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Getting Exit-Ready: Manufacturing Focus

TheNonExec gives the inside view on successfully selling a manufacturing company (and avoiding a price-chip).

In the world of privately-owned companies, the sale of a manufacturing company is a relatively rare occasion. Selling a manufacturing company involves much the same sales process as any other type of organisation. And it follows that if a headline deal is agreed upon, a buyer will examine the seller’s business thoroughly during the phase called ‘due diligence’.

There are, however, some specific aspects of due diligence that are unique to manufacturers (or indeed any firm that adds value to a product).

This paper touches on some of the key issues specifically related to manufacturing companies – and offers case studies on a number of company issues that have presented themselves to us over the years. Case studies have been completely anonymised and overall quanta adjusted, but the underlying issues do reflect actual real-world examples known directly to us.

The principal way to avoid a ‘price-chip’ is to fully understand how an experienced buyer will evaluate your stock and work-in-progress and to prepare accordingly.

But why stock and work-in-progress?

Because stock and work-in-progress (‘WIP’) usually form a significant value on a manufacturing company’s balance sheet.

Or put differently, an experienced buyer understands that if a selling company has not valued its stock and WIP correctly, that it may be able to (significantly) reduce the headline asking price!

In order to understand stock and WIP, a buyer will focus on three connected areas – (1) company ‘systems’, (2) physical stock and WIP, and (3) its stock obsolescence policy.


All companies will have a ‘system’ that handles the various processes needed to operate the business – e.g. generating sales orders, purchase orders, stock management, production control, etc. Each company will have its own way of doing this.

Manufacturing Systems and Company Sale Value

For example, most will have a specific software vendor used to handle the finances, whether on-premise or cloud-based. Think of systems such as Sage, Xero, QuickBooks, etc. Some will have a separate 3rd party production-control system and some will have fully integrated ‘Enterprise Resource Planning’ (‘ERP’) platforms such as SAP, Microsoft, Oracle, etc. that bring together all elements of the business – finance, sales, purchasing, production, HR, etc.

The buyer will examine, very carefully, how these systems generate the data that flows into the income statement and the balance sheet. The systems will be audited to follow the actual process flow and how this affects the financial data collected in the ‘finance module’ – i.e. the software/system used to compile the management / annual accounts.

Parts ordered to fulfill production orders move around the factory and the balance sheet – stock can be ‘in-transit’ (i.e. despatched from a supplier but not arrived), held in pre-quality inspection, held in inventory, rejected due to poor quality, moved to production (i.e. converted to WIP) – and hence a buyer will need to know how this mechanism works (a) in practice and (b) using the company IT system.

One of the key areas that will be examined will be the mechanism for the calculation of WIP. A manufacturing company creates value through its production process – and parts that are transferred from the stock into the production area will be subject to increasing value. The supporting calculations and process flow are critical.

Case study: A company produced manual calculations for WIP. This was based on a certain percentage of work calculated at each stage of production and a historical labour rate, £18 per hour in this case. On examination, the buyer concluded that the labour rate was disproportionately low and in particular did not factor in a substantial direct overhead cost related to the cost of production. The result was a significant under-valuation of WIP which under-stated the seller’s net assets – a disadvantage for the seller in a sales process.

Most companies produce management accounts on a monthly or quarterly basis. These will be used by the buyer to assess the accuracy of the seller’s internal controls. The accuracy of movement in stock and WIP on a monthly basis has a direct impact on the income statement – i.e. the quantum of profit (or loss) declared. It is highly important that the actual physical process of how the stock is moved through the value chain is recorded correctly and ‘as it happens’.

Case study. A company used MS Dynamics for its financial & production control systems. The company had not, however, loaded a full bill-of-material (‘BoM’) for its products into the system. Job cards issued to production only ‘pulled’ approximately 30% of the material (stock) through. The balance was simply a manual entry. As a result, stock shown by the MS Dynamics system at the end of each month was over-stated and WIP was significantly under-stated. Gross profit reports at product level were significantly incorrect. The monthly income statement was hence incorrect which un-nerved the buyer considerably. Whilst the seller conducted an annual stock check to ‘correct’ the system, the buyer struggled to get comfortable with the seller’s management accounts and the underlying gross margin.

