A manufacturer's reported gross margin is the output of five things: volume, selling price, input cost, product mix, and yield. A single margin percentage hides all five. In this sector, where capacity is built in advance and inputs are often imported, that matters more than in most businesses, because the reported margin may be an artefact of utilisation rather than a property of the product.
The diligence work is therefore arithmetic and evidence: rebuild the margin from its drivers, test the inputs against prices that exist outside the company, and establish what the capacity on the balance sheet will cost in depreciation once it is running.
Build the bridge, not the ratio
Construct a margin bridge for each of the last three years, separating the change into volume, selling price, input cost, product mix, and yield. Each driver carries a different implication:
- Selling price — whether the change is sustainable, or reflected a one-off market window.
- Input cost — whether the company can pass cost through, and with what lag.
- Product mix — whether margin improved because of a better portfolio, or because a low-margin line shrank.
- Yield and consumption — whether the change is operational, and whether it is repeatable.
- Volume — whether fixed cost absorption is flattering the margin at higher output.
Then compare the result with two or three listed peers in the same segment. Where the target's margin is materially above peers, the explanation should be specific — a product niche, a cost advantage, an integrated process. "Better management" is not an explanation a buyer can underwrite.
The volume driver deserves particular care. When a plant runs closer to capacity, fixed overhead is spread over more units and margin rises without anything improving. If the buyer's plan assumes lower volumes, that benefit reverses, and the bridge is the only place it becomes visible.
Capacity, capital commitments and depreciation
Advanced manufacturing businesses are usually mid-build. Construction in progress, equipment on order, and land or factory commitments all represent cash that has been spent or promised, and future depreciation that the current margin does not reflect.
Three items to establish:
- The capital expenditure committed but not yet paid, including equipment purchase contracts and construction contracts.
- The expected date each project becomes operational, and the depreciation that will follow.
- Whether any project has been delayed, and what that means for the demand it was built to serve.
The output is a pro-forma margin: what gross margin looks like once the committed capacity is depreciating at the planned volume. A manufacturer whose margin only works at full utilisation is a different investment from one whose margin survives at seventy percent.
Supplier concentration and imported inputs
Input cost is usually the largest line in cost of sales, and it is testable against evidence that exists outside the company: purchase invoices, contracts, and market quotations for comparable grades.
Three questions matter. Is the price paid consistent with quoted market prices for the same specification? Is it consistent across suppliers? And has it moved with the market over the period, or stayed flat while the market moved — which suggests either a related party arrangement or a contract that will not survive the closing?
Concentration is a continuity risk. Ask for the top ten suppliers by value, the duration of each relationship, and whether the supply agreement is contractual or informal. A single-source input is a single point of failure after closing, and the cost of qualifying an alternative supplier belongs in the price.
For imported inputs, add the currency exposure and the consistency of landed cost. Whether duties and freight are included on the same basis each year changes the margin without changing the business, and a margin that improved because a freight surcharge was classified differently is not a margin improvement.
Working capital and supplier terms
Payment terms finance the margin. Where supplier terms lengthen while revenue grows, working capital is funding the business — and that reverses after closing, when a new owner is expected to pay on standard terms. Compute days payable outstanding for each period and compare it with the contractual terms in the supplier agreements. A gap between the two is either a negotiation the buyer inherits or a liability that has not been recognised.
Inventory needs the same treatment. Ageing by category, turnover, and cost versus net realisable value: where the ageing has lengthened but the provision has not moved, part of the reported margin is sitting in inventory carried above the value it is likely to realise.
Where the four diligence areas land
- Revenue — customer concentration, price realisation after rebates, sell-in versus sell-through where distributors exist, and cut-off at period end in a high-volume invoicing environment.
- Cost of sales — margin bridge, purchase price benchmarking, supplier concentration, subcontracting, and inventory at cost.
- Operating expenses — the four-way payroll reconciliation for a large production workforce, shared costs provided by an affiliate, and non-recurring items.
- Related parties — founder-linked suppliers and landlords, favourable purchase arrangements that will reprice after closing, and intercompany funding.
What to request
- Cost of sales breakdown by product and by period, for three years
- Purchase invoices and contracts for the top ten suppliers, with quoted prices for comparable grades
- Production output, capacity utilisation and scrap reports
- Capital expenditure commitments, construction contracts and project timelines
- Fixed asset register with depreciation policy and useful lives
- Inventory ageing, provision analysis, and physical count results
The most common practical obstacle is that cost of sales is presented as a single aggregated line, with the breakdown by product arriving only after the valuation has been drafted. Ask for it in the first data request.
This page describes a general approach. It is not accounting, tax, or legal advice for a specific transaction. Figures and examples are illustrative. Views are my own and do not represent any firm.