Once the inventory has been tested and sampled, and any accounting adjustments have been undertaken, actual value applications can be made. As described earlier, the nature of the valuation will depend upon the scope and function, as related by the purpose and use. The client, presumably not well versed in appraisal methodology, may not be able to express in detail a true expectation, especially with inventory. The appraiser must be able to help interpret the client’s expectations based on the intended use of the appraisal. While the client must ultimately decide the parameters, and accept the definition, explaining in detail the fundamental concept based on the intended use of the appraisal is incumbent upon the appraiser.
As with any appraised asset, an inventory appraisal can be designed for any number of potential audiences, and though there are numerous uses for inventory appraisals, a thorough discussion using practical applications of the three most popular uses for inventory appraisals, which is for Ad Valorem Tax, Allocation, and Financial Considerations, will be made.
Ad Valorem Tax
Appraisals for Ad Valorem Tax can be extremely important to both companies and taxing authorities, since many of these appraisals are intended to resolve a specific dispute. However, the laws, guidelines, terms, and calculations vary so from state to state, and municipality to municipality, that presenting any generalities except one, is difficult, and this only tangentially since it too can be superseded. Many Ad Valorem Tax disputes are centered on the meaning and proper quantification of the term “Market Value”.
For demonstration purposes, the current tax statues for the State of Texas will be used to illustrate the issues involved in the appraisal of inventory, specifically for Ad Valorem Taxation. For example, in the state of Texas, Section 23.12 of the Property Tax Code provides that “the market value of an inventory is the price for which it would sell as a unit to a purchaser who would continue the business”.
The property tax code further provides that market adjustments can be made where applicable. Market adjustments are considered those adjustments required in Subsection “C” of Section 23.12, in which the chief appraiser is directed to apply "generally accepted appraisal techniques in computing the market value" of the inventory under consideration. According to the intent of this provision, following are some market adjustments an appraiser would consider when determining market value. This is because they are issues any potential purchaser would factor into their offer to purchase.
1. Current (Generic) Merchandise: Buying practices differ between each corporation, whether it is a manufacturer, distributor, or wholesaler. This is largely due to targeted markets, products, and client needs. Therefore, any potential purchaser of an inventory would not only lose the ability to fill, but would also lose the privilege of choice regarding products and quantities.
Even within national brand merchandise, the mix of inventory would not fit exactly within a potential purchaser’s current buying practices or client base. Additionally, it would not be prudent for a buyer, at the same level of trade, to pay full cost, as the subject company may have already built its burden into the cost.
It is also possible that a potential purchaser, even at the same level of trade, could have stronger buying power due to areas such as excellent vendor and banking relationships. This is notwithstanding the fact that the potential purchaser also has general operating overhead expense to consider and, therefore, would not invest in an inventory where double burden and possible excess costs have not been excluded from the purchase price. Consequently, willing buyers contemplating a purchase of inventory as a whole would weigh these factors into the price they are willing to pay for the current merchandise.
2. Private Label: Due to the proprietary nature related to brand names, private label merchandise restricts the sale of such merchandise to another for public sale without extensive brand removal and re-labeling before resale. In addition, without a license agreement to sell the merchandise under its original label, the purchaser would not be able to restock and replenish to optimal level. Bulk sale of inventory under the Texas Statute does not, under any circumstances, include the transfer of an intangible license. In short, the purchase may be a one-time sale, without recourse to replenish. Therefore, the market value of the inventory under such a scenario would be greatly reduced from its original cost.
The merchandise considered as private label would be those product brands developed and/or marketed by a specific company. These products would have an intangible value associated with them due to the proprietary nature associated with the private labels.
Within inventory, an appraiser would evaluate two possible areas when considering the issue of private labels. These areas would be:
Manufacturer Private Label: The manufacturer private label products consist of product brands developed and marketed by a specific manufacturing company such as Tommy Hilfiger, Reebok, Calvin Klein, and many more.
Customer Private Label: The customer private label products are those that are specifically developed for and solely marketed by a specific entity such as a department store, grocery store, or wholesale club. Therefore, any purchasers of this inventory would do so on speculation that they would be able to obtain the business of these customers.
Additionally, the nature of the private label merchandise could require repackaging of some products, but doing so may not be possible or feasible due to factors related to contamination issues, or may not be economically feasible. Nevertheless, just as that of the current (generic) merchandise, the ability to fill and privilege of return is lost upon purchase of the manufacturer private label and customer private label inventory. Both elements are not taxable according to the provision that specifically excludes the taxation of intangible personal property. The discount applied to the private label merchandise would be greater than that of the current (generic) merchandise due to the added issues concerning the intangible nature of the manufacturer private label, and the market of the customer private label being limited to that of one specific customer.