Tip! Buyers will want to see accurate and regular management accounts throughout the sales process (which can range from 6 – 12 months).

Most manufacturing firms will have a complex and potentially diverse supply chain. Supply lines could be arriving from the UK, Europe, or as far afield as Asia, the Americas or the Middle East. Supply could be arriving by air-freight, by land, or by sea. The seller needs to account for these goods correctly – a buyer will want to ensure in particular that goods ordered (but not received) have been correctly accounted for.

Case study. A UK company bought parts from India. The product was shipped on a 12-week lead-time to the factory in the UK. As the financial year-end closes, the company ordered £1M of parts from India – ordered but not paid for. The supplier shipped the product (but does not yet invoice). The company did not account for these ‘goods-in-transit’ and hence closing stock at year-end did not record the value. Buyer due-diligence argued that because the company had to insure the product in transit (due to change in goods title), that it should be accounting as ‘goods-in-transit’. This additional ‘goods-in-transit’ value changed, substantially, the income statement that the seller had depended on to strike a deal…

A buyer will wish to check that foreign purchases are accounted for correctly – and at the correct exchange rate at the time of the transaction.

Case study. A UK company ordered a substantial supply from the USA. The purchase order was created in USD $. The company converts USD $ to GBP £ on a fixed rate adjusted quarterly. The difference in value (systems rate versus actual paid) flows to a reserve account on the balance sheet. A low-margin volume producer, the net result was that the operating margin reported by the company in its income statement was misreported on a monthly basis.

A buyer will want to test the company mechanism for (re) ordering supply lines and to ensure that such systems are robust and timely. It may pay particular attention if supply lines are subject to some form of automated re-ordering using MRP…

Case study: A company moved from ‘manual’ minimum re-order levels to an ERP enabled ‘manufacturing resource planning’ (‘MRP’) module. Configured to automatically re-order supply lines to a Chinese supplier, the system automatically sends purchase orders based on a system-based knowledge of stock forecast levels. Buyer due diligence uncovers that the ‘algorithm’ uses a 4-week lead-time against a real-world lead-time of 14-weeks – hence the system has been under-supplying. Stock is under-stated and urgently needs to be replenished (mid-deal). The extra stock required is in excess of £1.5M which substantially changes normalised working capital.


A manufacturer is unlikely to operate without stock or indeed without creating ‘work-in-process’. But there can be a considerable difference between what the company system states is ‘in stock or WIP’ versus reality!

Only a very few manufacturing companies will have full traceability and/or control of 100% of individual stock items. Consumable items such as screws, washers, packaging – these are often treated as kanban items – i.e. replenished on a ‘pull-basis’.

A company ‘system’ that supposedly allocates stock to production might have serious technical flaws from an accounting perspective (and yet continue to facilitate ongoing production).

A simple test for this is to count stock & WIP outside the normal check-cycle (e.g. year-end) and compare against the system value.

Case study: A company undertook a rolling stock check of its warehouse on a quarterly basis and was confident of accuracy. The buyer checks and finds almost 30% inaccuracy! The principal reason for the difference is that one large volume material is purchased in 10m lengths, whereas the system records it in weight (Kg). The stock-checkers did not understand the difference – which produced a discrepancy in stock value just under £1.3M…

Tip! One of the biggest issues in stock control is system metrics. It is critical that units of measurement are managed carefully – i.e. units used in the purchase order module flow through to the same units of stock / BoM and that these are measured and counted correctly.

Whilst stock can be often viewed as component material and parts, stock value can also include the value of ‘finished goods’ – e.g. completed products held for general supply or to satisfy future orders. It is critical that finished goods are valued correctly!

Case study: A company used a spreadsheet to manually calculate WIP and finished goods. The company used a direct labour rate of £32 per hour to value WIP. WIP is transferred to ‘finished goods.’ Buyer due diligence uncovered that the spreadsheet used a direct labour rate of £75 per hour for finished goods (instead of the correct £32 per hour) – a manual input error in the spreadsheet. With a finished goods value of £1.2M, the corrected value reduces this to less than £0.7M – an asset reduction of some £0.5M.


