Template for Estimating the Value of Business Interruption Claims

Imagine your business operations have been interrupted by a fire, hurricane, or a ransomware attack. How would you determine the impact of this event on your bottom line, and how would you prove this to a third party such as an insurance company or a jury? Now, image that the determination of actual business interruption costs may be different from the business interruption losses that your insurance policy will cover.

This blog provides some simple tools for estimating the actual cost of business interruption. You can use these tools as a first step to determining the value of your claim for reimbursement from a third party for the cost of the consequential lost income and extra expenses.

Insurance industry experts frequently refer to two approaches for determining a business interruption loss:

1. Top-Down or Gross Receipts method: Lost sales minus the expenses that were avoided as a result of the interruption.
2. Bottom-Up or Net Income method: Profit that should have been earned during the period of loss plus the actual expenses that continued during the loss period.

These approaches work well under certain circumstances, such as 1) small cases, 2) when the period of loss is clearly defined, or 3) when there are no extra costs that continue significantly beyond the period of business interruption. However, as a claim becomes more complicated, the simplicity of these approaches begins to break down.

Fundamentally, business interruption cost is the difference between the expected results from business operations (i.e., the "but for" scenario) and the actual results of business operation. This can occur well past the period of the actual business interruption, particularly when there is a permanent loss of customers to another competitor or when there is long-term damage to intellectual property, such as brand image.

The following is a template for calculating business interruption losses that is based on a comparison of "but for" operations to actual operations.

The remainder of this blog will focus on describing the critical elements of this template.

	Business Interruption ("BI") Claim Template (2)
			2014		2015		2016		2017
			(Before BI)		(During BI)		(After BI)		Total Damages
	"But For" Scenario:
	Sales (routine)		100		100		100
	Cost of Sales		60		60		60
	Gross Profit		40		40		40
	Plant Overhead		15		15		15
	SG&A		10		10		10
	Profit		15		15		15
	Actual Performance:
	Sales (routine and postponed)		100		0		90
	Cost of Sales (routine)		60				54
	Continuing Costs				20
	Gross Profit		40		-20		36
	Plant Overhead (routine)		15		10		15
	Plant Overhead (extraordinary)				1		2
	SG&A (routine)		10		8		10
	SG&A (extraordinary)						2
	Profit		15		-39		7
	Damage Calculation:
	BI Damages		0		-54		-8
	Present Value ("PV") Factor (2)
	PV as of December 31, 2017		1.31		1.21		1.12
	PV Damage Amount		0		-65		-9		-74
	PV Interest Rate	8%
	Footnotes:
	(1) Assumes that the interruption is exactly one year (i.e., all of 2015).
	(2) Assumes a mid-year convention.
	(3) All numbers highlighted in yellow require analysis to determine. The remaining numbers are either
	calculated by the spreadsheet or obtained from the company's financial statements.

The "But For" Scenario

The first step in determining a business interruption loss is to build the foundation. This requires defining the financial performance that would have occurred assuming the interruption never occurred. Developing the foundation relies on assessing the historical trends of the business, market trends, and competitive trends. The simplest approach to this is to extrapolate the trends in overall unit sales, and unit prices, to determine revenue, and then to:

1. Subtract the historical percent of variable direct costs.
2. Subtract the dollar value of historical fixed cost.

Note that the actual sales immediately after the period of interruption may not necessarily equal the sales that should be included in the "but for" scenario for that same period. There are two primary reasons for this result:

1. Postponed sales: Postponed sales are sales that should have occurred during the interruption period that were delayed and actually occurred after the interruption period. In the "but for" scenario, the postponed sales are actually accounted for in the interruption period and therefore to include them in a period subsequent to the interruption period would be to double count these sales.
2. Long term loss of customers: A business interruption event, such as a data breach that effects customer's personal information, can result in long term loss of customers. The "but for" scenario should include these sales. Consequently, when actual sales are subtracted from the "but for" sales, to determine damages, the damage amount will include these lost sales.

The sales dollars in the "but for" scenario must be forecast beyond the period of interruption and must reflect the sales that would have been achieved "but for" the interruption event. By doing this the damage amount eventually calculated as the difference between the "but for" results and the actual results will more accurately reflect the business loss.

Analyze Actual Performance

This step relies on data obtained directly for the business' financial records, assuming the business interruption event affected the entire business or a segment of the business for which separate "segment" financial data is tracked. Special attention should be given to determining the following amounts (refer to the Template to see where these costs fit):

1. Cost of Sales - Continuing Costs: Unique costs that under normal circumstances would be variable expenses but due to the business interruption become fixed. Examples include direct material that spoiled during the interruption, or deposits on direct material that were forfeited.
2. Plant Overhead - Extraordinary Costs: Overhead costs that are in over and above historical overhead costs either because they were required during the interruption period or because post interruption operations have changed. Examples include security costs during the interruption, or higher utility costs post interruption due to changes in the physical plant.
3. SG&A – Extraordinary Costs: SG&A costs that continue into the future which are required to overcome damages caused by the interruption. Examples include advertising to repair damage to the business' brand, or additional customer service personnel needed to reach out old customers to assure them that the business is safe to visit.

Close:

This blog provides a brief overview of the issues and approaches related to determining business interruption damages. Business interruption claims vary widely due to differences in the underlying facts. This blog is intended to provide a basis for structuring your approach to determining business interruption damages. The analyst and/or expert witness responsible for determining business interruption damages will build on this foundation using the unique facts of the matter being analyzed.

Resolution Experts PC, "ResX, PC", provides independent forensic accounting services for complex litigation and contract compliance and fraud. ResX is based in Michigan and serves clients throughout the United States. For more information and to learn about working with ResX, please visit our website: www.resxpc.com. Follow our page on LinkedIn here.

The preceding narrative presents concepts that are dependent on facts and circumstances. These concepts can change depending on the specific facts and circumstances of an individual matter.