The idea that the sale of an entire inventory would take place as of January 1 does not consider the demise of the company. It is only the inventory that is being addressed and, therefore, there is no assumption that leases, leaseholds, real property and attachments, or other personal property would also transfer. In addition, no other taxable personal property specifies "sale as a unit” and, therefore, even if a transfer took place at the same time, there could be separate and distinct buyers for other reasons than to "continue the business”. By default, return privileges may not continue in part or in total for the subject inventory, as it was sold to another to continue the business; for a retail store this would be the selling of goods. By default, any guarantees or warranties could not exist unless the transfer included intangibles. By default, no "fill-in" could exist, as the intangible product line is not considered as part of the asset title transfer. Even if the assumption were that the distributor would continue to fill, it would be at retail to a competitor unable to compete at that increased cost, therein reducing the amount initially paid.
The amount for each private label category of the inventory would be adjusted to reflect recovery for non-branded merchandise, absent of labels, return privileges, and implied and expressed guarantees and warranties. Under this scenario, the purchaser of an inventory would face, among others, the following issues, which would greatly reduce the value:
· The subject company would require that all the private brand merchandise labels and other proprietary markings be removed. Such a process would entail a degree of labor expense that would reduce the sale value.
· The "unlabeled" merchandise would have to be discounted to mitigate customer perceptions of less valuable inventory. This is because consumers are very reluctant to purchase unlabeled merchandise without significant savings, since unlabeled merchandise gives customers no assurance of quality or any method of return.
The private label merchandise would not be replenished as sold. Thus, the sell-down of that merchandise would, in effect, be a one-time sale. This one-time sale traditionally captures a return that is less than cost. Further, the public's perception of retail prices is that national brands are worth more and command higher prices than private label merchandise. They would, therefore, expect that a sale of this merchandise would warrant an even lesser amount. The result is that the already reduced prices would be reduced even more. In all likelihood, this value would be significantly below the private label's current cost. Such a reduced recovery would be factored into the price a purchaser would be willing to pay.
The net effect of the above means that the potential buyer of an inventory would be limited to "off-price" retailers. Such retailers buy and sell discontinued and odd-lot merchandise in bulk, and generally offer the inventory at lower than traditional retail prices.
One method of calculating the private label market adjustment discount factor is demonstrated in the table below.
|
|
Private Label |
National Brand |
Total Inventory |
|
Retail |
425000 |
1195000 |
1620000 |
|
Cost |
195000 |
575000 |
770000 |
|
Cost Mix |
25.33% |
74.74% |
100% |
|
Devaluation Factor |
340000 |
|
340000 |
|
Net Market Value |
85000 |
1195000 |
1280000 |
|
% Of Cost (Branded) |
43.59% |
|
|
|
Cost Adjustment |
110000 |
|
110000 |
|
% Of Total Cost |
14.29% |
The above table was calculated in the following manner:
1. The Retail - Private Label is multiplied by 80% to arrive at the Devaluation Factor.
The 80% factor utilized is based on actual recovery when selling Private Label merchandise.
[425,000 x 80%] = 340,000
2. The Cost - Private Label is divided by the Total Inventory Cost to arrive at the Cost Mix - Private Label.
[195,000 ÷ 770,000] = 25.33%
3. The resulting amount is then deducted from the Retail - Private Label to arrive at the Net Market Value - Private Label.
[425,000 - 340,000] = 85,000
4. That amount is divided by the Cost - Private Label for Percent of Cost (branded).
[85,000 ÷ 195,000] = 43.59%
5. The Net Market Value - Private Label is then subtracted from the Cost - Private Label to arrive at the Cost Adjustment.
[195,000 - 85,000] = 110,000
6. The Cost Adjustment is then divided by the Total Inventory Cost to arrive at the Percent of Total Cost.
[110,000 ÷ 770,000] = 14.29%
In the above example, it was determined that market value of private label goods is 80% of retail. Otherwise, the retail dollars would need to be converted to cost dollars for a proper comparison.
3. Slow-Moving/Obsolete: One method of quantifying slow-moving inventory is by calculating the number of day’s sales on-hand, which would determine the turn for each item of inventory, and would indicate what products are either slow-moving or obsolete. This would typically be any product with no sales history, or those with more than 365 days supply on-hand.