Stock Obsolescence and Company Sale Value

Parts or materials are purchased to support an immediate or future product need. As stock increases, so does its ‘aging’ profile. Some of the stock will be relatively new – e.g. purchased in the last few months, and some might be older, say, a few years old.

Stock is valued according to the accounting policy chosen by the company – and within this definition, there is considerable scope for the company to choose how it values the older stock.

Some manufacturing companies would argue that all stock, independent of its age, is valued in full. For example, raw material kept in dry and unused condition – e.g. stainless steel, should carry its value in full, right?

A buyer will see this in a different light. Most larger buyers will have a strict accounting policy that applies a ‘stock provision’ (i.e. write-downs in the value of the stock) according to its age. Some will completely write-off stock older than 12—24 months, some will have aggressive write-downs for stock older than 6 months.

The point being here, that a buyer will likely argue to apply a similar stock write-down policy to a seller’s business.

Tip! The actual value of a part or material is different from its accounting treatment. Buyers will want to see a consistent write-down policy to reflect older stock.

Case study. A company operated successfully for 30 years producing general engineered products. Carrying a stock value of £3M, it never wrote off stock on the basis that it can potentially use stock. Buyer due diligence discovered 70% of the stock is older than 3 years (~ £2.1M). The buyer argued that the 3-year old stock is largely a legacy stock and its accounting value should be treated as such.

Tip! Putting a stock-provision policy in place – i.e. writing down stock value, is not an admission that stock is unusable. It is simply a good practice from an accounting viewpoint. Discuss with your accountant and review ‘best-practice’. A stock provision policy needs to be consistent and well thought through – and needs to stand up to buyer due diligence!

SUMMARY – Getting Exit Ready: Manufacturing Focus

Stock and WIP tend to be a focal point for a buyer’s financial due diligence. What is considered to be a simple internal process to a seller can be considerably more complex on examination by a buyer.

The point here is important. A seller may have relied on certain practices and processes to operate his / her company successfully. But that does not mean they are robust from an accounting perspective. We have seen more than two dozen manufacturing companies that are financially highly liquid, yet on inspection, cannot say with any degree of accuracy what its product margins really are. Or what its stock value is “real-time”. Very often commanding big-ticket deal prices of many £M’s, a buyer will want to have this information nailed down exactly before finally committing to the deal.

Often as not, under scrutiny, the seller will advise the buyer that their external accountant is ‘comfortable’ with the accounts – and that this should simply close off the matter because the ‘accountant says so’ – i.e. the company has been held to a high level of independent scrutiny.

Worthy of a paper on its own, this rarely stands up. For the first part, small businesses with revenue < £10.2M do not require auditing and hence operate under enormous flexibility led by the company directors. Even if the company is audited, this still provides for considerable flexibility in how the business is operated – with accounting firms usually disclaiming responsibility on the basis that they act only on prima facie data and limited tests.

The simple fact is that a buyer will conduct its due diligence in considerably more detail than an external accountant would ever conduct, under normal terms of engagement. And for this reason, the buyer’s audit usually holds out as being definitive!

Stock and WIP tends to be a focal point for a buyer’s financial due-diligence

What can a manufacturer do to plan for an exit?

  1. Engage a competent accounting firm to run pre-due-diligence on its stock and WIP control process – including full stock checks.
  2. Implement corrective actions – e.g. create an effective stock provision policy for older stock, improve production control processes, implement effective cut-off dates for stock transactions.
  3. Implement rolling stock counts across all major product groups.
  4. Produce monthly management accounts that provide accurate stock & WIP values and product margin on a monthly basis.
  5. Ideally, implement a full ERP system that provides 100% BoM traceability through the production process.
  6. Regularly test the management accounts to reconcile income statement, balance sheet against cashflow. If the financial period has started with a 100% stock-check, any error in operating profit should show up in the numbers.

Having a bullet-proof stock and WIP control is a great way to avoid a price chip. It’s not the only area a buyer will focus on by any means, but at least this one will be ticked off the list.

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