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October 13, 2023

From Overhead to Overdrive: How to Optimize Overhead Costs for Cannabis Retail Success

In 2020, about two thirds of cannabis retailers were profitable. Fast forward to 2022, and that number is down to 31%, according to MJBiz daily research.

There are a lot of reasons why that’s the case. Price compression keeps gross profit down as customers shop around for the best discounts. With prices set by the wholesalers, retailers typically use a standard markup of 100% which sets gross margin at 50% before discounting.

When you take into consideration overhead for a mid-sized cannabis company – a good overhead ratio is in the 25-30% range – you’re left with net income of around 20%. That’s a strong number, and for almost any industry, it would leave a business in a good financial position.

But for cannabis, that’s not the end of the story. Until cannabis gets rescheduled to Schedule III, federal taxes for retailers – which can be anywhere from 20%-40% – are essentially calculated based on gross profit because of Internal Revenue Service Code 280e.

Even in a best-case scenario, with all these numbers on the lower end, margins are razor thin. If a retailer’s tax rate is at the higher end, they can wind up breaking even – unless they nudge up their gross margin to above 50%. (See Chart 1.)

Achieving even a 40-50% margin has been a challenge for retailers, with price compression and competition from the illicit market. So, one lever for maximizing profitability is to keep overhead under control.

Overhead Ratio for Cannabis Retailers

There is not a lot of low hanging fruit when it comes to saving on overhead for cannabis retailers. The only area where the industry tends to save a few pennies is in marketing, since the industry is excluded from the costly channels, such as print and digital ads and billboards.

In the other major overhead categories, additional costs eat away at profit: high banking fees and expensive lines of credit (at least until SAFE banking gets passed); security, and higher rental/real estate costs.

Cutting those costs can help improve your bottom line, as I discuss here; but what really can move the needle is not slashing overhead – it’s decreasing overhead as a percentage of revenue (also known as overhead ratio).

Decreasing overhead by just a few points could help push a retailer into profitability. (See Chart 2.) To do that, we recommend scaling in the true sense of the word: increasing efficiency. In other words, increase profit while keeping your overhead number stable (or increasing at a meaningfully slower rate than your profit).

In the example below, you can see a retailer with a stable gross margin of 50%. By keeping their overhead costs stable over a five-year period, as they grow in revenue from $12mil to $17mil, they achieve $1.5mil in profits – even after tax at a 40% tax rate at the gross margin level (280E).

How to Maximize Overhead in Cannabis

When we talk about maximizing overhead for cannabis retailers, the question to ask is, “What can I do with what I have?”

Since marketing typically accounts for such a small percentage of overhead, the two areas to focus on are administrative and facility costs, both of which have a lot of potential for maximization.

Revenue Per Employee: Maximizing Your Administrative Expense

Regardless of revenue, every retailer needs to hire certain positions: inventory, security, compliance, and reception. The number of budtenders will be the most variable – and may fluctuate based on seasonal swings – but your salaried employees will stay relatively stable, even as your revenue increases.

Industry benchmarks suggest an average revenue per employee of $192,000, with an average of 6 employees per store. But that metric has a lot of wiggle room, going as high as $550,000.

We recommend keeping tabs on this metric in order to maximize your overhead. If your numbers are way off the industry average or are not improving steadily, you can look into issues like individual budtender performance. Inconsistent discounting is a common problem in cannabis retail and, considering the slim profit margins in general, you want to keep an eye on this by developing a process for setting limits on discounting.

Revenue Per Square Foot: Maximizing Your Facility Expense

A lot of small business owners are eager to grow by opening up new stores but growing into your square footage is one of the best ways to maximize overhead. In the example above, the retailer manages to increase their average basket size by five dollars per year. In year 1, their sales are $1,000 per square foot, and in year 5, that number has reached $1,400, while remaining in their two 6K square foot retail locations.

Increasing revenue per square foot is one measure to evaluate, as part of a scaling strategy. Using industry benchmarks, we know that $1,000-$3,000 per square foot is a reasonable expectation. When we look at a client’s goals, we can assess how much more they can grow within their current square footage, before they start to look at opening additional locations.  Having a solid understanding of your overhead costs will help you understand the cash flow needs as you expand and ultimately scale the business.

Designing an Efficient Growth Strategy for Cannabis Operators

When you start to look into maximizing overhead, it often turns out that the answer to the question, “What can I do with what I already have?” is, “a lot.”

Gross margin and overhead as percentage of revenue are the two biggest pieces of the profit puzzle and two financial KPIs you should be tracking. Once you set your goals, then you can drill down into issues of how you tweak those numbers to reach them. Maybe you can get your overhead down a little bit or continue growing but keep the overhead the same. Maybe you can boost your gross margin from 40% to 45% by getting your discounting down and building customer loyalty.

Within the category of overhead, there are several Key Performance Indicators to watch and several levers to pull to help develop an efficient growth strategy for your cannabis retail business.

Interested in learning more about how a virtual CFO can help you design a strategy for your business growth?

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