Inventory Accounting - Part 3
In our last 2 articles we discussed why accounting for inventory is necessary and that the accrual basis of accounting is the best practice for the cannabis producers. In this installment, we'll discuss some practical benefits of accounting for inventory as well as some of the issues in doing so.
Accounting for (and therefore tracking) inventory through the production cycle through processing and then to the point where it is a salable (finished goods) product helps management better understand costs to produce specific cultivars, how much inventory is in a particular stage, how much money is tied up in inventory and how long it takes to be sold. This allows management to make better decisions based on real data rather than a gut feel or guesswork.
How Do You Arrive at a Value for a Unit of Inventory?
How do you ultimately determine what it costs you to produce one 500mg vape cartridge if you are growing and manufacturing your own products? While accounting for inventory appears simple, many have just not given much thought to how to put a value on an ounce of sour diesel or that 500mg vape cartridge. Or even determining value of a 1000 plant crop currently in production. The clone that may have began the whole process was worth little at the beginning, turns into something very valuable at the end. Are you prepared to determine what that ending value is?
Methods of Valuation
In Canada, agricultural operations use a fair value method to value their crops as mandated by International Financial Reporting Standards. This dictates that they value their plants at market value less costs to sell it. In this circumstance, to value a crop which is nearing harvest, you would calculate what you could sell it for less costs to sell and that would be your inventory value. At the same time you would also recognize income on whatever that inventory value is as well. This is problematic for a number of reasons foremost of which is that these Canadian operations are recognizing guestimated income BEFORE the plants are even sold. We won't go any further into this as U.S. companies are not subject to the same accounting rules as Canadian companies but suffice it to say that we do not believe the U.S. will ever adopt this method of accounting.
While there are a few exceptions where the IRS allows fair value accounting they are very limited and not the preferred method. Most U.S. operations must use historical cost in adhering to Generally Accepted Accounting Principles (GAAP). Historical cost is the measure of value of an asset based upon the original costs to acquire or produce the asset. For our purposes, this would be the aggregation of all of the expenditures necessary to grow a crop, process an extract or make a gummy. The process being termed "cost accounting". These expenditure can include:
Materials used in production such as nutrients, fertilizer and rockwool
Utilities - water, electricity, Co2
Payroll for cultivation staff
Rent & depreciation
Any other expense necessary to produce and ready a product for sale
In addition, if you recall, due to IRC 280E only Costs of Goods Sold (COGS) are allowed to be expensed/deducted for tax purposes, capturing all costs of production is imperative. If you don't, you will basically be throwing money away.
So How Much Did It Cost to Produce That Vape Pen?
Now that you know what costs go into inventory, you will need to track all of your cost inputs through each stage of production and develop a method to allocate costs to each product you produce. In other words, you will need to aggregate all the costs used in growing the crop, the costs to harvest, trim and process and the costs to manufacture and package. You will also need to split (allocate) many of these costs between each production cycle and each type of product being produced. The more you produce, the more complex cost accounting becomes.
There are numerous ways to accomplish this cost accounting function, some being very detailed and time consuming but resulting in lots of useful information and some others while not providing as much detail, being much easier to calculate. There is a balance between having enough information and being efficient that is different for every business.
CannaBOS has developed some inventory process solutions that are time efficient and provide useful data necessary to manage your cannabusiness and minimize the IRC 280E problem. If you're having inventory or COGS issues, give us a call for a free consultation. (775) 525-1398 or email us at email@example.com.