Gross margin is the number a target is most comfortable presenting and the number a buyer should be least willing to accept without rebuilding. It is also where the arithmetic is most available: unlike revenue, cost of sales can usually be taken apart against invoices, specifications and physical output.
The objective is to rebuild the margin from the bottom up — by product, by customer, and by period — and then compare the result with what peers report.
Start with the bridge, not the ratio
A single margin percentage hides everything. A margin bridge separates the change into its causes: volume, selling price, input cost, product mix, and yield. Each of those carries a different implication for the buyer.
| Driver | What a move means |
|---|---|
| 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 |
Build the bridge for each of the last three years, then compare the result with two or three listed peers in the same sector. 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.
Test the purchase price
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 published or quoted market prices for the same specification? Is it consistent across suppliers? And has it moved in line with the market over the period, or has it stayed flat while the market moved?
Where the target processes imported inputs, add two more: the currency exposure, and whether landed cost includes duties and freight on a consistent basis year to year.
Supplier concentration and payment terms
Supplier concentration is a continuity risk: a single-source input is a single point of failure after closing. Ask for the top ten suppliers by value, the duration of each relationship, and whether any supply agreement is contractual or informal.
Payment terms deserve separate attention because they 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. The test is simple: compute days payable outstanding for each period and compare it with the contractual terms in the supplier agreements.
Is cost of sales complete?
A margin can be overstated by costs that sit outside cost of sales rather than by costs that are missing altogether. Four areas are worth checking:
- Energy and utilities. Whether consumption is recorded in cost of sales or absorbed elsewhere.
- Subcontracting. Whether outsourced processing is included in cost of sales, and whether the volume is consistent with output.
- Warranty and after-sales. Whether a provision exists, and whether the historical claim rate supports it.
- Freight and handling. Whether outbound logistics sits in cost of sales or in selling expenses — a presentation choice that moves gross margin without changing profit.
Inventory at cost
Inventory is the bridge between cost of sales and the balance sheet. Two tests on the closing position:
- Ageing and turnover by category. Slow-moving stock should show up as a provision. Where the ageing has lengthened but the provision has not moved, part of the margin is supported by inventory carried above its likely realisable amount.
- Cost versus net realisable value. For products where market price has fallen since purchase, the write-down should already exist. A missing write-down is a direct reduction to the maintainable margin.
What to request
- Cost of sales breakdown by product and by period, for three years
- Purchase invoices and contracts for the top ten suppliers
- Production output records and scrap reports
- Utility bills and subcontracting agreements
- Inventory ageing, provision analysis, and physical count results
- Supplier payment terms in the contracts, for comparison with actual payment behaviour
The most common practical obstacle here is not analytical. It is that cost of sales is often 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.
Common questions
What is a gross margin bridge in due diligence?
It explains the change in gross margin between periods or against a peer by separating volume, price, input cost, and product mix. Its value is that it forces each change to be attributed to something specific, rather than accepted as a trend.
How is a gross margin tested in due diligence?
By rebuilding it from the bottom up: recalculating cost of sales by product and by period against purchase invoices, production records and inventory, then using a margin bridge to attribute the change to price, input cost, mix, yield or volume rather than accepting the ratio as a trend.
Why can a gross margin be higher than it should be?
Usually for one of two reasons: costs that sit outside cost of sales — energy, subcontracting, warranty, outbound freight — or slow-moving inventory that has not been provided against. Presentation choices move gross margin without changing profit, so classification has to be consistent before any comparison.
This article describes a general approach. It is not accounting, tax, or legal advice for a specific transaction. Views are my own and do not represent any firm.