Such an exercise is undertaken because a prudent investor would consider the potential return on and of their investment before making an offer. With this, slow-moving and/or obsolete products would have a lesser market value than the prime products, as they historically have a longer holding period.
4. Markdowns: Markdowns and sale results for January are clear evidence and support for the market value of a January 1 retail inventory since the inventory was realized at a specified price. The impact of those January markdowns must be factored in the inventory value as a market adjustment. The inventory on January 1 and the relationship of the January markdowns is the basis and quantification for such an adjustment. This type of analysis is illustrated in the following tables.
|
Markdown Analysis In Dollars ($000 Omitted) |
|
January Sales Total |
January Sales @ Full Retail |
January Markdown Sales |
Avg. Discount % |
|
440 |
280 |
160 |
36.4% |
Average discount denotes the percentage off the original retail. For example, an item with a $10 original retail price was sold for $5.60, a discount of $4.40 that represents a 44% average discount.
|
Total Inventory Sold - January 1 |
440 |
|
Cost Of Goods Sold (61.7%) |
271 |
|
Sales, Net Of Markdowns |
280 |
|
Gross Margin |
9 |
|
Gross Margin % Of Sales |
3.2% |
|
Store Operating Costs % Of Sales |
24.9% |
|
Loss On January Sales % |
-21.7% |
|
Loss On January Sales $ |
-61 |
|
Realization On Cost Inventory |
77.5% |
In summary, the inventory sold in January was, on a weighted-average, sold at 22.5% below cost and, therefore, the type of retail purchaser acquiring such an inventory would require a gross margin of 45% and would, therefore, deduct from the subject company’s net realization the minimum acceptable margin (hurdle rate) as calculated below. The purchaser's minimum level of gross margin return of 45% includes recovery of all operating costs, cost of distributing and transferring the inventory, re-ticketing, and any other handling costs.
Markdown Summary:
The adjustment of 60.0% is the inverse of the bid potential purchase price, which applies to 32.0% of the total inventory. This is illustrated below to show that it was used to arrive at market value since it represents the percentage (sell-thru) of the inventory sold in January.
|
Total Inventory Sold January |
Total Inventory On-Hand January |
|
2611 |
1710 |
|
Markdown Inventory Composition Summary Adjustments |
|
Percentage Of Inventory Sold Below Cost |
54.0% |
|
Market Value Adjustment For Inventory Sold Below Cost |
60 |
|
Impact Of Market Value Adjustment As A % Of Total |
32.0% |
|
|
|
To arrive at the value of this markdown adjustment, the purchaser's bid is multiplied by the amount of markdown inventory sold below standard margins.
Any buyer contemplating a bulk purchase on January 1, of a retail inventory, would be knowledgeable of the fact that obsolete and discontinued merchandise is much more prevalent at this time of year than any other. They would also consider that the sales period to follow (January and February) is the slowest selling period and, therefore, the holding period and carrying costs would be much greater. Furthermore, the after Christmas season (January and February) is the most competitive retail period, with most retailers promoting storewide discounts and/or clearance markdowns on seasonal products.
The purchaser of such an inventory would inherit this competitive pressure, and accordingly, the Market Value would reflect this.
The above tables were calculated in the following manner.
1. The Total Inventory Sold in January is determined by adding the January Sales total to the January Markdowns total.
[280 + 160] = 440
2. Subtracting the January Sales Total from the Total Inventory Sold - January 1 gives the January Markdowns.
[440 - 280] = 160
3. Subtracting the Gross Margin from the Sales, Net of Markdowns gives the Cost of Goods Sold.
[280 - 9] = 271
4. Subtracting the Cost of Goods Sold from the Sales, Net of Markdowns gives the Gross Margin.
[280 - 271] = 9
5. Dividing the Gross Margin by the Sales, Net of Markdowns gives the Gross Margin % of Sales.
[9 ÷ 280] = 3.21%
6. The Gross Margin % of Sales is information supplied by the subject company.
7. The Sales, Net of Markdowns is information supplied by the subject company.
8. Dividing the January Markdowns by the Total Inventory Sold - January total gives the Average Discount Percentage.
[160 ÷ 440] = 36.36%
9. The Store Operating Costs % of Sales is supplied by the subject company.
10. Dividing the Loss on January Sales $ by the Sales, Net of Markdowns gives the Loss on January Sales %.
[61 ÷ 280] = 21.79%
11. To arrive at the Loss on January Sales $, the Store Operating Costs % of Sales is multiplied by the Sales, Net of Markdowns. Then, that answer is subtracted from the Gross Margin.
