How high should a cannabis company’s gross margin be?

IRS Publication 535 defines ordinary and necessary business expenses: “An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.” Examples of ordinary and necessary business expenses can be, but are not limited to, rent, marketing, accounting fees, legal fees, utilities, software, salaries, and wages.

Publication 535 also provides the definition of cost of goods sold:

“If your business manufactures products or purchases them for resale, you must generally value inventory at the beginning and end of each tax year to determine your cost of goods sold. Some of your business expenses may be included in figuring cost of goods sold. Cost of goods sold is deducted from your gross receipts to figure your gross profit for the year. If you include an expense in the cost of goods sold, you cannot deduct it again as a business expense.”

The publication goes on to provide some examples of cost of goods sold: “The cost of products or raw materials, including freight; storage; direct labor (including contributions to pension or annuity plans) for workers who produce the products; and factory overhead.”

Under Section 280E, cannabis companies are federally prohibited from deducting anything other than cost of goods sold as a deduction to arrive at taxable income. This means that when arriving at taxable income, which is the base to which a C Corporation will apply the rate of 21% in determining its income tax due to the IRS, correctly capturing all costs of goods sold is of the utmost importance.

A higher gross profit margin percentage means that the company has a higher percentage of expenses that are ordinary and necessary business expenses than cost of goods sold. For financial reporting and business purposes, a higher gross profit is a good thing – it suggests that the company’s product is profitable. For income tax purposes, for cannabis companies, however, the lower the gross profit margin percentage, the better – since for cannabis companies the gross profit is generally the de facto base to which the company applies its applicable tax rate.

To determine whether there appears to be a baseline industry standard/average gross profit margin percentage for a cannabis company, we downloaded the publicly available audited financial statements of five large cannabis companies: Cresco Labs Inc., Curaleaf Holdings, Inc., Green Thumb Industries Inc., Trulieve Cannabis Corp., and Verano Holdings Corp.

What we found was that these five companies had without exception similar gross profit margin percentages.

Our analysis shows that a cannabis company’s gross profit margin percentage tends to be somewhere between 45% and 55%. This was further confirmed by Gail Rand with Grand Consulting, who assessed Q3 2022 gross profit margin percentages of a sample of the Top 15 plant-touching public cannabis companies and found an average of 45%, which is in line with the CohnReznick analysis.

So what might explain the higher Trulieve Cannabis Corp. gross profit margin percentage? One possible reason is that the company may be more conservative in its cost of goods sold allocations than the other companies listed. There are several other possible reasons:

• Gross profit margin percentages can change based on the mix of retail, cultivation, and processing. Trulieve has a large processing business that produces vape pens, edibles, etc. Processed products have higher gross profit margin percentages by nature, potentially resulting in a higher overall gross profit margin percentage.
• Trulieve operates within Florida, a state that requires full vertical integration – meaning that to sell in Florida, Trulieve is also required to grow in Florida. Cannabis, as a legal business, is newer in Florida than in other states. As a result of less saturation, it is possible that gross profits are higher, resulting in a higher gross profit margin percentage. We noted that Trulieve’s gross profit percentage has steadily declined over the past three years, potentially a sign of maturing within the Florida market.

If a cannabis company’s gross profit margin percentage falls outside of this 45% - 55% range, it is also possible that there are operational issues or their accounting system is not set up correctly.

The CohnReznick cannabis team is here to help, offering tax, audit, valuation, transaction, and consulting professionals with deep cannabis industry expertise. Contact our team for more information or analysis.

Michael Harlow, CPA, Partner

301.907.2330

Seth Sherer, Senior Manager

301.280.1962