Loss of gross profit: the high cost of getting your sums wrong
Business interruption (BI) is a complex area of insurance, which requires a good level of understanding to achieve the right outcomes for customers.
There are a number of key elements to consider when setting a gross profit sum insured which is defined as:
Gross Profit = Sales - Production
However, this is not correct for insurance purposes and Insurable Gross Profit is:
(Turnover + Closing stock and Work in Progress) minus (Uninsured Working Expenses + opening stock and Work in Progress)
Examples of Uninsured working expenses include:
- Production wages
- Purchase of raw materials
- Maintenance and repairs
- Lighting and heating
- Packaging materials
- Postage and freight
- Printing and stationary
- Bad debts
- Credit card charges
Turnover, work in progress and opening and closing stock are easily determined in accordance with normal accountancy methods. But Uninsured Working Expenses is an insurance term that customers might not be aware of.
It actually refers to costs, sometimes called ‘specified working expenses’, which vary in direct proportion to turnover. So, if turnover is reduced by 30%, the costs will also reduce by 30%.
An accountant’s gross profit calculation will subtract any cost that varies in proportion to production; but for insurance purposes they must vary in direct proportion. This is a key distinction and the source of much underinsurance.
For example, a cheese maker, who regularly contracts with a local milk co-operative to take regular supplies at a fixed price over a period of time, will eliminate the risk of variable market prices of supply.
However, should a loss occur and resultant turnover reduce, these costs will not be reduced, as they are fixed under contract. It might therefore be best to ensure the purchase costs for fixed price materials is not deducted from the gross profit sum insured.
A common pitfall – wage roll
Following a major loss, a business will still retain key staff. These wages will still be incurred and the business will rely on its business interruption policy to help meet these ongoing costs. Therefore, subtracting these from the gross profit calculation would result in underinsurance.
A distinction must, therefore, be made between wages that vary in direct proportion (such as non-essential production staff) and those that do not (such as key personnel).
Considering partial losses
Another example is that of a business that makes cakes using egg yolks, and meringues using egg whites. Typically, such a business may uninsure the purchase of eggs, which is understandable for a total loss. But, imagine a loss that affected the meringue line only.
The business would continue purchasing eggs to continue the production of cakes. In these circumstances, there would be no savings on egg purchases, despite the loss of all meringue-related turnover.
Most business are partial and it is essential to consider this when determining uninsured working expense, and not just approach the question from a total loss perspective.
In the case of our cake and meringue factory, due to the way its raw material are used, it may, in fact, be more appropriate for the business to insure on a loss of revenue basis.
Setting the indemnity period
Setting the length of the indemnity period is very important, as all claims cover will cease at expiration. If the business’s recovery is delayed for any reason, such as planning consent or the need to replace bespoke machinery, then it may not receive an adequate indemnity and will be underinsured.
Customers need to carefully consider the length of the indemnity period and ensure it is long enough to allow the business to fully recover to the same financial position after the indemnity period as they were on the day before the loss, taking into account worst case scenarios and all possible delays.
Adjusting for future business trends
A business interruption policy aims to place the insured in the same position they would have been had the loss not occurred.
Having chosen the indemnity period, the gross profit sum insured will need to be adjusted for that length of time. In doing this, account must be taken of future business trends.
For example, if the business is predicted to grow by 20% over the next 24 months, then the gross profit sum insured should reflect this growth, in order to put it in the same position it would have been. This could include securing a large contract or developing into a new country.
Taking proper account of future business trends helps to ensure a full indemnity in the event of a loss.
The gross profit calculation is a common cause of underinsurance, and brokers play a key role in guiding their customers towards a figure that will provide full indemnity following a loss.
With an estimated 40% of policies thought to be underinsured, it is important to have a correct Gross Profit Estimate which we can assist you with. For More information, please don't hesitate to contact ourselves.