[280 x 24.9%] = 69.72
[69.72 - 9] = 60.72
12. To arrive at the Realization on Cost, the Loss on January Sales $ is subtracted from the Cost of Goods Sold. Then, the Cost of Goods Sold is divided into that answer.
[271 - 61] = 210
[210 ÷ 2710] = 77.49%
13. Dividing the Cost of Goods Sold by the Total Inventory Sold - January total gives the Cost of Goods Sold Percent.
[271 ÷ 440] = 61.59%
14. The percentage of inventory sold below cost is determined by taking the Net Sales divided by the Gross Inventory. This answer is then multiplied by the factor of 1.5.
15. The Market Value Adjustment for inventory sold below cost is the inverse of the Bid Potential Purchase Price.
16. The Impact of Market Value Adjustment as a % of Total was determined by multiplying the Percentage of Inventory Sold Below Cost by the Market Value Adjustment for inventory sold below cost.
[54% x 60%] = 32.4%
5. Shrinkage: Shrinkage occurs in any inventory through the natural course of business by way of theft or breakage from handling. Of course, any recovery on the cost of these goods is impossible and, therefore, taken as a loss. Therefore, historical trends in this regard would be measured to determine a reasonable adjustment.
6. Returns: This area of consideration would not involve vendor rebates where the retailer would receive a credit against the returned goods. However, returns from the customer, for whatever reason, affect the overall margin. This is because, in many cases, the returned goods have to be repackaged and, as a result, the cost of repackaging, i.e., labor, materials, and restocking have caused the net recoverable dollars to be lower than the booked cost. In some cases, the goods are marked-out because they are no longer in saleable condition, be it because of season or actual condition. By marking-out a product, the retailer has taken a total loss on the goods and, therefore, marked the price to zero. Subsequently, they dispose of the goods through some method such as donations or simply discarding of the goods.
7. Discontinued: Within an inventory, there is merchandise that has been discontinued due to factors inherent in the product (functional obsolescence) such as poor design or factors outside of the product (economic obsolescence) such as the production of a certain product not being cost effective to manufacture. Due to these factors, these products must be discounted to the point where the price is appealing enough to the public to entice them to purchase these goods, because a lack of market demand has already been established. Therefore, a purchaser contemplating an offer on an inventory with discontinued merchandise would consider this factor; because they would not be willing to pay cost for merchandise from which they could not get a return on their investment.
In addition to the above factors that a potential purchaser would consider when purchasing an inventory, many others would affect the purchaser’s bid. These issues would vary depending on the level of trade, industry, mix, maintenance, and management of the inventory by the subject company. Therefore, the individual characteristics must by analyzed by the appraiser to determine what adjustments would be appropriate for the inventory under consideration. Additionally, though the Texas Property Tax Code was utilized as an example in this section, the issues addressed would not be lost when dealing with the tax code from other states that tax inventory. This is because the basic theory and methodology, when valuing inventory based on Market Value, Just Value, Fair Value, or whatever terms the respective tax code utilizes, do not change.
Allocation
In the guidelines set forth in the Statement of Financial Accounting Standards No. 141, No 221-B, June 2001 regarding Allocation of Cost of an Acquired Entity to Assets Acquired and Liabilities Assumed in paragraph 37-c, the following is stated regarding inventories.
1. Finished goods and merchandise at estimated selling prices less the sum of a) costs of disposal and b) a reasonable profit allowance for the selling effort of the acquiring entity.
2. Work-in-Process at estimated selling prices of finished goods less the sum of a) costs to complete, b) costs of disposal, and c) a reasonable profit allowance for the completing and selling effort of the acquiring entity based on profit for similar finished goods.
3. Raw materials at current replacement costs.
4. Fair Value is defined as follows:
“The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale”.
Therefore, when establishing “Fair Value” for purposes of allocation of cost, the above adjustments would also need to be made by the appraiser, as these are factors a potential purchaser would consider as well.
