Cannabis Inventory Costing Methods: What Successful Operators Need to Know

Inventory costing is always important in manufacturing and retail. In cannabis, though, it’s mission critical. Costing touches compliance, profitability, and audit readiness — three areas where the stakes are higher than in most industries.

Here we explore the inventory costing methods most relevant to cannabis operators, how 280E shapes what counts as cost of goods sold (COGS), the risks of manual approaches, and how cannabis ERP, like Velosio’s SilverLeaf built on Microsoft Business Central, can help create audit-ready, real-time costing. The goal is not to provide tax or legal advice (always consult your CPA or attorney) but to highlight how the right systems and practices can give you clarity and confidence.

Why inventory costing is a hot button in cannabis finance

At the federal level, IRS Section 280E disallows ordinary business deductions for companies trafficking in Schedule I or II substances. That means cannabis operators can’t deduct typical expenses, such as rent, marketing, or payroll. The only allowable offset is COGS. In other words, the way you capture and allocate inventory costs has a direct impact on your taxable income.

This focus makes cannabis businesses a magnet for scrutiny. Auditors, from both the IRS and state regulators, expect operators to follow strict inventory and costing rules under Section 471(c) of the IRC. A government audit sampling three states found 59% of marijuana business returns likely required 280E adjustments, projecting tens of millions in unassessed taxes—evidence that inventory valuation and COGS documentation as well as financial document retention sit at the center of many disputes.

The bottom line is that without a strong approach to inventory costing, cannabis operators risk over or understated tax bills, audit findings, or missed opportunities to demonstrate profitability.

Common costing methods in cannabis

There’s no one right method for all operators. The best choice depends on your business model, product mix, and how your accountants structure COGS under Section 471. Here are the most common approaches:

• Standard costing – Uses predetermined costs for materials, labor, and overhead. It’s efficient and works well for larger producers with predictable processes. But variances between standard and actual costs need careful tracking and reconciliation.
• Actual costing – Records the actual cost of every input and activity. It’s precise and audit-friendly, but without automation, it can become a data nightmare.
• Activity-based costing (ABC) – Allocates overhead based on activities (lighting, nutrients, extraction runs). ABC provides granular insight into true costs but requires robust systems to maintain consistent and defensible allocations.
• FIFO, LIFO or weighted average – Common inventory flow assumptions. Both can work, but the key is consistency: once you choose, apply it across all entities and maintain clear documentation.

Each method has tradeoffs. What matters is using a system that supports the approach you choose and ensuring that approach maps cleanly into the COGS definitions your accountants rely on.

The 280E factor: what counts as COGS

The most important thing to understand about 280E is that not all costs qualify for capitalization into COGS.

Retailers are generally limited to the purchase price of cannabis products, as well as certain freight or handling costs. Ordinary operating expenses — like rent, payroll, or marketing — remain nondeductible. Producers and manufacturers (including cultivators, processors, and extractors) may include direct materials, direct labor, and certain production overhead.

Proper costing won’t eliminate the 280E burden. However, it can help lower your tax liability by making sure all allowable costs are included in your COGS — and that those costs are documented in a way auditors will accept.

Because interpretations vary and rules evolve, operators should always confirm their costing approach with qualified tax professionals. ERP helps by providing details and an audit trail; accountants help determine what can be capitalized.

Risks of manual costing

Many cannabis businesses start out managing inventory and costing in spreadsheets. That works until it doesn’t. The risks include:

• Inaccuracies. Missing costs, inconsistent units of measure, or errors in allocations can distort margins and inflate tax exposure.
• Audit exposure. The IRS and state regulators expect clean audit trails — not cobbled-together spreadsheets. Gaps invite scrutiny.
• Investor mistrust. In a market that already operates under enhanced scrutiny, unclear or unreliable costing erodes confidence and can stall fundraising efforts.

How ERP automates cannabis cost accounting

ERP systems purpose-built for cannabis embed costing into daily operations. That means:

• Real-time updates. Costs roll through cultivation, processing, packaging, distribution and retail automatically, so you always know your cost per unit.
• Flexible costing configurations. Whether you’re using standard, actual, FIFO/LIFO or weighted average, ERP supports multiple methods and ensures consistency across entities.
• Audit-ready records. Every batch, lot, and adjustment is tracked with the documentation auditors and investors expect.

Instead of reconciling after the fact, you get a live picture of costs and a reliable basis for both tax compliance and business decisions.

Best practices for cannabis costing

Even with ERP in place, good practices make the difference between compliance headaches and confidence:

1. Choose systems that allow multiple costing methods. As you grow, you may need to adapt — from actual to standard, or to ABC for more complexity.
2. Work with professionals. Consistently review your costing setup with accountants familiar with cannabis and 471 requirements.
3. Audit your models. Internal reviews and integrated reconciliations between ERP systems and seed-to-sale systems (such as Metrc) help you catch errors before regulators or investors do.
4. Document everything. Written policies, variance analyses, and signoffs create the audit trail that protects you in reviews.

The bottom line

Inventory costing is more than an accounting exercise for cannabis operators — it’s the backbone of compliance and profitability. While 280E limits what you can deduct, accurate and well-documented costing ensures you capture every allowable dollar and build investor confidence.

SilverLeaf ERP, powered by Microsoft 365 Business Central, simplifies cannabis costing by automating roll-ups, supporting flexible methods, and maintaining audit-ready records. Paired with the guidance of your tax and accounting advisors, it gives you both clarity and confidence.

Ready to see how SilverLeaf can simplify cannabis costing? Book a walkthrough.