Quality of Earnings for Manufacturing Acquisitions

A buyer signed an LOI on a precision sheet metal shop in Ohio at $8.2M. Reported EBITDA of $1.6M on $11M of revenue. The seller had three CNC press brakes, two fiber lasers, and 40,000 square feet of clean floor space. The teaser called it "diversified industrial customer base."

The QoE pulled invoice-level sales data and found that 64% of revenue came from one Tier 1 automotive supplier. When the buyer pressed on that relationship, the seller disclosed that the supplier had been notified the prior month that the line was moving to Mexico in 12 months.

The deal repriced to $4.4M with a $1M earnout tied to replacement revenue.

If you are buying a manufacturer this year, this post covers what a Quality of Earnings report finds and what kills these deals.

Inventory Is Where the Math Breaks First

Manufacturing inventory has three layers. Raw materials sit on the floor in coils, sheets, or bar stock. Work in process moves through cells with partial labor and overhead applied. Finished goods wait for shipment.

The QoE pulls perpetual inventory records and physical count history and asks:

• When was the last full physical count, and what was the book-to-physical variance?
• How is overhead absorbed into WIP and finished goods?
• What standard costs are being used, and when were they last updated?
• Are slow-moving and obsolete items reserved against?
• How does the seller value scrap, drops, and remnants?
• Has production outpaced shipments in the trailing twelve months?

Production volume matters as much as the count. When a shop builds inventory, part of its fixed overhead (rent, depreciation, supervision) moves onto the balance sheet instead of through COGS. Same cash out the door, higher reported margin. A seller who ramps production ahead of a sale can lift trailing EBITDA without selling another part. The QoE compares units produced to units shipped by month to catch it.

A custom metal fabricator in Tennessee carried $2.4M of inventory on the balance sheet with no reserve for obsolescence. Physical inventory found $480K of finished assemblies for a customer that had filed Chapter 7 two years prior.

The inventory had never been written down, and a write-down would have squeezed the borrowing base on the operating line. The QoE excluded the $480K from normalized working capital, so the seller did not get credit for it at closing.

Customer Concentration Kills Multiples

Industrial buyers care about customer concentration more than any other risk factor. A manufacturer with one customer at 50% of revenue trades at a different multiple than the same shop with no customer above 15%.

The QoE pulls three years of sales by customer and asks:

• What is the percentage of revenue from the top 1, 5, and 10 customers?
• Are there long-term supply agreements, blanket POs, or is everything spot?
• How has the mix shifted year over year?
• Are there any customers on credit hold or stretched terms?
• What is the price erosion trend on the largest accounts?

A precision machining shop in Michigan reported $14M revenue with 38% from one aerospace customer. The QoE pulled the supply agreement and found that the customer had reduced annual volume commitments by 22% for the upcoming year.

The seller had not disclosed the cut, and the seller's projections still assumed prior-year volume on that account.

The trailing EBITDA was real. The forward EBITDA was not. On a pro forma basis for the lost volume, $2.1M of EBITDA became $1.6M. At a 5x multiple, the deal repriced by $2.5M.

This is one of the common QoE adjustments that manufacturing buyers miss without account-level revenue analysis.

Equipment Tells the Story of Future Capex

Reported EBITDA does not capture maintenance capex. A 12-year-old CNC turning center with a worn ball screw and a failing spindle will demand $40,000 of repairs or a $180,000 replacement within 18 months. The seller knows. The QoE forces the question.

A clean review pulls the fixed asset register and asks:

• What is the age and condition of each major piece of production equipment?
• What has been spent on maintenance over the past three years?
• Are there machines that are fully depreciated but still load-bearing for revenue?
• What is the deferred maintenance backlog?
• How does maintenance capex compare to depreciation?

A plastic injection molding operation in Indiana reported $2.8M EBITDA. Depreciation ran $310K. Annual capex over the trailing three years averaged $190K.

The buyer's diligence team brought in an independent mechanical assessor. The assessor flagged $720K of needed work across three presses, two robots, and the chiller system. None of it was in the seller's forecast.

The headline price held, but the economics did not. $720K of the purchase price was paid as a seller note, forgiven dollar for dollar as the maintenance work was completed and verified. In effect, a $720K price reduction.

Labor and Overhead Absorption Hide Real Margins

Manufacturers run labor through job costing or process costing. Both methods absorb overhead into product cost. A miscalibrated overhead rate makes gross margin look better than it is.

The QoE asks:

• What is the basis for overhead allocation: direct labor hours, machine hours, or revenue?
• When was the overhead rate last updated?
• Are indirect labor and supervision being properly classified?
• Are rent, utilities, and depreciation being fully absorbed?
• What is the variance between standard cost and actual cost, and how is it treated?

A contract assembly shop in Wisconsin reported 34% gross margin. The QoE rebuilt the overhead absorption using actual hours and current burden rates. Real gross margin was 27%.

The seller had been running 2018 overhead rates against 2026 labor and utility costs. The underabsorbed overhead landed on the P&L as a separate line the seller called "manufacturing variance," and the seller's adjusted EBITDA added it back as a one-time item. It recurred every period. It was structural.

The QoE reversed the add-back. That 7-point margin gap on $9M of revenue was $630K of EBITDA the seller was asking to be paid for. At a 5x multiple, the deal repriced by $3.1M.

Owner Compensation and Family Payroll

Most lower middle market manufacturers have the owner running the shop floor, the sales pipeline, or both. A QoE normalizes owner compensation to the cost of a replacement.

The review pulls payroll register data and asks:

• What is the owner's full compensation, including W-2, distributions, and benefits?
• Are family members on payroll, and at what rates relative to their role?
• What would it cost to replace the owner: a general manager, a sales manager, or both?
• Are there discretionary expenses running through the business that benefit the owner?
• What is the depth of the management bench below the owner?

A fabrication shop in Pennsylvania paid the owner $180K and his wife $95K. The wife was the office manager three days a week. The owner ran sales, scheduling, and customer relationships.

The seller's adjusted EBITDA added back all $95K of the wife's pay. The QoE normalized the owner's comp to $250K for a replacement general manager and the office manager role to $45K, a market rate for three days a week. Instead of a $95K add-back, the net adjustment was negative $20K. That $115K swing moved the price by $575K at a 5x multiple.

The bigger issue was key person risk. The owner held every major customer relationship, and the QoE flagged it for the lender. The lender required a 12-month transition consulting agreement at $120K, a one-time cost the buyer had not budgeted for.

What to Do Before You Sign the LOI

Manufacturing diligence breaks deals more often than the buyer realizes. In our experience, most manufacturing deals that fall apart after the LOI break on one of the five issues above. None of these issues show up on a sell-side teaser.

Before you sign:

• Request the top 20 customer list with three years of revenue by account
• Request the fixed asset register with original cost, accumulated depreciation, and acquisition date
• Request the last three years of physical inventory variance reports
• Request the perpetual inventory and the most recent reconciliation
• Ask for the maintenance log and the deferred maintenance list
• Ask whether any major customers have given written notice of volume changes
• Pull the operating line agreement to check covenants tied to inventory or AR

Then engage a QoE provider that has worked on manufacturing deals. Generic financial diligence will not catch the five things that kill manufacturing deals.

Get Your QoE Started

Bedrock has run quality of earnings reviews on contract manufacturers, fabrication shops, injection molders, machining operations, and assembly businesses across the lower middle market. We know what the seller's add-backs hide, what the customer concentration reveals, and where the equipment risk sits.

If you are under LOI on a manufacturer, book a call. We will scope the engagement, confirm timing, and start pulling the data the same week.

Schedule a consultation or email will@bedrockqoe.com.