Cannabis COGS Calculation: What Costs Can You Actually Include?

Cannabis businesses pay federal income tax on their gross income with exactly one offset: cost of goods sold. That is the consequence of IRC 280E, which denies every deduction and credit to any business that traffics in a Schedule I or Schedule II controlled substance. As of this writing, marijuana remains on Schedule I under federal law, and 280E remains fully in effect. No rescheduling or legalization bill has been enacted. The only relief available is the COGS subtraction, because COGS is not a “deduction” under the tax code. It is an adjustment to gross receipts that determines gross income in the first place. The broader mechanics of 280E are covered in our 280E overview. This article is about the calculation itself: what goes into COGS, what stays out, and how to build the cost-accounting methodology that survives an audit.

Why is COGS the only offset under 280E?

Because the statute denies “any deduction or credit” to a business trafficking in a controlled substance, but COGS is neither a deduction nor a credit. COGS is the mechanism by which gross income is calculated under IRC 61. The IRS recognized this distinction in Chief Counsel Advice 201504011 and in its examination guidelines for marijuana businesses. The Tax Court confirmed it in Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173 (2007), holding that a cannabis dispensary could subtract COGS from gross receipts even though 280E barred all other deductions. The CHAMP decision did not expand what counts as COGS. It confirmed that the existing COGS rules apply, and that 280E does not override them.

The practical result is that every dollar you can legitimately move from “operating expense” into “cost of goods sold” reduces your taxable income dollar-for-dollar, while every dollar that stays classified as an operating expense produces zero tax benefit. For a cannabis business in the 37% federal bracket, a $100,000 cost that qualifies as COGS saves $37,000 in federal tax. The same $100,000 classified as a selling or administrative expense saves nothing.

What costs go into COGS for a cannabis cultivator?

The IRS requires cannabis businesses to use the inventory-costing rules under IRC 471 and IRC 263A as they applied before the Tax Cuts and Jobs Act of 2017. The TCJA added Section 471(c), which lets certain small businesses (average annual gross receipts of $32 million or less for 2026) use a simplified inventory method or treat inventory as non-incidental materials and supplies. The IRS has taken the position that cannabis businesses cannot use these simplified methods because doing so would effectively allow deductions that 280E prohibits. The result is that cannabis cultivators must apply the pre-TCJA full-absorption costing rules under Section 263A, which actually works in the taxpayer’s favor: full absorption captures more costs into inventory (and therefore into COGS) than a simplified method would.

Under the full-absorption method, the following categories of cost are includable in COGS.

Direct materials. Seeds, clones, starter plants, soil, growing medium, nutrients, fertilizers, pesticides, and water used in cultivation. These are the raw-material inputs to the production process and are always part of COGS without dispute.

Direct labor. Wages, payroll taxes, and benefits for employees whose work is directly attributable to the cultivation, processing, trimming, curing, or packaging of the product. This includes growers, trimmers, extraction technicians, and packaging line workers. It does not include budtenders, delivery drivers, sales staff, or the general manager (unless the general manager spends a substantial, documented percentage of time on production activities, in which case that percentage is allocable).

Packaging and labeling materials. Containers, child-resistant packaging, labels, and compliance stickers that are part of the finished product as it enters inventory. These are direct materials consumed in the production process.

Quality-control testing. Testing costs incurred as part of the production process (potency testing, contaminant screening required before the product can be sold) are allocable to COGS as an indirect production cost under 263A. Testing performed for marketing purposes or consumer education is not.

Facility costs allocated to production. This is where the calculation becomes both more valuable and more contentious. Under the Section 263A full-absorption rules, indirect costs that are incident to and necessary for production must be capitalized into inventory. For a cannabis cultivator, this includes the portion of facility rent, utilities (electricity for grow lights, HVAC, water systems), property taxes, insurance, and building depreciation that is attributable to the cultivation and processing areas of the facility.

The allocation must be reasonable and documented. A common method is square-footage allocation: if 60% of a facility’s square footage is dedicated to cultivation, processing, and packaging, then 60% of rent, utilities, property insurance, and building depreciation is allocable to COGS. The remaining 40% (retail floor, offices, break rooms, storage for non-production items) is a period cost, and under 280E, it produces no tax benefit.

Equipment depreciation. Depreciation on equipment used directly in production (grow lights, irrigation systems, trimming machines, extraction equipment, packaging machinery) is an indirect production cost under 263A and is includable in COGS. Depreciation on office furniture, point-of-sale systems, or delivery vehicles is not.

What costs are excluded from COGS?

