Whether you’re a Cannabis CBD/Hemp CEO or an accounting professional supporting licensed businesses in this space, knowing what is required with regards to compliantly managing inventory, as well as understanding the necessary processes and controls is valuable knowledge that can serve you well.
It’s complicated for licensees who need to comply with how their particular state tells them inventory must be reported yet need some relief from the punishing effects of 280E. IRC 471 makes some relief possible. The only caveat here being that inventory must be accounted for compliantly. What we often see is that business owners don’t have the right processes and procedures in place to comply with state rules, or in some cases to ward off theft or fraud, which can get them into trouble, but also erase any opportunity they have to benefit from tax savings.
Proper inventory management is not optional, it’s mandatory. In this blog, we’ll help you identify the crucial aspects of what is needed in order to maintain your licensing status, what to look forward to if you are hoping to obtain a license some day, and of course, considerations for accounting professionals who are looking to support Cannabis companies with their inventory.
Mitigating Theft With Cannabis Inventory Management & Internal Controls
Internal controls (rules, processes, and SOPs) minimize risk by reducing the mishandling or theft of product or cash as well as support any audit that your company will go through. They are how corporate governance “from the top” is applied to each important facet of a company’s operations. Everything related to dealing with product, cash, equipment, and valuables, including intellectual property (IP), should be safeguarded by having and maintaining effective internal controls, and enforcing them.
Segregation of Duties
Whether the business is a dispensary, cultivation site, or some other kind of enterprise, Segregation of Duties (SOD) should be a crucial building block of all possible internal controls. SOD splits responsibilities so that one person may perform a task while another reviews and verifies correct fulfillment of the task by signing off on it in a log or on a document. Another key component of SOD is that any employee who has access to physical custody of assets has no access to the accounting system.
SOD between cash/accounting and product-handling responsibilities is an internal control many investors want to see spelled out in their Cannabis-specific accounting manual and enacted in daily operations. Whoever has custody of products, like budtenders for example, should not also have access to POS system reporting or the accounting system that manages the inventory count. When an individual has access to both, it creates an opportunity for fraud and theft. A budtender could take product and then reduce the amount of inventory to reflect a reduction in product and thereby hide the theft. Designating which employees have access to cash, POS, and ERP systems, and which have access to the products can help prevent losses. In the event that a loss or theft does occur, an effective SOD can go far in pinpointing where and when the mishap took place, and who was responsible for handling cash, goods, or records when the event occurred.
Cannabis Inventory Controls
Cannabis inventory controls are as essential to farms and cultivation sites as they are to dispensaries and retailers. When establishing or reviewing controls it can be helpful first to consider the physical layout of the site and all possible ways to enter and exit the site.
Controlling who has access into and out of the business is key. Limiting the number of persons who can access certain areas can minimize the opportunity for theft or misappropriation. For example, if the cultivation site has an administrative office on site, individuals working in that office do not need to have access to the growing areas, and vice versa. Conveyance of any product or supplies to or away from the site need to be safeguarded by having solid surveillance and security, as well as clear logs for when product is added or removed. If, for instance, a delivery of liquid nutrients arrives on site, the delivery driver should not be admitted into the cultivation area. Instead, the number of items delivered should be checked against the invoice. If the invoice accurately reflects the delivery, then the appropriate personnel from the cultivation department can pick up the nutrients and load them in the designated area.
An effective inventory control system will establish and enforce procedures for conducting every operation of the site. Having employees review others’ work and verify the proper completion of tasks by signing off on a log is a widely used internal control method.
Specific procedures for accepting product deliveries, verifying their accuracy, addressing any inconsistencies (and documenting them when they happen), stocking shelves, performing inventory, and all other common, regularly-occurring activities need to be thought through from a security standpoint after which appropriate internal controls can be drafted and tested prior to being put in place.
Surprise Inventory Audits
Inventory counts should be done monthly for cultivation and manufacturing and cycle counts at dispensaries every week. One great inventory management tool and internal control for today’s Cannabis businesses is inventory audits. Unscheduled, “surprise audits” can uncover issues and discrepancies that would have otherwise gone unnoticed and negatively impacted the business’ profit margin. Conducting unscheduled audits also reduces the risk of non-compliance, communicates the importance of following procedures in a by-the-book manner, and reduces the potential for financial discrepancies.
Inventory audits can also greatly help to prevent and deter theft. Because they carry valuable, in-demand inventory, dispensaries are often the victims of theft. Unannounced audits can act as a powerful deterrent that underscores the severe consequences of theft and its harmful effects.
