Inventory Costing: One of Cannabis’s Most Misunderstood and Financially Critical Business Processes

Inventory costing remains one of the most misunderstood and financially consequential areas in the cannabis industry. For cultivators, the process begins in the soil. Costs start accumulating long before harvest, yet many fail to track expenses like nutrients, labor, and overhead as plants move through the stages of clone, veg, and flower.

A common issue for operators and cultivators is the lack of having a clear methodology for converting cultivation costs into finished goods. In other cases, cultivators may not realize that live plants in various stages of production should be considered raw material inventory before harvested.

Under general accounting guidance, inventory is initially valued at acquisition or production costs. These costs include purchase price, conversion (the cost to convert raw materials into finished products) and production, and other costs incurred to bring inventory to its present location and condition for sale. Production costs are also capitalized if they are related to the production process, such as depreciation of manufacturing equipment, factory utilities, maintenance of production facilities, production supervision quality control, and indirect labor (e.g., factory support staff).

Delaying the recognition of inventory throughout the various stages of the grow cycle until drying or packaging can result in understated inventory balances, incomplete balance sheets, and inaccurate cost of goods sold (COGS). This is a critical pain point. Without accounting for inventory throughout the various production stages, businesses risk missing key tax deductions under Internal Revenue Code Section 280E and risk distorting asset valuations, which can impact financial reporting, investor confidence, and compliance.

These issues are compounded in a high-cash, low-banking environment. Inventory purchases are a significant cost to retailers, and having appropriate data tools to analyze traction and product mix is very important. Cannabis businesses must comply with strict IRS and state-level recordkeeping standards while managing the limitations of Section 280E. Missteps in inventory classification and valuation can reduce operational visibility, create compliance risks, and hinder strategic decision-making.

Those who invest in accurate costing and analytical tools reduce risk, support a stronger tax strategy, and make better-informed business decisions.

Why Is Proper Inventory Costing Crucial in Tax Compliance and Outcomes?
Inventory costing is a critical tool for improving tax outcomes and operational efficiency. Under Section 280E, cannabis operators have limited deductions, which makes accurate cost allocation one of the few viable strategies to reduce taxable income. Tracking all allowable costs tied to cultivation, processing, and packaging is essential—and often underused.

To support this effort, operators may categorize work-in-progress (WIP) inventory by plant maturity—clone, vegetative, flowering—with increasing value assigned as the plant progresses. This staged approach not only helps quantify production costs but also provides the documentation needed to support tax filings. Operators who understand their true cost per unit are better equipped to set prices, protect margins, and respond quickly to market shifts. Relying on estimates or outdated assumptions often leads to distorted financials and reduced profitability.

GAAP Compliance and Market Fluctuations: The Need for Monitoring Pricing Trends
Another layer of complexity arises due to inventory valuation rules under Generally Accepted Accounting Principles (GAAP), specifically Accounting Standards Codification (ASC) 330, which requires inventory be stated at the lower of cost or net realizable value (LCNRV). This rule becomes especially important in a price-sensitive, rapidly evolving market. When market prices fall below production costs, businesses must write down inventory to reflect that lower net realizable value.

These write-downs help ensure the accuracy of properly stated inventory valuations and proper matching of cost of goods sold on the income statement. However, this rule also carries weight as reversals of previous write-downs are prohibited under GAAP, even if market conditions improve later for inventory held on a relatively longer-term basis. Cannabis operators need to monitor pricing trends and market fluctuations closely. Timely adjustments help support accurate financial reporting and tax deductions.

Plan Ahead for Inventory Valuation During an Exit (and Smarter Recordkeeping)
As cannabis operators plan for growth or transition, it is important to consider how future exit strategies will affect inventory valuation. Whether the goal is to sell assets or shares, the structure of the transaction carries significant tax consequences, especially when it comes to how inventory is valued and treated. Early planning may help mitigate risk, align valuation methods with the intended approach, and avoid surprises during due diligence.

Even for cannabis operators not actively pursuing a sale, understanding how inventory is treated in various exit structures can inform smarter recordkeeping and valuation strategies today. The decision between an asset sale and a stock sale shapes how inventory is reported, taxed, and valued—and may affect long-term planning, financing, or restructuring.

Inventory Costing Strengthens Operations and Strategy
Accurate inventory costing does more than support compliance. It equips cannabis operators with the insight needed to make well-informed decisions about pricing, production, and resource allocation. A clear understanding of cost per gram, pound, or unit helps avoid underpricing and protect margins—critical factors in an industry with narrow windows for deductibility and ongoing regulatory oversight.

Operators who regularly evaluate their cost structure are better prepared to adjust to shifts in market demand, scale operations responsibly, and plan capital investments with greater precision. Thoughtful inventory management is also essential for building a reliable foundation for financial reporting, internal controls, and external audits.

Rather than viewing inventory costing as a routine task, cannabis businesses benefit from treating it as a strategic discipline. When approached deliberately, it becomes a tool for maintaining tax compliance, improving operational efficiency, and supporting long-term growth.

Janice O’Reilly, CPA, CGMA, is a leader in AAFCPAs’ Cannabis practice and its CannCount data intelligence advisory services, providing financial leadership and strategic guidance to cannabis operators at every stage of growth. She has extensive experience advising operators on strategies to improve cash flow management and profitability—all tailored to the unique complexities of the cannabis industry. Additionally, O’Reilly plays a key role in the firm’s Business Transaction Advisory practice, helping clients navigate buy-side, sell-side, and internal transactions with informed decision-making and execution throughout the deal cycle.