Business Interruption Claim After a Plant Fire
Precision Parts Inc. (PPI) manufactures automotive components at a single plant with two production lines. A fire on March 1 destroyed Line 1; Line 2 continued operating. PPI's business-interruption policy covers 12 months of lost profits. PPI's prior-year revenue was $18.0 million, with variable manufacturing costs at 70% of revenue, fixed manufacturing overhead of $2.4 million, fixed SG&A of $1.8 million, and net income of $1.2 million. For the claim period, PPI expected revenue to remain flat at $18.0 million, but actual revenue was $13.5 million. PPI shifted 40% of Line 1 volume to Line 2, incurring $150,000 in overtime, and saved $200,000 in variable costs. PPI also earned $200,000 by subcontracting work to a competitor. PPI's public adjuster submitted a $2.4 million lost-profit claim, using a 20% net margin on estimated lost revenue of $12.0 million. The insurer retained you to evaluate the claim.
1. Calculate the lost contribution margin for the claim period and adjust it for additional expenses and mitigation income. State the resulting lost-profit figure and show each step.
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Step 1 - Lost revenue. Expected revenue of $18.0M less actual revenue of $13.5M = $4.5M lost revenue. The adjuster's $12.0M lost-revenue figure is not supported by the facts.
Step 2 - Contribution margin. Variable costs are 70% of revenue, so the contribution margin ratio is 30%. Lost contribution margin = $4.5M × 30% = $1.35M. The $200,000 of saved variable costs is already reflected in the actual results used to measure lost revenue; adding it separately would double count.
Step 3 - Additional expenses and mitigation. Add the $150,000 overtime needed to serve remaining customers. Subtract the $200,000 subcontracting income because it reduced the loss.
Result: $1.35M + $0.15M − $0.20M = $1.30M in lost profit before any policy limits or waiting period. No deduction is made for fixed costs because the facts do not show they were avoided.
2. PPI's adjuster used a 20% net margin on $12.0 million of estimated lost revenue. Identify at least two errors in that approach and explain how they affect the claim.
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The adjuster's approach contains at least three judgment errors:
- Lost revenue is overstated. The supported lost revenue is $4.5M, not $12.0M.
- Net margin is the wrong measure. Net margin (reported net income of $1.2M ÷ $18.0M = 6.67%) reflects fixed costs that continued during the interruption. Lost profit is measured by contribution margin, not net margin, unless the evidence shows fixed costs were avoided. Using a 20% margin is also unsupported by the financial statements.
- Mitigation and extra expense are ignored. The $200,000 subcontracting income reduces the loss, and the $150,000 overtime increases it. The $2.4M claim is therefore not supportable; the supported figure is approximately $1.3M before policy terms.
3. What additional evidence would you request before finalizing your opinion, and why?
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Request: (a) the policy, including waiting period, extended period, and any limits; (b) pre-fire sales forecasts, backlog, and customer contracts to test expected revenue; (c) production and sales records for the claim period; (d) the fixed-cost ledger and payroll to confirm whether any fixed costs were avoided; (e) overtime payroll and the subcontracting agreement; (f) variable-cost detail to confirm the 70% ratio; and (g) evidence of mitigation efforts. The judgment call is causation: the insured must show the lost sales were caused by the fire, not by market decline or pre-existing business problems.