The Hidden Downfall of Skipping Yearend Inventory Counts
“I think our inventory is pretty spot on.”
These are the famous last words we hear from every client we have ever brought on. It’s understandable as to why. Point of sale systems, accounting software, and even your team of employees make you feel there are enough tools and resources in place.
Why should you think there is anything wrong?
The reason inventory tracking is so critical has nothing to do with Metrc or trace and track. The IRS tax code, famously frustrating in cannabis, known as 280(e) says that no deduction or credit shall be allowed for any business trafficking in a Federally controlled substance. Until cannabis is removed from Federal drug schedules, this tax provision will remain a big challenge from a tax liability perspective.
Let’s look at this with numbers. Let’s say your small cannabis business made $1,000,000 last year. Between cultivating your product and buying from other wholesale businesses, you spent $600,000 to have a product to sell. You now owe taxes on $400,000; at that income level, you’re looking at 37-39% just Federally, with more owed to the state. If you’re a solo entrepreneur, you will most likely owe another 7.65% in self-employment taxes.
YIKES! That equates to a nearly $180,000 tax bill and almost 20% of your gross revenue!
Other expenses beyond just your product cost, like payroll for employees, advertising, insurance, professional account, legal fees, licensing fees, etc., are primarily not able to be treated as a cost of goods sold. This means you probably spent your cash to pay all these expenses but are not getting any benefit for them at tax time. You are now in the vicious cannabis business cycle of owing tax dollars with no cash flow to pay it.
Back to inventory…
That $600,000 we used in our example for your cost of product that number becomes critical. It’s the only number preventing you from paying taxes on your full $1,000,000 in gross revenue. If that $600,000 is wrong or doesn’t hold up in the event you’re audited, you now have an even bigger problem.
Why would it be wrong?
Almost every business does the following when they are doing their own accounting. They buy supplies for their grow house and record the purchase to the cost of goods sold. They buy inventory from another vendor and record the transaction to the cost of goods sold. This is inherently wrong and a huge red flag for audit purposes.
Those items must be added to your INVENTORY when you incur these expenditures. They only become part of the cost of goods sold when you SELL the products. Any time you incur growth costs or buy wholesale, you’re supposed to bring those costs into your inventory value first. Only once the month is over, and we see the change in inventory (what you added minus what you sold) can we find your true cost of goods sold number.
Cost of goods sold = Beginning inventory value + Purchases – Ending Inventory Value
This makes the single largest area of error in the valuation of your inventory both at the beginning and the end of the period. This makes your cost of goods sold wrong, and you don’t know by how much, why, or in which direction.
So you have to count. EVERYTHING. Yes, including stickers and packaging and T-shirts. You can’t spot-check; you can’t assume there are still 30 pre-rolls in that box out back. You can’t run a report out of your point-of-sale system and hope it matches what you have on hand. Product walks out your door all the time, whether you know about it or not. Human error plays a role in your point-of-sale system numbers almost always being incorrect.
You must count.
Further, many clients come to us looking to understand what they are allowed to “allocate” to cost of goods sold. How much of my rent can I allocate? How much of my payroll can I allocate?
You can indeed do some of these things, but accounting and tax rules require the following to happen first:
Your inventory has to be valued at the lower of cost or market – this means you HAVE to have an accurate inventory count and then know what your original cost was for every single item on that list, including products you cultivated and manufactured yourself
You must be following accrual basis accounting – this is another article entirely but suffice it to say most bookkeepers are not qualified for this level of accounting
You have to be able to document everything WHEN (not if) you get audited
So do so many cannabis business owners not take the most critical piece of their business seriously? After all, your inventory is your milk and honey.
It’s daunting. Imagine tracking the grams of flower in every pre-roll.
It can be done, but not without a system of controls and a business owner who takes the time to understand their system, including their point-of-sale software. You can never assume a computer is doing this work for you; humans feed the computer the information.
If you’re setting your new years resolutions as a cannabis business owner, facing your inventory controls should be the top one on your list. You simply cannot afford to skip this.
If you would like a free consultation to discuss our inventory and controls systems services, please contact us at grow@cultivateconsulting.co