Determining Inventory Costs for Your Cannabusiness

Since Bridge West started working with cannabis and hemp companies in 2009, one of the most challenging accounting and tax issues has been determining inventory costs.

Determining the cost of inventory is a very complex and difficult accounting and tax issue for most operators because there are no legacy cannabis accountants to guide clients in calculating accurate inventory costs.  This issue becomes even more complex for vertically integrated operators because there are potentially three types of accounting methods in one business: agricultural accounting for the cultivator; manufacturing accounting for the processor; and retail accounting for the dispensary.

Because most states have mandated inventory tracking software, new operators typically don’t think about using an integrated ERP system that tracks both financials and operations, like a typical manufacturer would. As a result, accountants need to merge financial data with production data.

At Bridge West, we have reviewed many cannabis and hemp companies’ financial statements and/or tax returns.  Below are examples of different methods that we have seen used in determining costs for the following type of operators:

• Cultivator – (a) plants have no value regardless how many plants are in the grow. This is because the Company can’t legally sell the plant therefore, it has no value; (b) plant values are calculated based on an estimate of how much yield will be generated from the plant and an estimated cost per gram of yield; and (c) the cost of the yield is calculated by operations on certain cultivation costs which does not include all indirect costs.
• Processor – (a) the operator will develop a Bill of Material (BOM) for each product using standing costs without regard to actual production activity or labor / overhead costs; (b) product costs are determined by discounting the retail price by a margin to be realized; and (c) no inventory costs are applied to inventory quantities at all.
• Dispensary – (a) cost is determined by discounting of the retail pricing by the expected margin; (b) a Bill of Material (BOM) is developed for each product, using standing costs without regard to actual production activity or labor / overhead cost.

Unfortunately, none of the above costing methods will accurately calculate your inventory costs, which means your companies’ total gross margin and gross margin by product is unreliable.  Understanding your gross margin is key to the success of your cannabis or hemp company.  Also, most of the above methods have not held-up to various IRS or State income tax audits.

Bridge West has handled some IRS audits for clients that had previously their tax return prepared by someone else and were notified that their taxable income was understated because of too low or no inventory value.  The penalties were significant.  In other situations, where we reviewed tax returns prepared by other firms that had identified this issue, we spread the understatement over a four-year period by using Section 481 adjustment.

We have seen significant progress in ERP systems for the cannabis and hemp industries that can provide better Supply Chain Management, as well as, a fully integrated accounting system.

If you have questions or would like to learn more about determining inventory costs in the cannabis industry, contact Cory Parnell at cparnell@bridgewestcpas.com.