As the cannabis industry continues to grow, management teams responsible for cultivation and infused product manufacturing face a challenging task: providing insights to help reduce waste, allocate resources, optimize profitability, and measure performance against strategic targets. If that isn’t challenging enough, management teams are also being asked to employ an approach simple enough, fast enough, and flexible enough to still be meaningful.
Thankfully, companies can deploy proven tools, whether operating in markets where full production utilization is the focus or in markets where efficiency is a greater focus.
Cost accounting is a critical tool to tackle the challenge. Two methods are standard costing or direct costing: standard costing is the better method for less mature markets, in which full production utilization is the focus because demand exceeds supply (e.g. Massachusetts); direct costing is the better method for mature markets where competition is fiercer (e.g. California, Oregon, Colorado, etc.).
Regardless of the chosen method, all managers should be involved, and nonfinancial metrics should be set and measured. Successfully implementing a cross-functional approach will yield increased accountability, continuous improvement, and ultimately increased value.
Standard costing for measuring and achieving full production utilization and efficiency
Standard costing is a tool to quantify spending and usage variances based on the differences between actual and standard quantities and prices. The practice includes inventory valuation and Costs of Goods Sold (COGS), performance evaluation, production planning and scheduling, and budgeting. This method has the added benefit of being an acceptable inventory method for GAAP and the Internal Revenue Code (i.e. income taxes), if the results are not materially different from actual costs.
Standard costing begins with developing initial (or basic), ideal, and attainable costs standards. Attainable cost standards should be used and developed by analyzing historical performance and future expectations. This is a key point – while knowing the ideal goals or performance metrics is important, this exercise must reflect real life. Once attainable standards are set and the SOPs are implemented, spending and usage variances can then be identified immediately (e.g. purchase price variances for materials) and thus alert management to execution performance and trends. Further, production planning becomes possible and important questions can be answered about break-even points, value-adds, benchmarking, and whether to produce or buy.
Variances can be positive or negative and should be viewed on balance and with the reminder that the degree of a variance is dependent on how high or low the standard is set. So, some words of caution: an overemphasis on standard costing can negatively distort business decisions (e.g. unnecessarily large purchase orders resulting in the benefit of lower unit costs at the cost of higher carrying costs and increased risk of obsolescence, or overly strict adherence to standards, including labor hours, resulting in increased operational risk). A balanced scorecard will help mitigate over-emphasis.
Direct costing to simply and quickly measure performance
Direct costing is a simpler, faster approach that measures some or all of the direct costs in production and even distribution. Direct costs primarily include materials and labor, both, costs that vary with production levels. The practice supports lean manufacturing initiatives to maximize efficiency and when paired with a customer driven approach, should provide timely product delivery at lower prices and higher quality.
Similar to standard costing, direct costing begins with understanding what costs are direct and indirect and the degree of variability. Once it is implemented, it can be modified to measure certain performance problems such as plant failure, scrap and spoilage. Alternatively, these measurements can be implemented at the onset. Finding the balance of measurements is not always easy but sticking to the purpose of direct costing—simplicity and speed–will help.
Regardless of the direct costing method employed, additional cost accounting will be required to close the books for GAAP and tax purposes. However, it need not be arduous or be done wholly internally.
This will be a fast-paced year of more change, challenge and opportunity for cannabis businesses. Getting a more sophisticated, organization-wide (and even value-chain-wide) view of costs relative to customer and business value will help managers get a clearer picture of the company and drive improvements for the future.
Kevin leads AAFCPAs’ Cannabis Practice, specializing in advising plant-touching businesses and investors on business and tax strategies to maximize stakeholder value throughout the business lifecycle. His cannabis experience includes buy-side due diligence and tax consulting for public multi-state operators (MSOs) and private equity funds on mergers & acquisitions with a deal value in excess of $4 billion and advising companies on industry-first tax strategies. Kevin’s 10+ years of diverse experience in public accounting allows him to provide a wholistic approach to business issues and deliver sophisticated tax advice.
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