Back In Black
A guide to profit margins and tax strategies to keep your business out of the red
There are seemingly a million factors to consider and decisions to make when opening or operating a cannabis retail store. While many of them aren’t accounting or tax-related, having a good handle on these items is critical to your success.
Having hundreds of clients in the cannabis industry, I’m often asked by friends, “How much are those marijuana retailers making? They must be making money hand over fist, right?”
That’s certainly the public perception, but that’s unfortunately not always the reality. Here, I will address some issues you’ll face and questions that you will not only have to ask yourself, but more importantly, need to answer before jumping into cannabis retailing. If you’ve already jumped in, these issues, and questions and answers, could mean the difference between financial success or failure.
Smart Budgeting
If you don’t know where you’re going, you’re never going to get there. When you’re putting your business plan together, one of the key elements of that plan is creating a capital expenditures budget and an operating budget.
A capital expenditures budget outlines the funds that you’ll need to invest in the physical assets of your business. Examples are display cases, cash registers and store build-out.
An operating budget is essentially a projection of all your estimated income and expenses based on your sales forecast for a given period. I recommend breaking down the operating budget by month for the first year for more granularity. When doing this, it’s wise to consult a CPA or someone familiar with financial matters. But that doesn’t mean you should have someone create the budget for you. Try to put together these budgets yourself, then bring in an expert to help you refine them.
If your margins aren’t strong enough based on your projected sales volume, you could have a difficult time covering your fixed monthly operating expenses.
You are also going to need an accounting system to help you manage your business effectively and compare your results to your budget. It’s impossible to make good business decisions without a good accounting system in place. There are plenty of good systems out there that are relatively inexpensive and easy to use. Be sure to get a recommendation from a bookkeeper or a CPA.
One of the first questions you should ask yourself is: Will your business be profitable on an after-tax basis? To figure that out:
Start with estimating what you think your monthly sales are going to be.
Next, gain an understanding of how much the items that you’re going to sell will cost.
Once you have a handle on these two items, you’ll be able to figure out your gross margin and gross margin percentage. This is important because you’ll want to know how much in sales is required to break even.
Gross margin = sales – cost of goods sold
Gross margin percentage = gross margin ÷ sales
Let’s say you sell something for $50 that cost you $30 at wholesale, your gross margin is sales ($50) – cost of goods sold ($30) = $20. Your gross margin percentage is gross margin ($20) ÷ sales ($50) = 40%
When you have a better idea of what your gross margin is, you’ll be able to figure out how much in monthly sales are required to cover your fixed operating expenses. This is known as the break-even point. Fixed operating expenses are items that don’t change relative to sales volume. Examples are rent, utilities, advertising, payroll and debt service.
Because federal income taxes are effectively much higher for cannabis retailers, it’s important to set them aside every month even though they don’t need to be paid to the IRS every month.
Break-even point = fixed operating expenses ÷ gross profit margin
So, if you have $50,000 per month in fixed expenses, and your gross margin is 40%, your break-even point is: fixed operating expenses ($50,000) ÷ 40% = $125,000. So you’ll need to have a sales volume of $125,000 per month to cover your fixed operating expenses and to break even. If your gross margin is 50% you will only need to have sales volume of $100,000 ($50,000 divided by 50%) per month to cover your fixed operating expenses.
Understanding these concepts can’t be overstated. They’re going to drive your purchasing and pricing decisions on a daily basis. If your margins aren’t strong enough based on your projected sales volume, you could have a difficult time covering your fixed monthly operating expenses.
TERMS TO KNOW
Break-Even Point: Revenue needed to cover a company’s total fixed expenses during a specific period of time.
Capital Expenditures Budget: A budget outlining the funds a company will need to acquire physical assets for its business.
Fixed Operating Expenses: A business expense that does not change regardless of sales and must be paid regardless of a company’s performance.
Gross Margin: A company’s total sales revenue minus the costs of goods sold.
Gross Margin Percentage: A company’s gross margin divided by its total sales revenue.
Internal Revenue Code Section 280E: Prevents businesses from deducting ordinary expenses from income associated with Schedule I or Schedule II substances.
Operating Budget: A projection of a company’s estimated income and expenses based on its sales forecast for a given period of time.
Talking Taxes
Let’s throw in a twist and talk about federal income taxes. Because of Internal Revenue Code section 280E, the only deduction that a cannabis retailer can take against income is cost of goods sold. As some of you know all too well, this means that most of your fixed operating expenses (rent, utilities, advertising) are not deductible for federal income tax purposes. This puts the cannabis retailer at a distinct tax disadvantage to other types of retailers who can deduct all their operating expenses against income when they compute their tax. Therefore, you need to consider federal income taxes when computing your true gross margin and true gross margin percentage.
Let’s say you have a 50% pre-tax gross margin, $130,000 per month in sales volume and $50,000 per month in fixed expenses. The business technically made a $15,000 pre-tax profit (sales x pre-tax gross margin – fixed expenses). However, your taxable income is going to be $65,000 (sales ($130,000) x gross margin (50%)), not the $15,000 you would expect for a non-cannabis business. Assuming a 34% corporate income tax rate, you’ll have a tax expense of $22,100 ($65,000 x 34%) for the month. Instead of making a profit, the business actually incurred a loss on an after-tax basis.
Because cannabis retailers pay income tax on their gross margin rather than normal net income, you can make a simple calculation to compute the after-tax gross margin (using the above figures as an example):
Take your pre-tax gross margin (50%) and multiply it by the corporate income tax rate (34%) = 17%; then reduce your gross margin percentage (50%) by that figure (17%). Your after-tax gross margin would be 33%.
Going back to our previous examples where we had a monthly fixed cost of $50,000, when we apply our after-tax gross margin (33%), we find we will need $151,515 ($50,000 ÷ 33%) in sales per month to break even after taxes.
The chart at right is what it looks like in financial statement format.
It is critical that you understand what your after-tax gross margin percentage needs to be to figure out your break-even point. If you don’t consider the effect of federal income taxes, you will underestimate the amount of sales required to break even by a significant amount. In this example, you would underestimate your break-even sales by more than $51,000 per month.
Because federal income taxes are effectively much higher for cannabis retailers, it’s important to set them aside every month even though they don’t need to be paid to the IRS every month. I recommend that you set up a separate business bank account specifically reserved for taxes. Keep those funds out of your operating account, and you’ll be more likely to have the funds available when they are due. Once you fall behind, it is very difficult to catch up.
An easy way to figure out how much to set aside every month is to use a figure that is based on a percentage of your sales. You can apply knowledge of gross margins to reserving for taxes. Simply take your gross margin percentage and multiply it by the corporate tax rate, and the result is the percentage of sales you should set aside for federal income taxes. Example: If your gross margin percentage is 40%, then you should expect your federal income tax burden to be 13.6% (40% x 34%) of your sales. This is the amount that you should be setting aside in your tax account every month.
Understanding these concepts should help you along the path to long-term success and staying ahead of your taxes.