I was asked by the National Association of Certified Valuators and Analysts (NACVA) to present a webinar concerning Work In Process Inventory Adjustments. I thought it would be a good time to preview a bit of what will be discussed during the webinar. You can click here for a link to the webinar site if you are so inclined.
Many businesses have work in process inventories that can be difficult to work with in a business ownership transition. These businesses include manufacturing, agriculture, some types of value-added distribution and even some service businesses. These inventories may change in quantity and value based on the stage of production that each product is in and often on the type of product being produced. Adjustments must be made at closing of an ownership transition to properly account for these changing inventories.
Â— Some Value-Added Distribution businesses
Â— Some service businesses
What distinguishes the first two?
- Â— Perishable
- Â— Must determine how to accurately allocate overhead costs
For nearly every business that changes ownership a Working Capital Adjustment will be made. Simply put, when an offer is made and accepted it includes a figure for Working Capital. Simply speaking this is Inventory + Accounts Receivable â€“ Accounts Payable in an asset sale. This number will almost always change somewhat between the time the offer was made and the closing, necessitating an adjustment to the final purchase price to account for the change.
For businesses with sophisticated cost accounting systems this is often not a significant problem since they are constantly allocating direct overhead to inventory. So long as the parties agree on the overhead allocation the only thing that needs to be done is a Working Capital Adjustment at closing.
Many mid-sized and smaller businesses do not employ these types of cost systems however, or they have inventories that are highly perishable or may change seasonally or simply based on volume. These inventories may be more difficult to account for and will require negotiated mechanisms to value them at closing.
Why is This Important?
Â— To reach a proper business valuation
Â— To demonstrate to lender inventory value for financing requirements
Â— Valuing a business utilizing Discounted Cash Flow Analysis places heavy weight on immediate cash flows
Â— The buyer needs to clearly understand product pricing and GM
Â— To calculate WC adjustment and tax impacts at closing
Â— To determine the impacts of changes in accounting practices post-closing for tax and financing projections.
Components to Examine
- Are the following costs included in COGS or are they carried in overhead?
- Direct Labor
- Do these inputs vary based on the product being produced or the season in which it is produced?
- How do you fairly value a product that may not be marketed for several months?
- Is inventory subject to mortality (death loss) and how will this be handled?
- Is inventory subject to morbidity (poor performance due to disease) and how will this be handled?
- Is inventory subject to sudden changes in production practices and how should this be valued and projected?
- How was inventory purchased and financed?
- Is inventory held at off-site locations and how does this impact the due diligence process.
There are many other issues that can occur. These are usually handled via an adjustment at closing, a post closing adjustment, a â€œescrow basketâ€, claw back provisions, earn out provisions or some form of variable pricing on inventory dependent on future sales. It is nearly always a point of contention and will involve significant negotiation.
This is generally a difficult issue for both parties to a transaction. If you do not have an experienced transaction advisor involved you can leave significant value behind.