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The Resurgence of Domestic Manufacturing in an Unlikely Place—Cannabis

November 4, 2019
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Domestic manufacturing is on the rise in the United States, as a result of factors such as current public policy, technology, and favorable tax treatment. As the cannabis industry continues to emerge, making its way into the mainstream business world one state at a time, it is beginning to contribute to the resurgence of domestic manufacturing. Cannabis is widely considered an agricultural business, but few consider that, beyond the growing process, taking the raw plants and producing the myriad of cannabis products on the market is a manufacturing (and, later, distribution) process. Ironically, the factors leading to the resurgence in traditional manufacturing, as a whole, are the same things that present challenges to cannabis companies operating under state-legal licenses.

Tax considerations

Cannabis (which includes all cannabis products, except for industrial hemp, as defined in the 2018 Agricultural Improvement Act) is still a Schedule I controlled substance, making the business of cannabis federally illegal under the Controlled Substances Act (CSA). Those operating with a state-legal license are considered to be trafficking in a controlled substance and are therefore subject to IRS Code Section 280E, which disallows ordinary and necessary business deductions for tax purposes. As cost of goods sold (COGS) is considered an adjustment to income, and not a deduction, cannabis companies are only allotted a reduction in taxable income in the form COGS.  

As manufacturers of cannabis products (both licensed cultivators and infused products manufacturers), cannabis companies must adhere to IRS Code Section 471 to calculate inventory for COGS deductions. This code section dates back to the 1970s, when domestic manufacturing was a staple industry for the United States economy, and is referred to as “full absorption costing.” Cannabis companies are prevented from utilizing the onerous requirements of IRS Code Section 263A (the Unicap provisions), which hangs up portions of selling, general, and administrative expenses on the balance sheet, for tax purposes, as part of the calculation of inventory for certain companies that reach set revenue thresholds. Traditional manufacturing companies are typically not in favor of the Unicap provisions, as it delays the deduction of certain operating costs. Cannabis companies use the provisions of 471 to allocate as many costs as possible to inventory, as the deduction of inventory is the only relief from taxable income.  

IRS Code Section 471 allows for the absorption of direct and indirect materials, labor, and overhead costs into inventory, and allows for two methods of allocation—the burden rate method or standard costing. Cultivators and manufacturers typically calculate the theoretical capacity of their operations as a base for the allocation of costs onto products expected to be produced. Mixed costs are typically allocated through reasonable allocation drivers, such as square footage for facilities that may include both manufacturing space and retail or office space. Payroll is allocated between direct and indirect payroll evidenced, with timecards and timestamps between various manufacturing or administrative rooms in the facility.  

Technological considerations

The technology required to determine costing of plants and infused products in the cannabis world is still emerging, so many of the calculations related to the costing of products are still performed manually. While traditional manufacturing software exists to allocate standard costs and manufacturing variances, technology for cannabis-specific companies is lagging. Traditional manufacturers and cost accountants, who have weathered the storm of the downturn in domestic manufacturing, are the most knowledgeable resource from a business operations perspective regarding the costing of inventory and the business decisions needed to be profitable. 

The evolution of cannabis manufacturing is happening at a rapid pace. As public policy, tax policy, and technology change, we will begin to think of cannabis not as a nascent industry trying to push into the manufacturing space, but as an indicator of where the future of manufacturing in the country may be headed.