As an example, consider that DLM Corporation recently purchased Anna Corporation. Both manufacturers produce baby furniture. However, Anna Corporation was known for their high quality, hand painted baby furniture, which was sold by specialty furniture stores on a regional basis, whereas, DLM is known for their high quality baby furniture, which is sold by well-known furniture stores on a national basis.
|
Finished Goods |
|
Product Line |
Cost |
Fair Value |
|
Louise Baby Beds |
$10,000,000.00 |
$16,000,000.00 |
|
Louise Chest Of Drawers |
$7,000,000.00 |
$11,200,000.00 |
|
Louise Book Case/Shelf |
$3,000,000.00 |
$4,800,000.00 |
|
Anna Bean Changing Tables |
$2,000,000.00 |
3200000 |
|
Anna Bean Toy Chests |
$1,000,000.00 |
$1,600,000.00 |
|
Total |
$23,000,000.00 |
$36,800,000.00 |
|
Cost Of Disposal |
$7,040,000.00 |
|
Profit Allowance |
$14,720,000.00 |
|
Fair Value Finished Goods |
$15,040,000.00 |
As can be seen in the above table, the only adjustments made to cost for purposes of allocation, according to the guidelines as outlined on page 64, were for Cost of Disposal and Profit Allowance.
To arrive at a fair value for the work-in-process, and in keeping with the guidelines as outlined on page 64, the work-in-process was valued as if complete. However, as can be seen in the tables on page 66 & 67, a percentage of the work-in-process on-hand inventory could not be finished out due to the mix of work-in-process on-hand inventory as compared with the raw material inventory as of the allocation date. Therefore, that percentage remaining after the finish-out was given no value consideration. Even at that, after the finish-out, but before the allocation adjustments, the fair value was $1,034,000 greater than the cost on-hand for this segment of the inventory. After the allocation adjustments, the fair value was $3,316,000 less than the stated cost.
|
Raw Materials |
|
|
Cost |
%
Remaining After Finish-Out |
Remaining Cost |
|
Pre-Cut Wood |
$3,000,000.00 |
9 |
$270,000 |
|
Mattresses |
$700,000.00 |
12 |
$84,000 |
|
Changing Table Pads |
$300,000.00 |
15 |
$45,000 |
|
Toy Chest Pads |
$150,000.00 |
18 |
$27,000 |
|
Hardware (All Products) |
$1,000,000.00 |
30 |
$300,000 |
|
Total |
$5,150,000.00 |
|
$726,000 |
The following facts are considered in the valuation process.
1. Anna Corporation did not sell the “Louise” or “Anna Bean” product names.
Unlike those issues addressed with National Brand and Private labels in the above Ad Valorem Tax example, though the Louise and Anna Bean product lines are well known, the potential purchaser would have no problem selling the Finished Goods without the proprietary names, as the design is unique so the Baby Beds, Chest of Drawers, and Book Case/Shelf would carry with them an element of sight recognition and, therefore, a positive psychological appeal due to the superb reputation of the Louise and Anna Bean names.
2. The pre-cut wood was purchased from an outside vendor. The sizes are standard, but the design is not due to the proprietary design of the furniture.
|
Work-In-Process Before Allocation Adjustments |
|
Product Line |
Cost |
% Remaining After
Finish-Out |
Fair Value Before
Adjustments |
|
Louise Baby Beds |
$3,300,000.00 |
12 |
$2,904,000 |
|
Louise Chest Of
Drawers |
$2,500,000.00 |
9 |
$2,275,000 |
|
Anna Bean Changing
Tables |
$2,500,000.00 |
5 |
$2,375,000 |
|
Anna Bean Toy Chests |
$500,000.00 |
4 |
$480,000 |
|
Total |
$8,800,000..00 |
|
$8,034,000
|
|
Work-In-Process After Allocation Adjustments |
|
|
Total Cost |
Fair Value Before Adjustments |
|
Total |
$8,800,000.00 |
$8,034,000 |
|
Allocation Adjustments |
|
Cost To Complete |
$1,200,000.00 |
|
Cost Of Disposal |
$350,000.00 |
|
Profit Allowance |
$2,800,000.00 |
|
Fair Value Work-in-Process
|
$3,684,000 |
|
Raw Materials - Price Adjustment |
|
|
Price Change % |
Replacement Cost After Price Adjustment |
|
Pre-cut Wood |
5 |
$13,500 |
|
Mattresses |
-3 |
$81,480 |
|
Changing Table Pads |
-3 |
$43,650 |
|
Toy Chest Pads |
-3 |
$26,190 |
|
Hardware (All Products) |
8 |
$302,480 |
|
Total |
$467,300 |
|
|
|
|
|
3. The mattresses are of a standard size, purchased from an outside vendor, and compatible with other baby furniture manufacturers’ products.