The unauthorized sale of products or the diversion of products through leaks in the supply chain or various cracks in the internal controls can also be revealed by conducting audits of inventory and POS systems during normal business hours. While performing such audits may be somewhat inconvenient for staff, it enables the CEO or manager to get a precise snapshot view of the day-to-day operations in action, and whether or not standards are being met.
Conducting surprise inventory audits also demonstrates a dispensary’s commitment to transparency and accountability. It enhances the trust of investors, potential buyers and partners, and regulators. By regularly conducting audits, these businesses can showcase their adherence to best practices, regulatory compliance, and accurate financial reporting.
Internal Revenue Code 471: The General Rule for Inventories
Internal Revenue Code 471, the rule for inventories, can be explained as a process for figuring out how much it costs a business to make its products or goods. It instructs you to add up all of the costs involved in making your product (direct materials, workers’ time), but also indirect costs including the costs that change (electricity) and costs that stay the same (rent). Once you’ve figured out all of your costs in this way (and the only good way to do this is “GAAP” level cost accounting), you can ascertain how much of the business’ money is tied up in the stuff you’ve made but haven’t sold yet, and how much you’ve spent on the stuff you’ve already sold. Learn more about IRC 471 in this post.
Internal Revenue Code 471-11 for Cannabis Cultivators & Product Manufacturers
For cultivators and makers of Cannabis and CBD products, from edibles, foods and beverages, to tinctures and oils, lotions to rosins, 471-11 applies to their concerns. The business incurs the costs of paying for materials and workers’ time, such as seeds, soil, and the labor involved in planting those seeds; those are the direct costs. The electricity to run the lighting and HVAC systems are indirect variable costs, and the farm’s rent is a fixed indirect cost. Specific indirect costs not permitted under 471-11 include advertising and marketing expenses, selling expenses, accelerated depreciation, and more.
The ability to maximize what a manufacturer can ultimately include in cost of goods sold (COGS), i.e. their materials, labor, rent, utilities, etcetera, requires abiding by generally accepted accounting principles (GAAP), including accrual absorption accounting. Before any cost goes to COGS, it must first go to Inventory via GAAP cost accounting. Such cost accounting practices are complex and require expertise, tools, and resources to be completed in an efficient, timely, and regularly-occurring manner.
Cannabis Inventory Accounting for Cultivators
During the inventory accounting process, the CEO and/or accountant are trying to determine the business’ cost to develop the product. For the sake of simplicity, let’s assume a farm grows Cannabis that they turn into flower and then sell to dispensaries or processors.
This cultivator’s Blue Dream strain takes 120 days to grow from seed to maturity and yields one pound per plant. Their Golden Goat completes its growth cycle in just 90 days, and yields one and a half pounds per plant.
The inventory balance sheet will list three categories: raw materials, work in process (WIP), and finished goods (FG). In this scenario, those categories will contain the following items:
- Raw materials are seeds, soil, as well as pesticides and nutrients added to the plant as it grows.
- WIP includes all plants, regardless of what stage they are in: veg/growing, harvesting, lab testing, and packing it for the buyer (dispensary or processor).
- Finished goods (FG) will include all Cannabis flower that is ready to sell (post-lab tested) but currently unsold.
During inventory, the WIP entries will include a “percent complete” figure estimating how far along a plant is in the growth cycle. Even if the aforementioned Blue Dream and Golden Goat strains were planted on the same day, their percent complete figures will be different due to the varying lengths of their growth cycles. The costs of producing them will also be different since the Goat strain grows 75% faster than the Blue Dream.
By adding up all of the allowable direct and indirect costs that were invested into growing a particular strain (from seed to harvest and lab), and dividing that number by the total yield, one can ascertain the total cost spent and price their product accordingly.
Most cultivators favor having little to no FG inventory in stock. Having it earmarked and sold prior to delivery enables them to convert their expenditures on product into COGS once the product is sold. COGS should equal the sum of all associated direct and indirect costs allowed in IRC 471-11. Total revenue minus COGS will equal the gross margin.
Cannabis Product Manufacturers & Bill of Materials
When conducting inventory accounting for Cannabis product manufacturers and processors, a Bill of Materials (BOM) for each product will be needed to determine their respective unit costs. A bill of materials gathers all of the costs and resources needed to create a product (like a recipe, quantities and all). In this document, the raw materials, labor, overhead, etc. reflect the amount of materials used in the production of every unit that is sold to the end user. If an edible manufacturer makes gummy bears, figuring out the average cost per box will require a BOM that includes a breakdown of all of the ingredients, raw materials (RM), and allowable direct and indirect costs (assembly costs, allocated overhead, etc.).
