How to Legally Maximize Your Clients’ Tax Benefit: An Introduction to Cost Accounting for Cannabis/CBD/Hemp

cost accounting gaap Mar 05, 2021

Cost accounting is essential for proper Cannabis and CBD/hemp accounting and tax; however, if you are not doing cost accounting correctly (or at all), your clients could be missing some benefit under IRC 471-11 and paying too much in taxes. On the other hand, if you claim a significant amount of costs allocated to inventory (and eventually COGS) incorrectly, your clients could end up in hot water when audited, and potentially owe thousands of dollars in back taxes, interest, and penalties.   

Two tax codes make cost accounting imperative for your clients: 280E and IRC 471. 280E prevents Cannabis companies from deducting business expenses because, federally, they are trafficking Schedule 1 controlled substances. CBD and hemp aren’t subject to 280E, but must still comply with IRC 471. IRC 471 classifies which costs can go into inventory (and what cannot be allocated as an inventoriable expense). These costs will eventually be categorized as Cost of Goods Sold after the product is sold, and if done correctly, you can help legally lower your clients’ taxable income.

The Importance of Cost Accounting in Cannabis/CBD/Hemp 

Cost accounting is the practice of documenting, analyzing, and categorizing the costs of producing a good or delivering a service. Cost accounting requires consideration of both fixed and variable costs, as well as direct and indirect costs.

Business owners, management, board members, and investors use the data derived from cost accounting to run the daily operations of their business and plan for the future. With properly managed books, these decision makers can determine product profitability and accurately predict future cash flows. Cost accounting is also required for financials to be GAAP compliant, which will add value if (and when) the company is audited, subjected to the due diligence of lenders and investors, or strategically merging and/or exiting.

Most importantly, if the cost accounting is done in the recurring financials and in compliance with GAAP inventory accounting, IRC 471-11 allows for more costs to be allocated into inventory, which means lower taxable income for your clients, after those products are sold.

How To Do GAAP and Tax Cost Accounting in These Industries

Ultimately, cost accounting is a process to move costs between various trial balance accounts to correctly account for inventory and COGS, and thereby better understand what is happening in a business. With cost accounting, you can use rational allocation methods to attribute certain parts of an overall monthly expense into inventory (work In progress (WIP) and finished goods (FG)),  and eventually into COGS. Remember, all COGS costs start in inventory until the product is sold.

For example, if a company spent $8,000/month on electricity at a farm for indoor lighting, without cost accounting, you would just see “electrical expense” on the P&L (profit and loss) at $8,000/month. With cost accounting, the “electrical expense” may be documented as only $1.600, with the remainder of the cost being distributed according to where the electricity is used on the product in different parts of the supply chain. $3,200 might go into WIP, with $1,600 in FG and $1,600 in COGS.

To begin categorizing the different expenses of your clients, you will need to evaluate each of the many costs on the trial balance and determine if it’s a fixed cost or a variable cost.  The next step is to determine an appropriate allocation method and amount for each account.

Fixed costs are monthly expenses that must be paid, whether your clients produce millions of products or none. This could include rent, other lease expenses, or interest on business loans.

Variable costs are expenses that vary based upon production level. This could include raw materials, machinery costs, and labor. Variable costs are positively correlated to the number of units or the extent of the services offered; if a higher number of goods are manufactured, there will be a higher cost associated with the supplies and labor required to make those products.

What Does it Cost to Grow A Plant?

Understanding exactly how much it costs to grow a pound of Cannabis or CBD/hemp is essential to complete proper cost accounting for cultivators and growers. 

Common costs that partially or fully belong in inventory, and eventually COGS, include:

  • Direct labor
  • Indirect labor
  • Direct materials
  • Rent
  • Utilities
  • Security
  • Maintenance and repair
  • Small tools

Other “non-financial” data must be also collected each reporting period to do accurate cost accounting. This includes:

  • Inventory counts
  • Full cycle time for each strain (planting, veg, flower, harvest, dry, cure, trim, lab testing, packaging, ready for sale, etc.)
  • Percentage completion based on full cycle time for each plant and strain at each report date
  • Estimated yield per strain
  • Equivalent units of WIP, FG, and COGS
  • Allocation percentage for each cost on the trial balance that relates to production or manufacturing

Once you identify what kind of expenses your client has, you will need to find a rational way to allocate each of these costs to the proper categories each month. For example, rent might be allocated based on the percentage of square footage used in production and indirect labor might be allocated based on the actual time worked by a person in production. If you were to assume the indoor grow space was 60% of the total facility size, you could allocate 60% of the price paid for rent to inventory and COGS (i.e. with a $20,000 per month rent, $12,000 could be allocated to inventory and eventually to COGS according to IRC 471-11). 

What Does It Cost To Manufacture A Product?

For your manufacturing clients, it is crucial you correctly determine the cost of whatever is produced. For some companies that means understanding the cost of a gram of THC or CBD oil; for others, it’s breaking down the cost of components in an edible gummy bear or a hand cream.

Each inventoriable product will have a “bill of materials” (BOM), which is a detailed list of all raw materials, parts, assemblies, and necessities required to create a good.

Manufacturers will have many raw materials costs, plus assembly costs and allocated overhead. Assembly is often quick, so there is often very little WIP and mostly RM and FG at period end. You should track costs on the trial balance, and at the end of the month you can allocate costs to WIP, FG, and COGS using equivalent units. If there are many products manufactured, you might need a manufacturing inventory software to build and track product costs.

The IRS is aware that proper cost accounting is not being completed by many businesses in these green industries. Poorly maintained books and a lack of compliance could have severe consequences for your clients. However, if you correctly execute GAAP cost accounting for inventory in their recurring financials, the day-to-day operations of your clients will be improved, and their future forecasting will be more precise. Additionally, the businesses’ books will be appropriately prepared for IRC 471-11 at tax time, allowing for the minimization of taxable income in accordance with 280E. 

DOPE CFO has streamlined the process to complete this imperative and complicated part of Cannabis and CBD/hemp accounting, and compiled the tools, workpapers, skills, and processes required to provide this valuable service to your current and potential clients. 

Ready to level-up your cost accounting abilities to better serve Cannabis or CBD/hemp clients? Ask us how to get started today.

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