Manufacturing businesses and understand gross profit margin

January 17, 2025

by a searcher from Columbia University - Columbia Business School in Princeton, NJ, USA

I have a deal under LOI in a manufacturing business. The financials for this business is a gross profit that only takes into account materials. Labor is captured in SGA. How should a manufacturing business under GAAP better represent this? The two things that come to mind is FOB destination sales and inventory costing as how these are accounted for can have a material impact on the normalized gross profit margin. Any help or guidance in this area would be greatly appreciated especially from technical professions in this space.

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Reply by an intermediary
from Babson College in Boston, MA, USA

I wouldn’t overthink this unless you have large amounts of finished goods inventory on hand, if the manufacturing cycle is more than a month or 2, declining sales or lastly a build up of inventory that they’re asking you to pay for.
But to answer your question directly, US GAAP captures labor as a component of inventory that ultimately gets expensed when product is sold and sale is recognized.
again depending on size of the deal, it’s likely not something you should be spending too much time on comparing to GAAP. For two reasons,
(1) benefit of knowing likely doesn’t outweigh the cost
(2) current owner won’t have the slightest clue of what you’re talking about and if it’s showing a negative impact to valuation he’s going to just throw you out the door.
feel free to ping me for further discussion. I’ve done well over 100 deals and have a lot of experience with manufacturing.

Reply by a searcher
from Concordia University in Toronto, ON, Canada

You see this in many small businesses even the material cost in your example might not be accurate as they expense whatever they purchase, without factoring in the stocks level at the beginning and at the end of the period.
As the business grows you get more accurate with COGS to include materials, freight, direct labor, sub-contract services, etc. into the COGS and additionally identify and report operating expenses such as utilities, repair and maintenance, rent, amortization, indirect labor, insurance, warranties, etc.
As an operator focusing on improvements, you will need to have a better idea of the cost structure and accounts to focus improving. But even then you do not need to reclassify everything to accord GAAP. You do it as much as you need (you can spend a whole money to prepare GAAP FS but the cost will exceed benefits).

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