The line is clear in principle: costs that relate to selling, marketing, administration, or distribution are not production costs and do not belong in COGS. Under 280E, they are simply non-deductible. The major categories that cannot be included are:

• Selling expenses: budtender wages, sales commissions, point-of-sale costs, display materials, customer loyalty program costs
• Marketing and advertising: website, social media, print advertising, promotional events, branding, consulting fees for marketing strategy
• General and administrative: executive compensation (unless allocated to production), legal fees, accounting fees, office supplies, office rent (for space not used in production), software subscriptions unrelated to production
• Distribution and delivery: driver wages, vehicle costs, fuel, delivery app fees, transportation insurance
• Regulatory compliance costs not tied to production: licensing fees, legal costs for license applications or renewals, lobbyist fees, compliance consulting
• Interest expense: under 263A, interest can be capitalizable for certain types of produced property, but the IRS has generally challenged interest capitalization for cannabis inventory, and the case law is thin

The temptation is to reclassify selling and administrative costs as production costs to expand COGS. This is exactly what the IRS looks for in a cannabis audit. A budtender is a retail employee, not a production worker, regardless of whether the dispensary’s internal titles describe the role as “product specialist” or “patient consultant.” A delivery driver’s wages are distribution costs, not production costs, even if the driver occasionally helps unload shipments at the warehouse. The allocation must reflect the actual function performed, not the label assigned to it. The audit risk and compliance article covers how the IRS scrutinizes these classifications in practice.

How do the Section 471 inventory rules interact with 280E?

IRC 471 requires a business that produces or resells merchandise to account for inventory. COGS is calculated as beginning inventory plus purchases (or production costs) minus ending inventory. For a cannabis business, this means every unit of product must be tracked from seed or clone through harvest, processing, and sale. The inventory valuation method (FIFO, weighted average, specific identification) determines which costs flow through to COGS in each period.

The TCJA’s Section 471(c) created an exception for small businesses, allowing them to treat inventory as non-incidental materials and supplies deductible when used or consumed. The IRS has taken the position, articulated in its cannabis examination guidelines, that this exception is unavailable to cannabis businesses because the deduction for materials and supplies is a “deduction” barred by 280E, whereas COGS under the traditional Section 471 rules is a gross-income calculation that predates and survives 280E. This position has not been fully tested in court, but it is the IRS’s operating stance, and as a practical matter, the traditional Section 471 rules (combined with 263A full absorption) produce a larger COGS than the simplified method would, so most cannabis businesses benefit from the IRS’s position even though it was adopted to restrict them.

The key operational requirement is perpetual inventory tracking. A cannabis cultivator or processor needs a system that records the cost of every input (seeds, soil, nutrients, labor hours, facility overhead) allocated to each batch or lot, tracks the inventory through each stage of production, and releases costs to COGS only when the finished product is sold. Seed-to-sale tracking systems required by most state regulators provide the production-side data, but they do not calculate costs. A parallel cost-accounting system, whether built in a general ledger, a specialized cannabis ERP, or a well-structured spreadsheet, must assign dollar amounts to each unit of inventory and reconcile to the seed-to-sale records.

How does the CHAMP case affect the COGS calculation?

The Tax Court’s 2007 decision in CHAMP (Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 173) is the foundational case for cannabis COGS. The court held that a cannabis dispensary operating as a reseller (buying finished product and reselling it) could subtract the purchase cost of the cannabis from gross receipts as COGS. The IRS had argued that 280E denied all offsets, including COGS. The court rejected that argument, holding that COGS is a component of gross-income calculation, not a deduction.

CHAMP also addressed the dispensary’s caregiving activities (counseling, support groups) and allowed deductions for those services under a separate-trade-or-business theory. That part of the holding is narrower and more frequently litigated. For COGS purposes, the important takeaway is straightforward: the purchase price of cannabis inventory (for a reseller) and the production cost of cannabis inventory (for a cultivator, under the 471/263A rules) is subtractable from gross receipts regardless of 280E.

Subsequent cases, including Olive v. Commissioner (139 T.C. 19, 2012) and Alterman v. Commissioner (T.C. Memo 2018-83), have reinforced that COGS survives 280E but have been skeptical of aggressive cost allocations. In Alterman, the Tax Court rejected the taxpayer’s attempt to allocate a large portion of facility costs to COGS without adequate documentation. The lesson is consistent: the full-absorption method allows substantial costs into COGS, but only with a documented, reasonable allocation methodology.

What does a proper cost-accounting system look like?

A defensible COGS calculation requires three layers: a cost-accumulation system, an allocation methodology, and reconciliation to external records.

The cost-accumulation system captures every cost incurred in the production process. Direct materials and direct labor are traced to specific batches or production periods. Indirect costs (facility rent, utilities, depreciation, insurance, production-area maintenance) are accumulated in cost pools and then allocated.

The allocation methodology distributes indirect costs to inventory using a reasonable, consistent basis. Square footage is the most common allocation base for facility costs. Machine hours or direct labor hours are appropriate for equipment-related costs. The methodology must be documented in a written cost-accounting policy that specifies the allocation base for each cost pool, the data source for the allocation base (floor plans for square footage, payroll records for labor hours, utility sub-meters for electricity), and the frequency of allocation (monthly or per-batch).

