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Accounting

Are You Shorting Yourself on EBITDA?

April 28, 2022
Many manufacturers seriously undervalue the cost of their products.

Know your worth. That’s an empowering message, and sage advice for an individual. There’s a similar and equally important message that needs to be shared with manufacturers. Know your product’s worth.

It’s not an exaggeration to say roughly half of all manufacturers don’t calculate the cost of their inventory properly. Both fixed and variable costs factor into the fully loaded cost per unit. There are also instances in which business owners miscategorize expenses, mismanage marketing initiatives and undervalue their company on their balance sheet and in acquisition negotiations.

It Takes More than Material

Just calculating the cost of the raw materials used to make a product is insufficient. Rent, electricity, employees’ wages, insurance and utilities all need to be taken into consideration. What if a business owner miscalculates the cost of producing a part by one cent? No big deal, right? But what if that business produces millions of those parts every year? Now we’re talking major cash.

A manufacturer can’t afford to misfire on their projections. If product A is half the cost in raw materials of product B, but product A requires 10 times more electricity to produce, that is critical information.

When it comes to rent and electricity, if you're using 50 percent of the building to manufacture a product, then 50 percent of the rent and electric cost should be allocated to the inventory. The same thing goes for depreciation of equipment, or the salary of a supervisor who spends half their time doing administrative tasks and the other half supervising the manufacturing.

Push the Right Product

Aggressive marketing campaigns can have tremendous success, but it’s important to budget wisely. Consider a manufacturer that has two main products. They decide to put a vast majority of their marketing dollars behind what they think has the higher margin.

But what if the other product is more profitable, and therefore more deserving of that push? Manufacturers can leave big money on the table when they make marketing and business development decisions based on faulty data.

Let’s Make a Deal

Companies that don’t realize how high their costs truly are expense too much too quickly and set prices too low. The valuation of inventory is wrong on the balance sheet. They’re misstating the P&L because expenses are too high and they're misstating the balance sheet because assets are too low.

In an acquisition, these costs should be capitalized to increase EBITDA. An acquisition price is often in the ballpark of a multiple of five or six times EBITDA valuation. The more of the overhead that’s expensed, the lower the EBITDA. Business owners do themselves a major, and expensive, disservice when it comes to the valuation of their company when they expense something that should be capitalized.

Time for another example. A CPA is doing sell-side due diligence for a company that developed internal software. The value of the software is $250,000, but it was expensed. The owner didn’t know that the company should have capitalized it.

The CPA says to the owner: You have this $250,000 asset that you expensed and you're trying to sell your business. We can capitalize this — that’s $250,000 times a six-multiple EBITDA. In other words, that's $1.5 million you, as a business owner, are shorting yourself on the valuation of your company. Now enjoy that extra $1.5 million in your pocket.

The software was an asset created by the company that is going to generate future cash flow. It's going to depreciate over the years rather than be expensed in the first year. Also, that depreciation is added back in when you calculate EBITDA.

As a manufacturer, you’ve already accomplished the hard part. You make a product people want to buy. Now make sure you know its true worth.

Mike Trinks is a partner at the Connecticut accounting and advisory firm Fiondella, Milone & LaSaracina LLP (FML)

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