July/August 2007

Many property policies use the wording “the proper proportion of overhead” relating to valuation of work in process stock losses. How should overheads be applied in stock losses?

A:
In our many years of experience evaluating property insurance claims on behalf of insurers, we have yet to see an insurance policy that defines the term “proper proportion of overhead.”  From an accounting perspective, overhead in manufacturing operations includes both variable expenses such as a portion of labor fringe benefits, consumable supplies, utilities and other costs that vary directly in proportion with production as well as fixed expenses such as fixed fringe benefits, depreciation, facility rent and other costs that do not vary with volume.  When a manufacturing concern values work in process or finished goods inventory for financial reporting purposes, both fixed and variable overheads are typically included in determining product cost.  Thus a valid argument can be made that including both fixed and variable costs in determining work in process inventory value in an insurance claim (or finished goods if there is no selling price valuation) would be consistent with financial accounting rules.  However, an equally valid argument can be made that in replacing damaged stock only variable expenses will be incurred on an incremental basis in order to remanufacture destroyed stock. 

While this issue should be decided by each insurer based upon their interpretation of policy wording, we believe it makes sense from an accounting perspective to value damaged inventory based upon total manufacturing overhead expended to the stage of completion of the stock at the time it was damaged.  However, because operating costs normally included in fixed overhead are usually included as continuing costs in determining the business interruption loss incurred, any fixed overhead allowed as part of the inventory claim valuation should be properly adjusted from continuing costs to avoid duplication of payment.  If overheads are handled in this manner, we believe that the insured’s financial loss will be properly measured.