Again, to adhere to the guidelines as previously stated, no adjustment, other than to account for current cost, will be made to this segment of the inventory after finish-out. However, unlike the pre-cut wood, the current owner would not encounter a loss on the remaining mattresses after finish-out should they choose not to continue this particular style or product line of baby beds, as most baby furniture manufactures sell mattresses separate from the beds, and the Louise mattresses are of a standard size.
4. The changing table pads are of a standard size and compatible with other baby furniture manufacturers’ products.
The only adjustment made to this segment of the inventory would be to account for current cost. Yet, unlike the baby bed mattresses, it is not standard practice for baby furniture manufacturers to sell changing table pads separate from the table and, therefore, if the current owner should choose not to continue manufacturing changing tables, they would be left with unusable products on that portion of the inventory that remains after finish-out.
5. The toy chest pads are of a standard size and compatible with other baby furniture manufacturers’ products.
As with the changing table pads, the only adjustment made would be for current cost, and the same problems would exist with whatever inventory remained after finish-out.
6. Though unique, the hardware is of a standard size and compatible with other baby furniture manufacturers’ products.
According to the guidelines outlined on page 64, there can be no adjustment made to this segment of the inventory other than for current cost. However, this particular hardware is unique and widely recognized as Louise and/or Anna Bean product hardware, and could have a positive affect on the product pricing structure. In addition, being of standard size, the current owner would most likely have no loss due to dead inventory, unless they decided to discontinue manufacturing a portion of the product line for which the hardware is meant. However, that would be unlikely, as they are in the business of manufacturing baby furniture.
The most critical change from the more traditional allocations for inventories is the departure point having been codified as “selling price” rather than “cost”. This is a major shift in emphasis from the appraiser’s perspective, analogous to climbing down a ladder instead of up one. Backing off a starting point is far different in the valuation process from building up to a finishing point, even if the answers are relatively similar. The challenge for the appraiser is communicating to the reader in a clear and precise manner (and supported by an appropriate example) the impact of the conclusion of value, as well as its impact within the entire scope of the appraisal assignment.
Financial Considerations
Another frequent use of an inventory appraisal is to assist a lender in developing an advance rate. The advance rate is the lender’s calculation, which is based partially on the appraisal. Therefore, understanding the lender’s intended use of the appraisal is important in the appraisal’s development. An advance rate is a mathematical expression, usually as a percentage, which is used to apply against the inventory cost.
For example, an appraiser may conclude that the Orderly Liquidation Value of a particular inventory would generate gross proceeds of 50% of cost based on the mix, and all other relevant factors present at the time of the appraisal. This 50% calculation is the appraiser’s conclusion, and should not be confused with the advance rate. Most lenders will build in an additional margin of safety against the appraiser’s conclusion that also compensates for the carrying costs and expenses attendant to sale.
To emphasize the extreme complexity, and profound differences between unrelated industries, and to demonstrate a means of addressing them, the following Hypothetical Assignment is offered as an example.
Hypothetical Assignment:
The appraiser was engaged to appraise, for financing purposes, a well-known domestic manufacturer of pianos under the Orderly Liquidation Value concept. To gain a complete understanding of the company's operations, the appraiser is required to inspect representative facilities of three completely different types, each of which maintains inventory at a differing basis, or level of trade. The three facilities are one manufacturing plant, one wholesale distribution warehouse, and one retail store.
The assignment includes an appraisal of the following components of inventory:
1. Finished pianos, vertical and grand;
2. partially finished pianos, work-in-process;
3. consignment pianos at retail locations;
4. pianos on loan to artists;
5. used pianos;
6. factory returns; and
7. all components of raw materials.
In addition to considering the various components of inventory, the following is known:
1. The company is one of only a handful of highly prestigious manufacturers. Its pianos are universally prized as among the finest in the world. Few are made in a given year, and distribution is strictly controlled.
2. The retail inventory is located in most major cities; wholesale inventory is located in one central warehouse; work-in-process inventory and raw materials are located in one plant.
3. The lenders have stated they are willing to advance on staged pianos where the percentage toward completion exceeds 95%. All other work-in-process is to be considered ineligible except some potential residual scrap value, which is to be determined by the appraiser.
4. The expression of value, typically illustrated as a percentage of "cost" may include some flexibility for "level of trade" considerations, but must be fully justified and supported with a credible Exit Strategy outlined by the appraiser.
5. Except standard holding costs, and the marginal expense of painting the “95%” pianos, the lender specifically directs that no other liquidation expenses would be allowed such as those of transportation or consolidation. All inventory would be sold on an "as is”, “where is” basis, and the lender has requested an estimate of all liquidation expenses.
