How Inventory and Work in Process Affect a Manufacturing Business Sale

For many machine shops, fabricators and contract manufacturers, inventory and WIP are among the largest assets on the balance sheet. They are also among the hardest to support. A buyer cannot see work on the floor in a P&L, so it relies on counts, job-costing records and reconciliations. Where those are missing, the buyer fills the gap with its own assumptions, and those assumptions rarely favor the seller.

Why inventory matters to both price and proceeds

Inventory accounting changes reported earnings, and inventory balances change the closing payment. Sellers need to understand both effects.

Our guide to working capital in a manufacturing sale explains how the peg and true-up work.

The four inventory issues buyers test first

1. Counts and reconciliation

Buyers want to know when the company last did a full physical count, whether cycle counts are done, and whether the count matches the general ledger. A count done only at year end, with large adjustments each time, suggests the monthly figures are estimates. That weakens both the trailing earnings and the working capital peg.

2. Obsolete and slow-moving stock

Material bought for a program that ended, finished goods for a customer that left, or bar stock that has sat for years may still be on the books at full cost. Buyers usually ask for an inventory aging report and expect old or unused items to be written down or reserved. If the seller has not done it, the buyer will, usually at the closing table.

3. Costing method and overhead

How labor and overhead are applied to inventory and WIP changes the value of every job on the floor. If the method changed between years, or overhead rates are not updated as volumes change, margins become hard to compare across periods. Buyers look for a consistent, documented method.

4. Customer-owned and consigned material

Many contract manufacturers hold material, tooling or finished goods that belong to customers. If that material is mixed into the company’s own inventory, or included in the count, both earnings and working capital can be overstated. Buyers will ask for a list of customer-owned items and how they are tracked.

How WIP gets valued, and where the disputes start

Work in process is partly finished jobs: material issued, labor spent and overhead applied, but not yet shipped or billed. Its value depends on how far along each job is and how much cost has been booked against it.

Common problems in manufacturing WIP:

• Estimated, not measured. WIP is calculated as a rough percentage of open orders rather than from job-costing records.
• Losses not recognized. A job that is over budget is still carried at full cost, even though the remaining revenue will not cover it.
• Billing ahead or behind. Progress billings or customer deposits do not line up with the work completed, which makes WIP and revenue harder to match.
• Stale jobs. Jobs that have sat open for months, waiting on customer changes or rework, remain in WIP at full value.

A buyer that cannot rebuild WIP from job records will usually take a conservative view. The seller can avoid that by running a WIP schedule monthly, by job, with the costs booked and the expected margin on completion.

Avoiding double-counting in the deal

The same inventory can be counted twice in a deal if the seller is not careful: once in the earnings that set the price, and again in an add-back or a separate payment. Buyers watch for this, and sellers should too.

A hypothetical example

A machine shop shows $1,800,000 of inventory and WIP on its books. In diligence, the buyer’s accountants find:

• $140,000 of material and finished goods for a program that ended two years ago, with no other customer or use for it,
• $60,000 of customer-owned bar stock included in the count, and
• $100,000 of WIP on three jobs that are already over budget, where the cost already booked will not be recovered from the customer.

In this example, the accountants conclude that all three items should come off the books. Together that is $300,000 of overstated inventory. Part of it may also have flowed through cost of goods sold, overstating the trailing earnings. If the buyer concludes that $80,000 of the overstatement inflated last year’s EBITDA, at a 6.0x multiple that is $480,000 off the price. Working capital can take a second hit. If the peg was set from the old, uncorrected balances, the corrected inventory delivered at closing can come in as much as $300,000 below it. If the peg is recalculated on the same corrected basis, most of that second hit goes away. That is why the inventory method should be agreed before the peg is. None of this means the business is weak. It means the records were not ready for the scrutiny of a sale.

What to clean up before you go to market

1. Do a full physical count and reconcile it to the general ledger. Then keep up cycle counts so monthly figures can be supported.
2. Age the inventory and reserve or write down obsolete and slow-moving items yourself.
3. Document the costing method for labor and overhead, and apply it consistently across the periods buyers will review.
4. Run a monthly WIP schedule by job, with costs to date, expected costs to complete and expected margin.
5. Separate customer-owned material and tooling in the system and on the floor.
6. Agree on the treatment early. Settle in the LOI how inventory and WIP are treated in the price and in working capital.

Inventory and WIP are also central to a quality-of-earnings review. See our guide to quality of earnings for manufacturing sellers for the broader financial preparation.

Frequently asked questions

Is inventory included in the sale price of a manufacturing business?

Usually, a normal level of inventory is expected to stay in the business as part of working capital, so it is included in the price rather than paid for separately. Some smaller deals handle inventory separately. The treatment should be agreed in the LOI.

How do buyers value work in process?

Buyers usually look at job-costing records to see the material, labor and overhead booked against each open job, then test whether the remaining revenue will cover the cost to complete. Jobs that will lose money, or that have sat open too long, are often valued lower.

What happens to obsolete inventory in a sale?

Buyers typically expect obsolete or slow-moving inventory to be written down or excluded. If the seller has not done it, the buyer will usually adjust for it in diligence or at closing.

Can inventory problems change my EBITDA?

Yes. Because ending inventory reduces cost of goods sold, overstated inventory makes earnings look higher than they are. A buyer that restates inventory may also restate EBITDA, which lowers the price.

How should customer-owned material be handled?

It should be tracked separately and excluded from the company’s own inventory and from the working capital count. Buyers will ask for a list of customer-owned material and tooling.

This article is general educational content for business owners. It is not legal, tax, accounting or transaction advice. The example is hypothetical. Inventory accounting should be reviewed with a qualified accountant.