Accounting for cannabis inventory is essential for dispensary owners and retailers alike. This, of course, involves an effective and efficient POS system that offers costing methods for appropriate inventory valuation and management.
But what does accounting for cannabis inventory entail, exactly?
In this post, we discuss the 280E loophole, inventory valuation for a compliant inventory system, and cost of goods sold optimization.
What is the 280E Loophole?
If you’re in the cannabis industry, you’ve likely heard about the 280E loophole. 280E excludes normal business expense deductions from federal taxes for companies operating in the cannabis space.
So, what’s the issue here?
Well, this exclusion limits profits and makes accounting for cannabis inventory more complex than other operations.
With limited access to deductions and credits, some cannabis businesses must deal with an effective tax rate of as much as 80%. It’s easy to see why so many cannabusiness operators are looking for a 280E loophole. But equally important to keep in mind is that many of the Section 280E strategies you might hear about online are as risky as they are aggressive.
Costly infractions can come as a result of incorrectly allocating expenses into cost of goods sold and putting costs to non-plant lines of the operation. Some cannacompanies find themselves wrapped up in litigation over these practices, especially if they do not have a cannabis CPA handling their books on their behalf.
Managing Tax Liability & Attracting Investment
At Northstar, we optimize our clients’ tax positions with a firm understanding of tax laws. This involves improving inventory accounting and finance functions.
We establish consistent methodologies, detailed reports, and documentation to ensure our clients are always ready for an audit. Current cannabis accounting practices lead our efforts.
Through this approach, we address the 280E loophole while establishing a solid foundation to support long-term growth. Without this organization and expert accounting practices, tax liability remains high and it’s challenging for cannacompanies to attract investment.
280E Cost of Goods Sold FAQ
Business operators, including cannabis business operators, subject to Section 280E must check Sec. 471 to understand how to properly capitalize inventory and valuation methods, as well as how to allocate expenses and their impact on cost of goods sold. But you might have more questions.
Here’s a list of the most common questions we get asked about 280E cost of goods sold:
What is deductible under 280E?
Under 280E, taxpayers are not allowed to make deductions for a trade or business in which the operations are involved in the trafficking of controlled substances. Since cannabis is still federally prohibited, the IRS does not want to see business deductions that are related to this federally illegal activity.
Can dispensaries deduct expenses?
Section 280E of the Internal Revenue Code does not allow dispensaries to deduct expenses. This is because these operations sell a federally illegal controlled substance. Thus, any expenses that come about in the production, distribution, and sale of cannabis are non-deductible.
Does 280E apply to growers?
Every business involved in touching medical or recreational marijuana and its products throughout the supply chain are subject to 280E. This, of course, includes marijuana growers. While these operations might be operating in a state that has legalized medical or recreational cannabis available, 280E still applies to growers and other cannabis-related businesses because of the definition in place.
Since Internal Revenue Service code section 280E keeps cannabis businesses from taking deductions, depreciation falls under it, as well. For instance, if retail cannabis operations were allowed to deduct depreciation, they’d be able to deduct the depreciation of cash registers, leasehold improvements, shelving and display cases, and other assets.
Accounting for Cannabis Inventory Valuation
For cannabis retail, inventory would be classified into primary, secondary, and tertiary categories. Here’s how this works:
- Primary – Products bought to sell in the same form they were purchased. This includes cannabis buds, extractions, and seeds, along with other products.
- Secondary – Secondary products would include the products prepared on-site. This can be anything from edibles to pre-rolled joints and concentrates.
- Tertiary – Tertiary products would include anything one might use to administer medicinal or recreational cannabis. This could be lighters, THC extraction equipment, pipes, rolling papers, and more.
During inventory valuation accounting for cannabis inventory, we methodically determine the total cost value of all products in stock at any point during the business’s accounting period.
By assigning a dollar value to the goods in stock, we know what a portion of the company’s current assets is worth. This comes in handy when handling financial statements for the operation and encourages better decisions when considering the available funds.
