The current challenge
When we think of basic business principles like calculating operating profit margin or cost of goods sold (COGS), we might expect a formula to materialize easily. The reality is that complicated supply chain-driven businesses necessitate much more consideration in calculating these principles, even in the best of cases.
If your case is cannabis, a nascent industry that happens to also be growing exponentially, the circumstances are incredibly complicated. Moreover, there are unique tax nuances that evoke additional unintended consequences.
However, as our team has learned through years in the cannabis space representing a wide variety of industry participants, there is quite a bit that operators can learn from analogizing to other industries that are more mature. We may understand the uniqueness of the cannabis industry, but we still often draw insight from our broad cross-section of additional experience when working with our cannabis clients.
Prioritizing the building of accounting and financial infrastructure can help make cannabis-specific challenges much less significant and make the corporate outcomes much better and more predictable.
Inevitably, the right costing systems are critical to setting prices and navigating the increasing profit margin journey within an intensely competitive and fragmented market.
Steps toward using cost analysis effectively
Costing in the cannabis industry is not an easy, one-time exercise. Before a clear system is in place, there will be a period of exploring the right approach for your company. You’ll learn how to better account for some margin of error in costing numbers due to material waste or manufacturing inefficiencies.
By performing a critical business process assessment, you can determine gaps and create a blueprint of the steps needed for process improvement. Even if this blueprint addresses just a few areas at a time, you can start by streamlining the supply chain and manufacturing processes, introducing connected systems, maximizing distribution efficiency, or determining the most appropriate pricing models. In the end, a move in the right direction can help drive value and advance where your company sits on the maturity spectrum.
Take the case study of a leading manufacturer we worked with in the consumer products industry. The company lacked insight into their supply chain and what was causing their thin margins, which were between roughly 5% and 10%.
To get a better understanding of how they were deriving their costs, a thorough analysis of their manufacturing costs was conducted, looking for any gaps or inefficiencies in labor, raw materials, and waste, as well as what types of costs they were capturing. Once they understood the detail and accuracy with which they were capturing manufacturing data, they could revisit their processes, update the type of data they were capturing, and bring in the talent needed to support improvements.
After implementing a new cost accounting process, the company achieved a level of transparency into cost that enabled them to reduce manufacturing operations by over 30%. Over the course of a few quarters, their margins began to stabilize and become healthy again, and the company was able to raise their margins to about 20% to 25%.
Three questions to ask
1. Do you have rigorous and tested costing processes that help with your understanding of true margins and profitability?
For cannabis producers, careful analysis of the full framework of your business is the first step in understanding your real profit margins. Spend time in the grow, the trim space, the packaging and processing areas, etc., going through each facet in painstaking detail. In addition to evaluating operations, take a careful look at the technology that drives each aspect of the business. As business operations increase in complexity, such as expanding into other states, the ability to keep track of compliance with systems and automation instead of headcount is crucial for cost containment.
In the case of the consumer products manufacturer, the finance side and operators implemented improvements that allowed them to harness accurate, timely, relevant, and supportable data to help them understand the true cost of their product. This helped create transparency throughout the organization and determine the steps needed to get to their desired margins, such as shutting down a non-U.S. manufacturing plant.
2. Is there an enterprise-wide roadmap used to assess and customize your cost accounting system?
Costing is essential in the decision-making process as it relates to pricing, inventory, product mix, and go-to-market strategies. With a clear understanding of where you are, you can work toward greater enterprise-wide stability and cohesion in the systems needed to track costing data and other key information. Demonstrating strong back-office operations, accurate profitability/efficiency data, integrated systems, and transparency of real-time financial information can enhance cannabis operators’ ability to access additional capital, and/or maximize valuation.
Build and strengthen your systems around a cost accounting method, but don’t jump right to using the one you have experience with: standard method vs. activity or job, product- vs. process-focused, etc. Consider what’s best for your environment, including how the methods fit with the systems you already have in place, as you may not need or want to bring a complete overhaul of your core functions into this process.
After testing several costing methods, the consumer products manufacturer decided to move forward with a system built on the average costing method. With little variability in their products and the processes for manufacturing them, they sought to hone in on driving down the cost of the processes to drive up margins.
3. Are your supply chain and manufacturing systems connected?
Integrating all the data across your stack – customer relationship management (CRM) system with your point of sale (POS) system, with your enterprise resource planning (ERP) solutions and the platforms maintaining your financial information – will put you on the right track to scale for the future by enabling you to grow in a lean but still effective way, especially as regulations continue to change and investors demand more transparency.
The manufacturer’s previous lack of discipline around collecting accurate cost data hindered their ability to price product for adequate profits; without a clear picture of their true costs, sales representatives and retail fronts couldn’t know what minimum prices they needed to maintain profitability.
Once the clean, clear, and mature new cost accounting process was in place, cost metrics were communicated to the sales team so that they would know that pricing floor, and avoid situations where they may be discounting below cost. The company was better able to align forecasting and planning to represent not only their current state but also where the business was going, putting ownership in a good position for a possible eventual exit. In the meantime, there was a clear vision and roadmap for where they wanted to head, which was toward growth.
Understanding your current business processes, technology, and people is the first step in assessing how your company can get a better handle on its profit margins. The goal will be to arrive at a business and technology blueprint that will support resource planning, optimize efficiencies, and, as more companies do the same, help transition cannabis from a novice state to a structured industry.
Subject matter expertise
Managing Principal – Real Estate, Cannabis Industries
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