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
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 40,000 650,000 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
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
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
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=80,000 250,000
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
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