6. The holding period may exceed three months, but may not exceed six.
Inspection
The manufacturing plant is inspected, and it is determined that everything is in order. The raw materials include raw lumber, in standard uncut sizes and cut pieces; hardware; sounding boards; piano string on rolls; paint and varnish in opened barrels; nameplates; and printed boxes. There is also a separate area for spare parts.
|
Segregation of the Raw Material |
|
Uncut Raw Lumber |
|
Mahogany |
$190,000 |
|
Untreated Pine |
$ 65,000 |
|
Treated Pine |
$ 60,000 |
|
Cut Raw Lumber |
|
Untreated Pine |
$100,000 |
|
Treated Pine |
$200,000 |
|
Hardware |
$ 75,000 |
|
Sounding Boards |
$ 60,000 |
|
String On Rolls |
$ 40,000 |
|
Paint/Varnish |
$ 17,000 |
|
Nameplate’s |
$ 5,000 |
|
Printed Boxes |
$ 2,000 |
|
Spare Parts |
$125,000 |
|
Total Cost
|
$939,000 |
The work-in-process consists of pianos in various stages of completion. There are 14 pianos as of the effective date of the appraisal that qualifies under the "95%" rule. Eight are grands, and six are vertical. The company can show there is $150,000 at cost of piano wire in the ineligible work-in-process. Cost to complete the pianos that qualify is $12,000 for grands, and approximately 10% more for vertical. The inspection of the distribution warehouse indicated that all finished pianos are boxed and ready to be shipped to the company's dealers. The warehouse also contains returns, most of which have some slight defect such as scratched varnish.
The final aspect of the inspection process is to visit a representative retail operation to determine the mix and display of the finished goods. The retail store contains a variety of all of the company's current models. They appear well displayed in a comfortable, accessible location. In addition to the new pianos, there are a few used pianos, most of which appear to be in excellent condition.
Market Analysis:
In addition to extensive discussions held with senior management during the inspection phase, the appraiser conducts an independent market analysis. For the subject, this includes everything from discussions with many of the company's dealers to researching current lumber prices. The analysis indicates that the following needs to be considered.
The finished goods must be considered in three "level of trade" groupings.
1. Since the client’s constraint excludes expending any transportation costs, the finished pianos, as well as all other components must be sold where they reside as of the effective date.
2. The research has confirmed that an identical piano can have three different value recoveries depending on where it is physically located, and at what level of trade.
3. The initial assumption is that whatever inventory is at the plant will be sold to competitors at their level of trade; whatever is at the wholesale location will be sold within the existing dealer network at their level of trade, and whatever is located in a retail store will be sold directly to the end user. Based on the market analysis, the appraiser determines the required discounts to be:
a. Retail Pianos:
1. Concert Grand, 30% off retail price;
2. Baby Grand, 20% off retail price;
3. All vertical, 40% off retail price;
4. Any piano with mahogany finish, an additional 15% discount; and
5. All used pianos, 50% off retail price.
b. Wholesale Pianos:
1. All grands, 35% off wholesale price;
2. All vertical, 45% off wholesale price;
3. Model ST, additional 30% discount, discontinued model;
4. Factory returns, same rules apply with 10% restocking fee; and
5. Pianos on loan to concert artists, 20% off wholesale price.
c. Factory work-in-process:
1. Once the “95%” pianos are completed (net of completion cost), the same discount percentage for wholesale pianos would apply against actual cost;
2. The piano wire in WIP could be salvaged at 15% of actual cost.
The raw material inventory is weighted heavily toward the lumber. An investigation into the current raw material lumber market shows that supplies are very tight for mahogany, and prices have been steadily rising over the past six months. The reverse is true for pine, which has experienced a 30% loss in spot prices over the last three quarters. The analysis shows that, because of market expectations, a sale of the mahogany within a 90-day period would produce a 60% recovery. However, were this inventory to be held an additional 90 days, recovery would be 30% higher. Selling the pine inventory immediately would clearly be best. Recovery on this is estimated at 55% for treated and 40% for untreated.
1. The hardware is, without exception, proprietary to the piano industry. There are only three potential purchasers of this inventory in bulk, and at two recently monitored auction sales hardware of this type was sold at bulk. The first was a furniture company that made standard student desks. The second was a company that built industrial fans, which fabricated its own proprietary fasteners.
This is a very competitive market in which there are over a dozen competitors, all of whom use generic hardware. Average recovery was thirty cents on the cost dollar. Recovery at auction for the hardware averaged ten cents on the cost dollar.
