Loss of Profit
Loss of Profit Insurance
Fire Insurance is concerned with Capital loss through the destruction of buildings, machinery, and stock. Consequential loss insurance (Loss of Profit insurance) is concerned with the loss of earning power Consequent upon the capital loss. Only with, Fire consequential loss insurance, full protection is obtained.
To understand the coverage, under fire material damage policy and LOP policy, consider the following diagram.
| Before Fire | After Fire | |
|---|---|---|
| Capital | Building, P&M, Stock | SFSP policy pay for this. |
| Variable expenses(V.E) | Raw material cost, unskilled labour charge | These diminish in proportion to the stoppage in production (These charges are proportional to Turnover) |
| Fixed Expenses/Standing Charges (S.C) | Overheads or continuing standing charges such as salaries, interest, rent etc., | Consequential Loss Insurance pay for these |
| Earnings | Net profit | Consequential Loss Insurance pay for these |
Hence Loss of Profits policy covers :
- Loss of Anticipated profit (Net Profit)
- Continuing trading expenses (Standing Charges)
- Increased trading expenditure (increase in the cost of working)
It provides compensation for Loss of Earning Power, While Material Damage (Fire) policy covers capital losses.
Increase in cost of working is the additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in turn over.
Consider an example:-
| Before Fire | % | After Fire | % | |
|---|---|---|---|---|
| Turn over | 50,00,000 | 25,00,000 | ||
| Production cost (V.E) | 35,00,000 | 70 | 17,50,000 | 70 |
| Standing Charges (S.E) | 10,00,000 | 20 | 10,00,000 | 40 |
| Net Profit | 5,00,000 | 20 | ||
| Net Loss | 2,50,000 | 10 |
As variable expenses directly proportional to T/O, this expenses constitutes 70% before and after Fire.
As standing charges are fixed, the % on T/O is increased from 20 to 40. Whereas the sum standing charges and Net profit/Net Loss constitutes the same 30% on T/O. This sum is known as Gross Profit (G.P). Hence the rate of G.P (Ratio of G.P) on T/O is the same before and after the loss.
The Consequential Loss policy sets out to make good the shortage in G.P (Loss of G.P) which can be arrived at by multiplying the reduction in T/O with the rate of G.P.
Therefore the Sum Insured in a LOP policy is the “Annual gross profit “
BUSINESS EXAMPLE OF BAKERY: –
Sales 500 loaves @ Rs. 30 /- per loaf per day Rs.15000/-
Expenditure (V.E)
Wheat flour 20 Kg @ Rs.40 / Kg / day Rs. 800/-
Sales per month 15000 X 30 days Rs.4,50,000/-
Less flour for 30 days Rs. 24,000 /-
Less monthly expenses Rs .1,20,000/-
Net Profit Rs.3.06,000/-
Monthly Expenditure (Fixed Expenses/Standing Charges):
Rent Rs.50,000
Salary Rs.50,000
Electricity Rs.15,000
Other Expenses Rs. 5,000
. ——————-
Total Rs.1, 20,000
. ——————-
What will be the loss to the bakery, if it is closed for 30 days.
Net Profit Rs.3, 06,000
Monthly expenditure Rs.1, 20,000
Gross profit Rs.4, 26,000
This is called “ADDITION BASIS”.
From another perspective, He has lost The Value Addition.
Sales Rs.4,50,000
Cost of wheat flour Rs.24,000
Hence Gross Profit Rs.4,26,000
This is known as “DIFFERENCE BASIS”
Standing charges = All Fixed Expenses like:
Salaries & Wages, Rental Rates & Taxes, Repairs & Maintenance, Administrative Overheads, Factory Overheads, Selling Overheads, Interest & Depreciation.
Working Expenses are:
Raw material cost, Power & fuel, GST, Wages of Piece rated workers, Sales commission, stores and spares.
These are “VARIABLE EXPENSES“ which decrease proportionately with production/sales. These are called “SPECIFIED WORKING EXPENSES” under a LOP Policy.
“VARIABLE COSTS “are called “WORKING EXPENSES” by Insurers.
“FIXED COSTS” are called “STANDING CHARGES“ by Insurers.
DEFINITIONS:
- TURN OVER: The money paid or payable to the insured for goods sold and delivered and for services rendered in course of the business at the premises.
- INDEMNITY PERIOD: The period commences from the date of Fire/Peril and ends when the business ceases to be affected thereby subject to maximum PERIOD specified in the policy.