The ABCs of Cannabis Cost Accounting

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Screen Shot 2016 10 17 at 10.31.56 AM

Cost accounting in the cannabis industry can be really confusing. Why does it matter, you ask?

Because the Internal Revenue Service disallows all trade or business deductions except cost of goods sold. Expenses such as rent, adverting, utilities, wages, etc. can’t be deducted unless they are related to the cost of making or purchasing an inventoriable product. The IRS makes it virtually impossible to legitimately meet your financial obligations when they tax you on phantom profits. Therefore, it is incumbent upon cannabis businesses to operate in a way that maximizes cost of goods sold through the cost accounting process.

In CCA 201504011, the IRS directs cannabis businesses to use the inventory capitalization rules under IRC 471 to determine cost of goods sold. IRC 471 first appeared in the Internal Revenue Code in 1954. It has gone through various revisions, including adding the Full absorption regulations under Treas. Reg. 1.471-11 in 1973. Costs such as repairs, maintenance, utilities, rent, labor, materials, tools, quality control, taxes, depreciation/amortization, insurance, and other administrative expenses are allowed as deductions if they are incident and necessary to the process of manufacturing.


To be able to use the full absorption regulations, you must be considered a manufacturer. In Rev. Rule. 81-272, the IRS describes types of businesses that are considered manufacturers. Examples include:


  1. A company sells printed towels. The company purchases white towels and contracts with an unrelated party to furnish the dye and design work. They have title to the towels at all times. When the dye and design work are completed, the company stores, packages, and markets the towels.
  2. The facts are the same as in example 1, except the unrelated contractor, in addition to dyeing and designing the towels, also stores, packages, and distributes the finished product to the company’s customers.
  3. A company purchases individual parts of dolls, assembles them, and markets the finished product.
  4. A company produces goods naturally, such as the aging of whiskey,


In Notice 88-86, the IRS states that activities described above are considered manufacturing, regardless of the type of facility they are incurred in (such as a storefront). I would argue that most of the California cannabis industry is, in part, manufacturing a product.

At the moment, California law requires cannabis collectives to buy from their patient members through cultivator agreements. Cannabis collectives pay cultivators for their time and other costs. Many times the cultivating member brings in bags of unprocessed cannabis, leaving it to the collective to make the product sellable. The collective then processes the cannabis, sometimes letting it dry or adding moisture through humidity. A collective will then send the product for testing.

Cannabis collectives many times assemble cannabis by putting it into childproof containers or making pre-rolls. Many cannabis collectives brand their own packaging, which can add to the value of the cannabis.

Overall, these processes make the cannabis more readily marketable, add utility to the product, and make it more suitable for use or consumption.

I recommend every cannabis business hire a certified public accountant who knows cost accounting and how to structure your business so you can take advantage of costs the IRS has stated will be allowed in cost of goods sold.
accountingAndrew Hay received a Bachelor of Arts degree in accounting from DeVry University and a Master’s in public administration nonprofit management from Keller Graduate School. He has been a licensed, IRS Enrolled Agent since 2004 and a certified public accountant since 2007.