Regardless of the specific language used, the rate applied in measuring business interruptions losses will fall under one of two different styles. For ease of reference we will refer to these styles by their traditional names – profits and earnings.
While the following calculation methodologies outlined below are pretty basic, it should never be forgotten that the underlying assumptions which are used to calculate the rates can at times be very complicated.
Profits (& Insured Standing Charges)
Under a gross profits style wording the profits rate is calculated as:
Net income (profit or loss in the period prior to the damage)
Plus: Insured Standing Charges
Divided by: Sales
Most policy wordings will define Insured Standing Charges based on what they specifically exclude, such as amortization of stock, bad debt, and ordinary payroll. Rarely if ever do they actually define an Insured Standing Charge. The commonly accepted meaning of an Insured Standing Charge is an expense which does not vary with the sales of a business, specifically a fixed expense. Common examples will include rent, insurance, and bank charges. The actual fixed expenses incurred by a business will vary by business size and industry.
Earnings
Under an earnings style wording the earnings rate is calculated as:
Sales
Less: Variable expenses
Divided by: Sales
Like fixed expenses, the variable expenses incurred by a business will vary from business to business and between industries. Typically, the largest variable expense is Cost of Goods Sold. These are the expenses directly incurred in the generation of revenue. Cost of Goods Sold can include items such as materials, direct wages and subcontracts.
Summary
Each policy will likely specify which of the above two methodologies is to be applied in calculating a business interruption loss. However, if the allocation of expenses between fixed and variable is consistent, both methods should yield the same result. That is, the rate produced by adding fixed expenses to net income and the rate produced by deducting variable expenses from sales will be the same.
To illustrate this principle that each policy should yield the same result, we have included an example:
|
Income Statement |
Gross Profits |
Gross Earnings |
||||
|
$ |
% |
$ |
% |
$ |
% |
|
| Sales | 5,000 | 100% | 5,000 | 100% | 5,000 | 100% |
| Cost of Sales | 2,500 | 50% | 2,500 | 50% | ||
| Gross Margin | 2,500 | 50% | ||||
| Other Variable Expenses | 500 | 10% | 500 | 10% | ||
| Fixed Expenses | 800 | 16% | 800 | 16% | ||
| Total Expense | 1,300 | 26% | 3,000 | 60% | ||
| Net Income | 1,200 | 24% | 1,200 | 24% | ||
| Gross Profit/Gross Earnings | $2,000 | 40% | $2,000 | 40% | ||
Final Thought
Trying to determine the appropriate methodology to use in assessing a business interruption loss, profits vs earnings, can be challenging, especially with all the different terms being used to describe the same basic things. While it is important to be accurate and follow the specific terms of your policy, in the end you can arrive at an accurate number under either methodology.