Inventory (stock held for resale) is a significant part of the tangible assets of most businesses. It is customary to include a normal inventory level in the purchase price of a business for sale that can sustain current revenues being generated by the business.

Just as tangible assets like machinery and equipment are included in the purchase price of a business for sale, the same holds true for inventory. Such assets as these are needed to generate the profit upon which the business is valued.

If a buyer is required to replenish the inventory or purchase additional equipment after purchasing the business, this additional working capital requirement would need to be taken into consideration prior to the initial valuation of the business if the sale is to be successful.

The agreement that both the buyer and seller sign into contract for the purchase of the business usually outlines the details of how inventory will be handled. The following are several aspects of inventory that are usually covered:

1) Prior to closing the sale, a physical inventory count is taken and the sale price is adjusted, up or down, from the amount included in the sale price. If seller financing is involved in the sale, there is the option to increase or decrease the principal amount due on the promissory note rather than the cash due at closing.

2) Inventory is valued at cost. If the inventory is significantly higher than the normal level, how much over the normal level will the buyer be obligated to purchase?

3) Will the cost of the inventory be determined by using the original invoice, a percent of retail price, or a professional inventory firm?

4) The fact that not all inventory is created equal is a variable. Aged or obsolete inventory, for example, will be examined for saleability and the price negotiated accordingly -- whether it be the seller financing a portion of such inventory, the buyer paying for it as it sells, or the seller discounting that portion of the inventory.

5) In some businesses, such as a manufacturing business, there will be other types of inventory you need to know how to handle, such as:

  • Raw materials: Everything a manufacturer buys to make a product is classified as raw materials. The raw material inventory only includes items that haven’t yet been put into the production process.
  • Work in process: This inventory category includes all raw materials that are in various stages of development. The work in process inventory also includes the cost of the labor to do the work, as well as manufacturing overhead, which is a catchall phrase for any other expenses the company has that indirectly relate to making the products. For instance, manufacturing overhead may include utility costs for the manufacturing plant, depreciation of factory equipment, and the cost of supervisory labor. Work in process inventory is based on how far each product has been processed.
  • Finished goods: When items are completely ready for sale but not yet shipped to customers, they’re finished goods. The finished goods, inventory, consists of the cost of raw materials, labor, and manufacturing overhead for the entire product.

While the calculation of the purchase price adjustment for work-in-process may seem complicated to decipher, it can be simplified by utilizing our step-by-step methodology.