Where the Value Is Generated: Looking Into the Machine Room of a Company

Material expenses play a major role due to the production intensity of many firms. This major role is also reflected in the financial statements.

Material expenses include expenses for direct material, direct labor, and manufacturing overhead. All these expenses relate to the manufacturing process.

A financial due diligence covers the relevant components and drivers. In the following article, I show three typical analyses to identify major developments.

Top suppliers

As mentioned above, there are three components of material expenses. This includes expenses for direct material, direct labor, and manufacturing. Direct labor might reflect own employees or temporary workers. Normally, materials are purchased from suppliers. To understand this structure better, you would perform a top supplier analysis. Within a supplier analysis, the suppliers are benchmarked. This is based on the purchased quantity over the last three years and helps understand if there is a strong dependency on major suppliers.

The supplier analysis can take various dimensions. Let’s assume the company produces four different products. The products are unrelated and need completely different materials. Then, you need to conduct four different supplier analyses.

In the case of comparable supplies for different products, one supplier analysis is enough.

Let’s assume the financial due diligence covers a carve-out situation. This means that the transaction object is part of a larger conglomerate/corporation. Then, check to which extend the current supplier conditions will apply in the future. For carve-out situations, this is important because the contracts are managed centrally. Current corporate discounts might not apply anymore to the carve-out entity. This needs to be checked.

Pass through of price increases

For firms that depend a lot on prime materials, there are two options. They can either pass through any fluctuations or bear them on their own. This includes firms that rely on oil or steel whose prices are publicly traded. If they pass cost fluctuations to end customers, the firms themselves do not see any impacts on the margin. If not, material expenses fluctuations will correlate with changes in prime material prices. If agreements exist, the company can pass through any fluctuations to the end customer.

Think about the fuel for your car. If the price was stable at $1, the gas station would “pay the difference” if the fuel price increases. If the price drops, the gas station would have an “extra benefit”. By passing price fluctuations to the end customer, the gas station makes its profitability more predictable. Also, it is less exposed to any “surprises”.

Material expenses by product

If the company produces different products, analyze the different material input ratios. This includes, for example, material expenses as a percentage of corresponding revenue. This helps identify which differences exist across the product portfolio. Also, check if the ratios per product remained stable in the period under review or deviated.

This analysis is also known as profitability by product. Gross profit = Revenue — material expenses. Hence, gross profit as a percentage of revenue shows the profitability per product.

Key takeaways

1. Understand components and drivers
2. Understand top suppliers and underlying conditions
3. Understand if fluctuations in raw material prices can be passed through
4. Understand if the current supply chain will change, if the transaction is part of a carve-out

Final thoughts

Material expenses play a major role in many firms. Especially in the production sector. To understand a firm’s profitability, understand what drives material expenses.

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