Inventory sold gives the business more cash flow. This allows the company to replenish goods and maintain appropriate stock.
From there, we add the value of all sold inventory and all associated direct costs to get the cost of goods sold. Then, COGS subtracted from the total revenue offers the gross margin.
We track inventory metrics like gross margin because this offers a clearer assessment of the company revenue and how much is available to cover operational costs. This also allows us to explore strategies to increase company revenue as we work to maximize profits.
Inventory Costing Methods for Cannabis Businesses
Unfortunately, there’s no single inventory costing method that will work for every cannabis business. We must identify which solution will work best for the company.
Cloud-based inventory management systems leave a lot to consider. However, with cannabis inventory typically having an expiration date, these three methods usually work best:
- FIFO Method (First-in, First-out)
- LIFO Method (Last-in, First-out)
- WAC Method (Weighted Average Cost)
The first-in, first-out method of inventory valuation considers the items that were first put into inventory as those which will be sold first. Most of the time, we observe this inventory management technique being used in the food industry and other perishable goods sectors.
Through this technique, businesses sell the goods purchased first before selling the newest stock. Thus, this method ensures remaining stock will have the most recently purchased or made goods, which are then accounted for at their purchase cost and give us an idea of the current value of the operation’s inventory.
With this costing method, perishable cannabis goods remain fresh, allowing these operations to minimize waste resulting from spoilage. This also allows cannabis business operators to easily comply with state and local laws that regulate efficient seed-to-sale tracking and rendering of unsold products after expiry unrecognizable.
Since the cannabis industry is impacted by price volatility and the existence of its black market, the FIFO accounting method also gives small operations the ability to report lower COGS and higher net or gross margin by selling order (lower-priced products first followed by higher-priced products found in inventory). But for scaled operations that have higher-volume transactions, FIFO makes accounting for cannabis inventory challenging, which means the business may be better off using a simpler alternative method.
The LIFO method (last-in, first-out) opposes FIFO’s methodology. This involves selling the most recently bought goods first and allowing older goods to stay in inventory for longer. With this method, you increase storage costs, spoilage risks, and the overall cost of goods sold.
However, using the LIFO method of accounting while checking for cannabis inventory has its advantages. It’s good for those looking to reduce their taxes by reporting higher COGS and lower profit margins. This also comes in handy for businesses with a high inventory turnover, looking to avoid higher costs of efficient inventory management, and wastage.
But cannabis businesses rarely use this solution. Since cannabis products are usually quite perishable and can expire before being sold, the LIFO method results in more wastage and losses.
The WAC method (weighted average cost) is the most straightforward method for inventory costing. This method calculates the average value of all inventory in stock. It does not matter when the items were purchased or will be sold. To calculate the weighted average cost per unit, it’s only a matter of determining the total costs of goods in inventory and dividing that number by the total number of units.
High-volume sales and volatile prices make this one of the quickest and most efficient solutions for cannabis. This facilitates inventory management in instances where multiple strains or cannabis flower batches are combined to make edibles or concentrates due to the difficulty of calculating individual item costs. While using the WAV inventory valuation method, it’s crucial to consider seed-to-sale tracking to maintain compliance.
Cost of Goods Sold Optimization
The first thing we recommend for our clients is to consider setting up Inventory Control Standard Operating Procedures (SOPs). Initially, this will involve checking to ensure there’s enough inventory in stock to satisfy the demand. However, it’s crucial to avoid tying up too much money in your stock.
The following are the SOPs we like to put in place for our clients:
Purchasing Cannabis Inventory SOPs
Every week, the person in charge of purchasing must check each product to determine which ones are low in stock. Then, they order a month of supplies. Checking important inventory indicators should be included in this process to determine which products to order. If the products are aging or expiring, they should not be purchased. Or, those product purchases should be lessened significantly to minimize waste.