Reconciliation ties the cost-accounting records to external sources: the general ledger, bank statements, payroll reports, vendor invoices, and the state-mandated seed-to-sale tracking system. In an audit, the IRS will test the COGS figure by pulling source documents and tracing them through the cost system. If the facility rent allocated to COGS does not tie to the lease agreement and a floor plan showing which rooms are used for production, the allocation fails. If direct labor allocated to COGS does not tie to payroll records and time-tracking data showing which employees worked in production (and for how many hours), the labor allocation fails.

How does entity structure affect the COGS calculation?

The entity itself does not change what qualifies as COGS. The Section 471 and 263A rules apply the same way to a sole proprietorship, an LLC, an S-corp, and a C-corp. But the entity structure affects how the non-deductible expenses hit the owner’s tax return, which changes the overall effective tax rate and therefore the relative importance of maximizing COGS. A C-corp pays entity-level tax on the income that survives the COGS offset, and the remaining after-tax earnings face a second layer of tax when distributed as dividends. An S-corp or partnership passes the income through to the owners, who pay individual rates but avoid the double layer.

The entity-structure analysis is covered in detail in the cannabis entity structure guide. For COGS purposes, the important point is that the cost-accounting methodology must be built at the entity level, documented in the entity’s books, and consistent from year to year. An entity that switches allocation methods without a justifiable reason (other than producing a larger COGS) invites scrutiny.

How do multistate operations handle COGS?

A cannabis business that cultivates in one state and sells in another, or operates multiple grow facilities, needs a cost-accounting system that tracks costs by facility and by product line. The allocation methodology must reflect the actual cost structure of each facility, not a blended average across the organization. A 20,000-square-foot indoor grow in Colorado with $300,000 in annual electricity costs has a different cost profile than a 5-acre outdoor farm in Oregon with $15,000 in electricity and $80,000 in seasonal labor. Blending the two into a single COGS pool obscures the true cost of production at each location and can produce allocations that the IRS challenges as unreasonable.

State-level tax treatment varies significantly as well. Some states conform to 280E, some decouple from it, and some have their own cannabis-specific tax regimes. The multistate considerations guide covers the state-level landscape. At the federal level, the COGS calculation is the same regardless of which state the production occurs in, but the underlying cost data must be facility-specific.

What documentation does the IRS expect in an audit?

Cannabis businesses are audited at a significantly higher rate than other industries. The IRS Cannabis Industry Compliance Program specifically targets COGS calculations, and examiners are trained to test the allocation methodology against source documents. The minimum documentation the IRS expects includes:

• A written cost-accounting policy specifying the inventory method (FIFO, weighted average), the cost pools, the allocation bases, and the frequency of allocation
• Floor plans or facility diagrams showing the square footage dedicated to production versus non-production activities
• Payroll records with time-tracking data distinguishing production employees from sales and administrative staff
• Utility records (ideally sub-metered for production areas, though sub-metering is not required if an alternative allocation is reasonable)
• Vendor invoices for direct materials, tied to batch or lot records in the seed-to-sale system
• Monthly or quarterly inventory reconciliations showing beginning inventory, production costs added, and ending inventory
• General ledger detail supporting each cost category included in COGS

The absence of any of these creates an opening for the IRS to reclassify costs out of COGS and into non-deductible operating expenses. The audit risk article covers the examination process and how to prepare for it.

What’s the single most common mistake in cannabis COGS?

Under-inclusion. Most cannabis businesses leave money in COGS by failing to allocate indirect production costs, not by over-allocating. The dispensary that calculates COGS as “what we paid our supplier for the product” and ignores facility costs attributable to on-site processing, packaging, and storage is paying more federal tax than the law requires. The cultivator that tracks direct materials and direct labor but does not allocate facility rent, utilities, and depreciation to the grow operation is doing the same.

The second most common mistake is inconsistency. A business that allocates 70% of rent to COGS in a profitable year and 50% in a loss year (because the loss year does not need the extra COGS) creates a pattern the IRS can use to challenge the entire methodology. The allocation basis must be set by the physical facts (square footage, labor hours, equipment usage) and applied consistently.

The third mistake is conflating COGS maximization with expense reclassification. Moving a budtender into the “production” category on the org chart does not make their wages a production cost. The IRS looks at the work actually performed, not the title. If the employee spends 90% of their time on the retail floor interacting with customers, their wages are a selling expense, full stop.

Related guides:

• Cannabis Ancillary Business Tax Planning
• Cannabis Entity Structure Llc Scorp C Corp
• Cannabis Irs Audit Risk Compliance
• Cannabis Payroll Employment Tax 280E
• Cannabis Real Estate Leasing Tax Treatment

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.