FACS FileS inSurAnCe GroSS ProFit vS. ACCountinG GroSS ProFit The Policy

FACS files
Insurance Gross Profit vs. Accounting
Gross Profit
The Policy
Accounting Gross Profit
By way of introduction, we begin with the typical language
from a Business Interruption policy: “Gross Profit -
Accounting gross profit is calculated as ‘turnover’ less ‘cost
of sales’, where turnover represents sales revenue and cost of
sales includes costs such as materials purchased. However,
cost of sales can also include factory costs, or direct costs,
which include production labour and utilities, as explained
further below. This results in Accounting Gross Profit. A gross
profit rate is expressed as a percentage, and represents gross
profit as a percentage of turnover.
•• (i) the sum of the amount of the turnover and the amounts of
the closing stock and work in progress shall exceed
•• (ii) the sum of the amounts of the opening stock and work
in progress (WIP) and the amount of the Uninsured Working
In the event of a loss, a claim under the business interruption
policy would be limited to:
•• “The loss of gross profit due to (a) reduction in turnover and
(b) increase in cost of working and the amount payable as an
indemnity shall be :•• (a) in respect of reduction in turnover : the sum produced by
applying the rate of gross profit to the amount by which the
turnover during the indemnity period shall fall short of the
standard turnover in consequence of the Incident
•• (b) in respect of Increase in cost of working; the additional
expenditure necessarily and reasonably incurred for the sole
purpose of avoiding or diminishing the reduction in turnover
which but for that expenditure would have taken place
during the indemnity period in consequence of the incident
but not exceeding the sum produced by applying the rate of
gross profit to the amount of the reduction thereby avoided.”
We therefore need to understand how Insurance Gross Profit
is calculated, what the Gross Profit Rate is and what the
Uninsured Working Expenses should be. The starting point is
often the Gross Profit from the profit and loss account of the
company or the Accounting Gross Profit.
Direct or indirect costs
Direct costs include those costs which directly relate to the
cost of production of goods for sale, and therefore represent
a cost of sale. These are distinct from indirect costs, which
cannot be directly related back to the production of goods for
sale. Indirect costs, or overheads, include expenses such as
administration, nonproduction payroll, rent and insurance also referred to as ‘standing charges’ or ‘continuing costs’.
Variable or fixed costs
Costs are generally considered to be variable or fixed in nature.
Variable costs are considered variable if they vary in direct
proportion to sales volume. But some costs can be stepped
(varying with steps in capacity, such as additional equipment/
site expansion) or semi-variable (incorporating a fixed and
variable element, such as electricity).
The mix
Direct costs are mix of variable and fixed costs, whereas
indirect costs are mainly fixed in nature. Deducting all costs
(both direct and indirect, or variable and fixed) from all revenue
gives a company’s net profit.
Insurance Gross Profit
Gross Profit
Accounting gross profit is therefore not equal to insurance gross
profit and the cost of sales figure according to normal accounting
principles is not equal to uninsured working expenses.
The purpose of business interruption insurance is to pay for the
loss of cash flow resulting from an interruption (caused by an
insured peril under the property damage policy) which would
The above simplified practical example shows the differences between
the two approaches and how, using the wrong methodology, it can
have a significant impact on the quantum of a gross profit calculation.
•• Turnover/Sales are the same under both methods
•• Costs of sales in accounting gross profit can include direct
costs – that include both fixed and variable expenses
•• Net profit is the same under both methods
•• Have been generated by the gross profit, i.e. turnover (sales/
revenue) less variable costs (top down approach), or in other
•• Be used by the business to cover the net profit and fixed costs
(bottom up/additions approach). Essentially a business must
ensure that it receives cash to compensate for the net profit it
can no longer earn, plus cover the costs that will continue to be
incurred during the interruption.
•• Costs of sales from an accounting perspective does not equal
uninsured working expenses (variable/ non-continuing costs)
resulting in a different gross profit and rates of gross profit
In the event of a business interruption loss claim, the gross profit
rate should be 65% (650 gross profit / 1000 sales). Inappropriately
identifying fixed costs as uninsured working expenses can result in
a gross profit declaration that is too low (350) and consequently a
rate of gross profit that is not sufficient (35%).
Both the bottom up and top down approaches effectively
produce the same end result. (sees FACS file Issue 1). Insurance
Gross Profit relies on the calculation of gross profit as defined in
the policy wording.
This can lead to a number of problems:
Uninsured Working Expenses
•• Under insurance or average being applied to the claim
depending upon the policy wording. In the above scenario – a
£65m claim could well be reduced to £35m;
The policy specifies the deduction of uninsured working expenses
which are those costs that are 100% variable in nature (i.e.
variable costs, as identified above, that vary in direct proportion
to turnover). These are costs that the business will no longer
incur if the business is unable to make the sale. This is therefore
fundamentally different to accounting gross profit. There should
be no deduction of fixed costs, such as production labour or fixed
factory overheads.
•• Inaccurate declared values;
•• A reduced calculation of the economic limit (the allowable level
of increased costs) as the gross profit being ‘protected’ is lower
and therefore any allowed increased costs will also be lower,
further reducing the claim.
Another common mistake in establishing insurance gross profit
is to only consider complete loss scenarios. So even if it has been
identified that fixed costs are included in cost of sales, some of
the fixed costs are still deducted in the calculation of gross profit
because it is assumed those costs will not continue if a complete
site is lost. We must ensure that the business is covered in the
event of a partial loss situation as well. A partial loss will result in
the majority of costs continuing, and only the truly variable costs
being saved.
It is important for all parties involved in both the placement of
business interruption insurance and the calculation of claims to
be aware of the differences between accounting gross profit and
insurance gross profit.
From a placement perspective, not only will it ensure that the
policyholder is adequately insured, but the policyholder will also
have a better understanding of what they are insured for.
All businesses are different and as such there is no ‘one size
fits all’ approach for calculating insurance gross profit. Only a
detailed review of a business can ensure that the gross profit
calculation is appropriate. This forms part of the Business
Interruption Insurance Review Service offered by the Forensic
Accounting & Claims Services (FACS) team.
The policy should specifically name those variable costs which an
insured has elected not to insure i.e. the specified or uninsured
working expenses. It is recommended that a thorough review
of the business and policy wording be undertaken to ensure the
detail is fully understood, and the correct uninsured working
expenses are identified.
Given that the quantum of any loss depends on the calculation
of the rate of gross profit, the identification of uninsured working
expenses becomes critical.
However, an understanding of the calculation of insurance gross
profit is not only important in the event of a loss. There must also
be a detailed understanding of the business and the nature of its
costs if the correct gross profit sum insured is to be established.
2 • FACS files
Marsh • 3
Contact us
Neil Greaves
Leader of FACS, UK
+44 (0)207 357 3887
[email protected]
The information contained herein is based on sources we believe reliable and should be understood to be general risk management and insurance
information only. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such.
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