2. The sounding boards are proprietary to this manufacturer, and could not be adapted to another manufacturer’s design. Additionally, sounding boards are rarely replaced. One dealer that was interviewed said it had been more than two years since he had purchased a sounding board and, at that time, he paid full asking price for it because there was nowhere else he could have bought one.
3. The String on Rolls is standard to all manufacturers, and is considered a commodity.
4. There are potential environmental hazards associated with the sale of opened barrels of paint and varnish. In addition, there is a limited shelf-life for the varnish.
5. The Nameplates have the company's name and logo, are made of brass, and of a patented design.
6. All packaging bears the company's name and logo.
7. The spare parts are all proprietary to the company's design. Average annual sales of spares of actual cost are approximately $300,000.
Valuation
The foregoing is a straightforward description of a hypothetical set of facts an appraiser may encounter in this type of inventory assignment. Before applying direct values resulting from the market analysis phase, development of a set of general overriding principles that would shape the actual application of value is important:
1. To explain the level of trade issue raised in this assignment is a serious challenge for the appraiser. In the scope of the assignment, the lender directed that no consolidation expense would be allowed, therein eliminating the opportunity of moving the wholesale pianos into the retail level of trade. A reader of the appraisal report would find that when comparing the detailed values, there are three different value recoveries on the identical piano, described as “mahogany baby grand”. The value shown at the factory is $1,000; at the wholesale distribution facility, the value shown is $1,300; and at the retail showroom, it is $2,000. This conclusion is not empirically supportable, but is theoretically dictated. Had the lender allowed all of the finished pianos to be moved into the retail store, which would be more than warranted after expenses are netted from the gross proceeds, all of the “mahogany baby grand” pianos would have been valued at $2,000.
2. There are only three major manufacturers of high-end pianos in the world, and this brand carries the highest cachet. It is played the world over by the most respected pianists who receive these pianos on loan, in exchange for their exclusive endorsement.
Market research has concluded that, if the line were to end suddenly, as is inherently presumed in the Orderly Liquidation Value concept, the Fair Market Value of many of these pianos, especially the concert grands, could be higher than cost. Especially at the retail level, where a hypothetical newspaper ad proclaims “Last of the X Pianos”, there is no doubt that, even by the auction method, much as it is with fine art, these last grands could bring recoveries up to twice what the retailer paid. Still, this is only because of the rare and unique nature of this piano. Does this mean that both Orderly Liquidation Value and Fair Market Value can be higher than cost? Isn’t this a contradiction? Yes, to both questions, but the issue is raised to illustrate the unusual circumstances that can attend any inventory appraisal assignment.
3. In the raw materials, there is a profound difference in recovery in the presumed failure of a proprietary product line. Were the line to be continued, and in this case it appears that it would, at least in a limited capacity, the proprietary items would retain at least some portion of their value. Items such as sounding boards, nameplates, printed boxes, and cut lumber would be valued on a going concern basis no differently than their non-proprietary counterparts.
An item such as a stamped nameplate has virtually nothing other than scrap value, if the line is summarily discontinued; the same holds true for lumber cut to specification. Uncut lumber, on the other hand, is a simple commodity item not restricted in any way to the production of musical instruments.
4. In this exercise, the lender dictated the qualification rules for work-in-process as including only those pianos 95% toward completion. Usually, however, the inventory appraiser must exercise judgment about how work-in-process will be addressed.
Generally, asset-based lenders simply make a universal exclusion of all work-in-process on the principle that, in this case, they have no desire to get into the business of manufacturing pianos. In this example, spending approximately $100 to complete the remaining 5% of labor would yield, even at the manufacturer’s level of trade, a $10,000 concert grand piano. Clearly, spending the $100 would be prudent for the lender, but it would be the appraiser who is responsible for identifying these types of anomalies.
5. The status of the mahogany market reveals another dilemma often faced by both the appraiser and the client. The example of the mahogany, while hypothetical, often occurs in commodity raw material inventories, though it only becomes an issue in large quantities. In some instances, holding the inventory for even an additional thirty days can produce dramatically higher results in resale. The offset is the expense of holding costs in what is a speculative venture on a future price. Most lenders will prefer to offset their losses immediately. In certain severe commodity shortages, there may be compelling reasons to hold a particular class of raw material for a brief period. While the appraiser would not, in this situation, engage in forecasting future recovery since only the commodity price on the effective date appears in the report, these factors should be discussed in the Exit Strategy section of the appraisal.
