannabusinesses and their accountants.
Utilization of professionals who understand cost accounting and the unique taxation requirements of the cannabis industry represents the key component to success or failure.
The IRS recently published guidance to provide cannabis businesses insight regarding compliance with IRS regulations. Major questions have been raised regarding Section 471 (c) which allows small business tax payers with revenue under $25 million to adopt the cash basis of accounting and prepare the books and records in accordance with the taxpayer’s accounting records. This seemed to open the door to modifying how cannabis businesses recorded cost of goods sold to minimize the impacted of Section 280E. Changes in Section 471 (c) resulted from the Tax Cuts and Jobs Act of 2018.
Section 280E disallows all deductions or credits for a business that sells or otherwise traffics marijuana. However, Section 280E does allow businesses to reduce its gross receipts by properly calculating cost of goods sold. This means that advertising or selling expenses are not deductible.
The guidance under Section 471 (c) according to the IRS is that it is just a timing provision and would not permit a taxpayer to recover a cost that it would not otherwise be permitted to recover or deduct for Federal income tax purposes solely by reason of it being an inventory cost. We’re not sure if this works and there could a conflict with Section 471 (c). This is a new regulation and is the IRS opinion on the application of Section 471 (c). They are adding Internal Revenue Code “flush language” via a regulation which is the opinion of the Internal Revenue Service.
I work with multiple cannabis businesses and have spent a considerable amount of time dealing with Section 471 (c) and how to apply it. The regulations say that qualifying businesses may choose to treat its inventory as reflected in the taxpayer’s books and records prepared in accordance with the taxpayer’s accounting procedures. If a change in accounting was made to adopt the new regulations, a Form 3115 is required to be filed outlining the changes.
A taxpayer taking the Section 471 (c) approach contrary to the regulations should consider disclosing any position that could be inconsistent with the new regulations. A disclosure should be made by filing a Form 8275R with the tax return. Determining cost of goods sold for cannabis businesses can be complicated and should be based on cost accounting logic. Cannabis businesses and their tax advisors should consult with someone experienced in these areas when applying these regulations.
IRS guidance has indicated that the growth of the marijuana industry will warrant increased tax compliance efforts. Accordingly, extreme care should be taken when developing and preparing cannabis tax returns based on the recent IRS guidance.