Consider the following for products that must be purchased each month:
- Lead time – Lead time shows how long it takes to receive the items in stock from the time the purchase order is placed.
- Safety – Safety described the absolute minimum number of days of stock for a specific product you’d like to have on hand.
- Projected monthly sales 30 – You’ll take your current inventory and multiply it by 30, then divide that number by your projected monthly sales. If this number does not equal or exceed the sum of lead time and safety, you’ll need to place a new order.
- Purchase budget – Your purchase budget equals ending inventory (safety x projected monthly sales/30) + projected monthly sales – current stock on hand
Receiving Cannabis Inventory SOPs
For receiving inventory, you’ll need to:
- Ensure that the amount and final price of the inventory being received matches the purchase order, stock receipt, and bill.
- Account for the stock and check the documentation to determine that the amount received is properly documented.
- Check the quality of each item to ensure they’re ready to be sold.
Cannabis Storage & Control SOPs
Cannabis product storage is essential for this space. These products must be stored safely and with the right temperatures to ensure freshness. This is where a regular cycle account comes in handy.
Each type of product should have an established cycle count. This establishes whether you’re experiencing a loss in inventory.
Poor inventory management policies typically contribute to inventory losses. For example, if your inventory is lost, stolen, or expiring constantly.
For cannabis storage and control purposes, you’ll have a team member perform a blind count of all inventory. Each product’s stock should be documented.
Inspections of the products is equally crucial. This involves checking to see which products will expire the soonest. These products should be the first to sell. Any products that are expired should be tossed and marked as a loss. Discrepancies should be reconciled and documented as a loss using the online inventory system in place.
Cycle counts should happen weekly. A KPI should also be in place to ensure inventory discrepancy remains less than 1%.
Security is equally important for cannabusinesses. Most of the time, security and cameras are enough to prevent theft. But if an operation needs to take additional precautions, having all staff sign a theft policy outlining what happens to people who steal can also discourage theft. Give your team the right to anonymously report theft, as well.
Cannabis Inventory Aging SOPs
We recommend doing an analysis of cannabis inventory aging weekly. A lot of the time, cannabis business operators will find part of their inventory is aged beyond 60 days. This means cash is tied up in inventory, and this isn’t reflected in the Profit/Loss statement but is in the Balance Sheet.
An inventory aging report will help to diagnose inventory issues. If the products are 60 days or older or close to their expiration date, they should be discounted to speed up the sales. If products aren’t selling fast enough, they should be removed from the inventory and the next order should request less.
Here’s a list of strategies we recommend for eliminating aging inventory:
- Offer discounts on aging inventory – This strategy should involve gradually discounting products to ensure they’re not a complete loss. For instance, products one month old can have a 20% discount and products 2 months old can have a 40% discount. The discounts should be more enticing as the products grow nearer to their expiration dates.
- Adjust the location of aging products – Repositioning your aging products to ensure more visibility can help them get sold before they expire. Try having them in a few different places throughout the operation. Many businesses will put these items at the register for an easy grab.
- Plan a sales event – Planning a flash sale event can help move aging products rapidly. These sales encourage quick sales through urgency, which can result in customers buying products that they might not have thought of trying in the past.
- Discount aging products – This strategy works, but it’s important to discount gradually.
- Offer items for free – Free cannabis products encourage customers to buy products, too. So, while you might be giving your products away for free, some customers will outright purchase other products during their visit. Keep in mind, this will not work in states that don’t allow businesses to give away cannabis products.
Closing on Accounting for Cannabis Inventory
Inventory accounting is a crucial part of managing any cannabis operation. The right tools and technologies should be used to ensure you’re having accurate estimations on all inventory levels, as well as aging reports that signify what’s been sold and the money made from the sales.
At Northstar, we’ll help your operation succeed while accounting for cannabis inventory. Contact us now to learn how we’ll scale your operation’s profits with proper inventory management SOPs and practices paired with financial services.