BOM for Box of Gummy Bears
|RM: 1 gram THC Oil||X (actual cost)|
|RM: Sugar, and other non-canna ingredients||X (actual cost)|
|RM: Box, Label||X (actual cost)|
|TOTAL AVG COST PER BOX||XXX|
With complete and accurate BOMs for all products made, costs can be calculated on a per unit basis.
Cannabis Dispensary Inventory Accounting
Effective, compliant inventory accounting procedures are a must for today’s licensed dispensaries which are required to abide by strict regulatory requirements that vary, state by state. By having their dispensary accounting buttoned up, dispensaries can prove their compliance at a moment’s notice, avoid hefty fines, and maintain their license to operate.
Regular, accurate tracking of inventory, including weekly cycle counts and reconciling those to the “seed-to-sale” software, can also help dispensaries make smart business choices on the kinds of products they carry. Consumer behaviors take place first in the marketplace, well before they’re touted as “industry trends.” Careful review of how fast or slow certain items are selling can help retailers anticipate trends and make savvy decisions on which strains and product categories they need to stock and which need to be reduced or phased out.
Cannabis Inventory Processes
Inventory processes for Cannabis businesses need to be objective, verifiable, and effective at tracking the amount of product or goods on hand. These processes should also easily align with accounting procedures and the business’ goals and objectives. For example, a printable inventory spreadsheet might list cartridges by name but fail to demarcate which products are CBD-only, or fail to list the name of the supplier. If key information is missing, a clear record of inventory is impossible to achieve. Therefore, prior to being instituted, all inventory-related processes need to be scrutinized by management to verify that the information gathered during inventory counts can be used and inputted across all necessary systems (ERB, POS, Seed-to-Sale, etcetera).
A Dependable System to Track Inventory & Determine COGS
All Cannabis businesses need to have a dependable inventory accounting system to keep track of purchases and enable the accountant or CFO to determine COGS at any point in time. This enables the business to ascertain the value of its inventory and hence the value of its business in a real-time manner. An accounting process that is well-documented and maintained is a must for most Cannabis investors. Banks and credit unions who work with businesses in this niche want to see clean records that provide current, reliable information. During M&A negotiations, a dependable, well-documented, and maintained inventory accounting system can be the deciding factor between success and failure.
A Separate Operating Account
Many businesses pay costs through an operating account, not a general business account, and fund it once COGS has been assessed. This helps to protect the business’ capital, prevents overpayment to vendors, and mitigates theft or misappropriation since the operating account will have a limited amount of funds.
A Standardized Purchase Order Process
A smart standardized purchase order process requires considering how particular products are selling and making thoughtful, informed choices on what needs to be ordered. Oftentimes, placing purchase orders gets treated as a task. Simply jumping through hoops and ordering the same amount that was ordered last month is not a winning formula.
All orders of product and supplies should be necessary purchases, and be scrutinized with a critical eye that’s looking to keep stock fresh and on-point and the operating expenses low.
So if a particular cartridge is not selling as well as it did a few months ago, the purchase order amount should be adjusted down to reflect that. Rather than instructing the floor manager to build up to ten, they can be informed that they should stock only seven going forward.
Internal purchase requisition forms or purchase requests (PRs) can be filled out by the floor manager or lead cultivator. Then, the CEO or another member of management can review those PRs and sign off only on those they deem necessary.
The delivery of products or supplies is a crucial part of the purchasing order process that tends to erode over time. Only authorized personnel who are informed on proper intake procedures should review deliveries. Delivered items should be carefully checked, including names, weights and amounts, to verify that what is listed on the receiving slip matches the delivery. All receiving slips should be checked against the invoice and PO, so that any adjustments in price or corrections to delivery orders can be handled in a timely manner, rather than simply falling through the cracks.
All states that have legalized adult-use or medical Cannabis have mandated seed-to-sale tracking software for all Cannabis companies. As the name implies, seed-to-sale software tracks everything from when a seed was planted to when it was harvested, lab tested, dried, trimmed, (i.e. moved through the supply chain of processor, manufacturer, distributor, dispensary), and then ultimately sold to the patient or consumer.
Seed-to-sale tracking systems are intricate, prone to glitches, and subject to human error. The mandated tracking software Cannabis companies are required to use (METRC, BioTrackTHC, Leaf Data Systems, Trace) varies by state, so do specific reporting requirements. Therefore, accurate and up-to-date knowledge of those requirements is necessary to ensure all reporting meets compliance standards.
