ACCOUNTING GROSS PROFIT DOES NOT EQUAL INSURABLE GROSS PROFIT
One of the problems with business interruption insurance is that the accounting terms such as Gross Profit and Gross Income used in insurance policies does not have the same meaning as accountants or business people use. The important differences are not usually taught at university and so there is potential for misunderstanding. Sadly this is a common mistake which is often not realised until claim time often with disastrous results for the policyholder.
The difference in definition between Accounting Gross Profit and Insurable Gross Profit occurs most often in manufacturing risks. The cost accountant is trying to determine the exact cost of goods sold. All the costs of manufacture such as direct materials, direct labour, and factory overheads are captured and deducted from sales turnover to arrive at accounting gross profit.
On the other hand, insurable gross profit is defined in an Industrial Special Risks policy as:
“GROSS PROFIT: the amount by which:
1. the sum of the Turnover and the amount of the Closing Stock and Work in Progress shall exceed
2. the sum of the amount of the Opening Stock and Work in Progress and the amount of the Uninsured Working Expenses as set out in the Schedule.
Note: The amounts of the Opening and Closing Stocks and Work in Progress shall be arrived at in accordance with the Insured’s normal accountancy methods, due provision
being made for depreciation.”
To be fully insured under a business interruption policy only those expenses, which are truly variable in direct proportion to sales, should be listed as an Uninsured Working Expense and not insured. Purchases are a good example. However, many other expenses may not slow at the same rate as sales revenue in the event of a disruption.
When you consider any expense it is important to consider what would happen to the expense in the event of a partial loss, not just a total loss.
Remember, if in doubt insure it.
Finally, remember that your accountant or your client’s accountant may not understand the important differences between Accounting Gross Profit and Insurable Gross Profit. It is for this reason that the Business Interruption Cover Calculators were developed to assist business owners get it right.