GROSS PROFIT Heather Parkinson

What’s your rate of gross profit? Ask a silly question, get a silly answer

WHAT IS GROSS PROFIT?

What is gross profit?   Accountant – deducts direct costs   Liability adjuster – deducts variable costs   Property / BI adjuster – deducts uninsured working expenses defined in the policy

COSTING IN GENERAL

Costing in general   Direct: Costs that are directly attributable to a unit of production.   Indirect: Costs that cannot be attributed to an individual unit of production

Costing in general Chinese Takeaway - direct or indirect?   Meat and vegetables   Chef’s wages   Packaging materials   Gas and electricity   Counter staff wages   Telephone   Rent and rates

Costing in general   Variable: Cost varies directly with the number of units produced. If one more unit is manufactured, the cost increases proportionally.   Fixed: Cost remains the same irrespective of the number of units produced, assuming the business continues.

Costing in general Chinese Takeaway - variable or fixed?   Meat and vegetables   Chef’s wages   Packaging materials   Gas and electricity   Counter staff wages   Telephone   Rent and rates

Manufacturer Direct/Indirect Variable/Fixed Raw materials Production wages Shift supervisor Cleaning wages Consumables/cleaning Packaging materials Packing wages Factory rates Group overheads Depreciation

Manufacturer Direct/Indirect Variable/Fixed Raw materialsDirectVariable Production wagesDirectFixed Shift supervisorIndirectFixed Cleaning wagesIndirectFixed Consumables/cleaningIndirectFixed Packaging materialsDirectVariable Packing wagesDirectVariable Factory ratesIndirectFixed Group overheadsIndirectFixed Depreciation IndirectFixed

Standard costing   Common for manufacturing businesses   Check variance analysis

Costing in general Summary   Are costs direct or indirect?   Are costs variable or fixed?   Is there a standard costing system?

Example - overlap with gross profit Selling price 100 Materials(20) Power (5) Gross profit 75 Wages(25) Overheads (20) Net profit 30

Gross Profit - policy definition The amount by which The sum of the amount of the Turnover and the amounts of the closing stock and work in progress Shall exceed The sum of the amounts of the opening stock and work in progress and the amount of the Uninsured Working Expenses.

Gross Profit - policy definition Turnover x Opening stockx Uninsured Working Expensesx Less Closing stock (x) (x) Gross Profit x

Gross Profit - accountant £ £ Sales50,000 Opening Stock 5,000 Purchases20,000 Wages 7,000 Maintenance 6,000 38,000 Closing Stock (4,000) (34,000) Gross Profit 16,000 Rate of gross profit =16,000 x 100% = 32% 50,000

Gross Profit - policy £ £ Sales50,000 Opening Stock 5,000 Purchases20,000 25,000 Closing Stock (4,000) (21,000) Gross Profit 29,000 Rate of gross profit =29,000 x 100% = 58% 50,000

No definition of uninsured working expenses £ Turnover1,500,000 Opening stock 50,000 Raw materials500,000 Packaging materials 50,000 Production wages 300,000 Salaries200,000 Bad debts 10,000 Consumables 40,000 Depreciation 80,000 1,230,000 Closing stock(55,000) (1,175,000) 325,000

No definition of uninsured working expenses £ Turnover1,500,000 Opening stock 50,000 Raw materials500,000 Packaging materials 50,000 Bad debts 10,000 Consumables 40, ,000 Closing stock(55,000) (595,000) 905,000 Rate of gross profit =905,000 x 100% = 60% 1,500,000

Rate of Gross Profit – common industries   If we have no definition of Uninsured Working Expenses what should we deduct?   What rate of gross profit would we expect

Rate of Gross Profit – common industries HotelRooms Bar and restaurant GarageSale of new cars Sale of used cars Servicing Paint shop Fuel Clothing retailerDesigner wear Department store Budget chain

ADEQUACY OF BUSINESS INTERRUPTION COVER

Two common types of policy   Sum Insured basis   Estimate Gross Profit or Declaration Linked basis

Sum insured basis Sum Insured is the Gross Profit which would have been earned in Maximum Indemnity Period but for the incident If Sum Insured is not adequate then Proportionate Reduction will apply

Estimated gross profit Gross Profit is declared each financial year Estimated Gross Profit is the Insured’s estimate of Gross Profit to be earned in the financial year most concurrent with the insurance period Policy Limit is 133.3% of Estimated Gross Profit If Estimated Gross Profit is an under or over estimate then must pay more premium or get a rebate

Sum insured basis ….provided that if the sum insured by this item be less than the sum produced by applying the Rate of Gross Profit to the Annual Turnover (or to a proportionately increased multiple thereof when the Maximum Indemnity Period exceeds 12 months) the amount payable shall be proportionately reduced.

Sum insured basis To check adequacy of cover Insurable Amount - estimate the Gross Profit which would have been earned in the Maximum Indemnity Period Consider Historic Turnover Trend Rate of Gross Profit

Turnover - £500,000 Growth - +10% FIRE Maximum Indemnity Period - 24 Months

Sum insured basis Example - 24 months Maximum Indemnity Period Turnover Last 12 months 500,000 Turnover in first 12 months (+ 10%) 550,000 Turnover in second 12 months (+ 10%) 605,000 Turnover in next 24 months1,155,000 Rate of Gross Profit40% Insurable Amount for 24 months 462,000

WRONG !

Sum insured basis Example - 24 months Maximum Indemnity Period Turnover Last 12 months 500,000 Turnover in first 12 months (+ 10%) 550,000 Turnover in second 12 months 550,000 Turnover in next 24 months1,100,000 Rate of Gross Profit40% Insurable Amount for 24 months 440,000

CORRECT !

Sum insured basis Example - How do we apply Proportionate Reduction ? Sum Insured 200,000 Insurable Amount 250,000 Business Interruption Loss 100,000 Amount Payable = Sum Insured X Loss Insurable Amount = 200,000 x100,000=80, ,000

Sum insured basis How can underinsurance arise? Sum Insured set on last available audited accounts Rate of Gross Profit too low Common misconceptions  Sum Insured perceived to be a limit  Maximum Indemnity Period is misunderstood

Estimated gross profit How can underinsurance arise? In theory if Estimated Gross Profit is calculated properly there cannot be underinsurance! Common errors in calculation   Wrong Rate of Gross Profit used in declaration   Maximum Indemnity Period is misunderstood

Conclusion If cover is properly set up there should never be underinsurance ! Estimated Gross Profit cover gives more flexibility for a growing business

BUSINESS INTERRUPTION RESERVES

Why are reserves so important? Insurers Returns to the DTI Make funds available to make payments Adjusters Loss mitigation steps Ensure involvement of appropriate staff Manage EVERYONE’S expectations

Setting the reserve It is imperative that we:   Understand the Insured’s business   Understand the potential effect of the loss on the business   Calculate the probable extent of the loss   Reserve conservatively and review regularly

The Insured’s business   What does the Insured do?   Financial data   Use of assets in the business   Software   Data back-up regime

Effect of the loss on the business   What has been lost and what did it do?   How quickly can the lost items be replaced?   Mitigation steps   Will business be lost? Be realistic

CALCULATE the probable extent of the loss   Period of interruption   Reduction in Turnover   Insured Rate of Gross Profit   Increase in Cost of Working   Savings   Adequacy of cover

Common pitfalls   Not appreciating importance of equipment lost   Accepting the Insured’s optimism   Ignoring long term effects   Incorrect Rate of Gross Profit Not understanding the business