Inaccurately inputting seed-to-sale data into the required tracking software can lead to significant penalties or even loss of license. Understanding of the seed-to-sale process is also necessary for correctly performing cost accounting and preventing overpayment of tax bills, as well as incurring tax fines and other negative repercussions.
Correct cost accounting and familiarity with resolving seed-to-sale challenges is needed to calculate Cannabis tax and correctly apply adjustments prior to reconciling the books. An accountant or CFO who specializes in supporting Cannabis businesses will have the tools and know-how required to manage common seed-to-sale software headaches and enter AJEs (Adjusting Journal Entries). .
Seed-to-Sale Tips for Cultivators
For the Cannabis cultivator to remain compliant, seed-to-sale software needs to have inventory amounts inputted into the system along with logs of every person who touched any plant during any stage of its development.
The following inventory management tips can help Cannabis growers minimize common seed-to-sale data challenges:
- Establish a precise, repeatable inventory weighing system with ironclad procedures.
- Enforce the above procedures and conduct surprise internal audits.
- Maintain a separate physical log of inventory (on paper) that is updated during specific days and times.
- Weigh product prior to it being moved to another area.
- Weigh product after drying but before packaging it as a finished good.
- Reconcile the physical log of inventory with seed-to-sale reports after each internal count is performed.
Seed-to-Sale Tips for Dispensaries
- Perform weekly cycle counts and compare counts to both Seed to Sale and POS. Correct and investigate as errors are uncovered
- Schedule and perform regular backups of your data (on cloud storage or an external hard drive). Doing so will ensure information that’s critical to the business will be available in the event of software errors of loss of data.
- Regularly update your software. Patches, bug fixes, and improvements are released regularly. Update only to stable versions, not beta releases.
- Document & report software issues right away. If possible, save an image of the error or issue and make a note of the specifics, including any error messages, error message numbers, and irregular performance. Clear information can help the software support team provide you with a workable solution.
POS Systems & Seed-to-Sale Integration Issues
Virtually every state that has legalized medical or recreational Cannabis has experienced problems with their state-mandated seed-to-sale software properly integrating with POS systems. Anticipating problems and establishing workaround solutions ahead of time can help lessen the impact and potential loss of business that can arise from integration issues.
1. Failure to sync.
POS systems and seed-to-sale tracking software need to communicate and exchange data seamlessly. When the two systems fail to synchronize properly, it can result in discrepancies in inventory, sales, and compliance records.
2. Inventory discrepancies.
POS systems and seed-to-sale tracking software should maintain accurate inventory records. Counts performed weekly and reconciled to POS will help minimize this. Be wary of synchronizing bad data from one system to another.
3. Data transfer errors.
Incompatibility between systems can lead to data transfer errors. Such errors need to be located and addressed to ensure the integrity of inventory amounts, data hygiene, and the accuracy of that data going forward.
4. Employee training and user adoption.
Employees and managers need to learn to navigate both systems correctly to ensure that correct inventory amounts are maintained jointly. System updates of POS or seed-to-sale systems can necessitate the need for additional training. Failure to do so can lead to massive clean up.
A word of caution: seed-to-sale software issues tend to flare up especially when states have changed Cannabis laws, regulatory policy, or compliance standards. When, for example, a state goes from being medical-only to allowing adult-use, so stay on high alert during these times and keep those workaround solutions handy.
ERP stands for enterprise resource planning. The purpose of the typically cloud-based software is to centralize, collect, store, manage, and integrate data across an entire business. Being able to integrate various processes across an enterprise definitely sounds like a beneficial tool, however ERP systems are relatively new to the Cannabis/CBD industry, are notoriously buggy, lack good training and support, take a long time to implement, and are extremely pricey.
Supporting businesses with ERP will require ample problem-solving and the ability to find, locate, and resolve issues with syncing, data integration, data contamination, and more. Integrating ERP, POS, and seed-to-sale systems can be a considerable challenge that requires time, patience, and expertise to resolve, as well as regular reviews to verify proper integration is maintained.
With the right accounting support and expertise in your corner, you can put the processes in place to properly manage your tax liability, safeguard cash and product, and make better, more informed decisions going forward.
Learn about DOPE CFO’s premier Cannabis/CBD accounting program for accounting professionals (bookkeepers, tax professionals, Controllers, CFOs, CPAs, etc) who are looking to go fully remote and support today’s fast-growing Cannabis/CBD industry.