Five non-continuing, production-related expense categories are subtracted from total revenues (Line "H") to produce the insured's 12-month business income exposure: 1) cost of goods sold (COGS); 2) outside services resold; 3) utility services that do not continue under contract; 4) ordinary payroll; and 5) special deductions for mining operations.

Two of the five expense categories apply only if specific endorsements are attached and the last applies only when the insured is a mining operation. Each of the Section "I" non-continuing production expenses is detailed in the following paragraphs.

Cost of Goods Sold (COGS) - A Required Deduction

Cost of Goods Sold is developed for both manufacturing and non-manufacturing risks with only minor calculation differences between operational types. Most of the information necessary to develop COGS can be found on the insured's income statement. However, standard income statements follow generally accepted accounting principles (GAAP) requirements but the business income report/worksheet strays from the GAAP when calculating a manufacturer's COGS.

Two distinct differences exist between the GAAP method for calculating a manufacturer's cost of goods sold and the business income worksheet's method for calculating their COGS. Knowing, planning for and advising the insured of these differences is vitally important.
• GAAP-calculated COGS includes the competed value of finished stock on hand in development of both beginning and ending inventory values. The value of finished stock on hand is excluded from the CP 15 15 COGS calculation; and
• GAAP-calculated COGS includes the cost of labor directly related to production. Production-related labor costs are specifically excluded in CP 15 15's COGS calculation.
These income statement and business income worksheet differences prevent the insured from copying COGS information directly from the income statement onto the business income worksheet (the COGS calculation is found on page 4 of the form).

Both costs included in the income statement but excluded from the CP 15 15 are applied in other parts of the business income worksheet:
• Beginning and ending finished stock inventory values are used to develop the Gross Sales Value of Production in the income section of the business income worksheet (Lines "B" and "C"); and
• Production-related labor costs are classified as "ordinary payroll" and subject to a specific endorsement (the CP 15 10). The insured may include all or only part of ordinary payroll as an ongoing expense. The CP 15 10 and the concept of ordinary payroll expense are detailed in an upcoming section.

Like the business income report/worksheet, the insured completes the COGS information for the most recently ended 12 month period and estimates the information for the upcoming 12 months (the policy period). The calculation is as follows:

1. Inventory at the beginning of the year
2. PLUS (+): The cost of Raw Stock
3. PLUS (+): The cost of Factory Supplies Consumed
4. PLUS (+): The cost of Merchandise Sold
5. PLUS (+): The cost of Other Supplies Consumed
6. EQUALS (=): The Cost of Goods AVAILABLE For Sale
7. Minus (-): Inventory on hand at the end of the year
8. EQUALS (=): Cost of Goods Sold

Step 1. Remember, manufacturing operations do not include the cost/value of finished stock on hand in this figure.
Step 2. This is not included in the calculation for non-manufacturing operations.
Step 3. This amount is not included in the calculation for non-manufacturing operations.
Step 4. This is the cost of stock/inventory purchased and held for sale by non-manufacturing operations. For manufacturers, this is the cost of merchandise manufactured by another party but sold by the insured.
Step 5. This is the cost of supplies consumed but not made part of the manufactured product. Examples include safety equipment (i.e. gloves, ear plugs, etc.), oil for machinery and other such supplies.
Step 6. Self-explanatory.
Step 7. Remember, the cost/value of finished stock on hand is excluded from this amount for manufacturing operations.
Step 8. The total carried over to the COGS line in Section "I."

Steps two and three apply only to manufacturing risks. Step four is the cost of inventory for non-manufacturing operations; but for manufacturing risks it's the cost of goods manufactured by others and sold by the manufacturer (i.e. a product accessory stocked and sold but not manufactured by the insured).

Not all entities require a COGS calculation. Entities that do not produce or sell a tangible product (insurance agencies, law firms, consultants and accountants are ready examples) or those that purchase rental income only protection may not necessitate this calculation.

Outside Services Resold - A Required Deduction

The second non-continuing production expense subtracted from total revenues is the cost of outside services resold by the insured. Examples of such expenses may include services offered by outside engineers in performing plan review ("stamped plans"), the cost of sub-contractors hired by the insured to perform specific tasks or the cost of independent consultants who the insured pays directly but charges the client as part of their total services.

Assume the insured is a structural steel fabricator - a manufacturing operation. One of the services offered by the insured is plan review by a structural engineer, but only when they are providing the steel. However, there is no engineer on staff; all plan review is done by a third party engineer. The cost of the engineer is paid by the fabricator (although the cost is passed along to the customer with a small markup). If the manufacturer has to close down because of a major loss, the cost of these contracted engineering services is deducted from revenues - because there is theoretically no need for the service when there is no manufacturing.

This deduction has two caveats: 1) the services have to be those that are resold to the insured's customers. This is not a deduction for services purchased by the insured for the insured's use (such as consulting services); and 2) they have to end when production ceases (i.e. if there is a contract that requires continued payment even when no work is being given, the insured does not deduct those costs).

Utility Services - An Optional Deduction

Power, heat and refrigeration expenses that do not continue following a loss-induced business shut down per contract between the utility and the insured can be deducted from total revenues, but only if CP 15 11 is attached. The CP 15 11 applies only to utility services related to production operations; so this is essentially a manufacturing-specific endorsement.

Manufacturing operations that consume large amounts of any of these services may enter into a contract with the utility provider for reduced rates and/or a more predictable payment schedule (rather than fluctuating costs that are hard to anticipate). If the agreement allows the insured to cease payments in the event of a business shut down, the CP 15 11 should be attached and the deduction taken.

If, however, the insured must make payments regardless of the business' operational status, this endorsement should not be attached and will not apply even if it is attached since the payments continue. Essentially, contracted utility payments that continue after a loss become part of continuing normal operating expenses.

"Ordinary" Payroll - An Optional Deduction

Does the insured want or need to keep all employees on staff during a loss-induced business shut down? Business entities that require specially trained employees which cannot be easily replaced may want to keep everyone on staff and paid until the business is running again. But some operations may not require highly skilled workers or operate in an area with ample talent and may decide to let all but the managers and executives go during the shutdown choosing to rehire them or others once the business is running again.

Insureds who feel they don't need to keep their non-management or non-specialty employees on staff may choose to attach the CP 15 10 - Ordinary Payroll Limitation or Exclusion. With the endorsement, the insured chooses the number of days it wants to pay these employees with ninety days being the most common choice. At the end of ninety days (or whatever amount of time is chosen), the business income policy ceases paying for these "ordinary" employees. The payroll expense for the remainder of the year is deducted from total revenues and no longer qualifies for coverage as a continuing operating expense.

Certain employees are not considered "ordinary" by the endorsement and are excepted from this exclusion. These are: officers, executives, department managers, employees under contract and any specifically listed employee or job description. Payroll for these "non-ordinary" employees continues unabated as continuing normal operating expenses - fully covered by the business income policy during the period of restoration.

"Ordinary Payroll" is: Payroll + Employee Benefits (directly related to payroll) + FICA payments + Union Dues + Workers' Compensation premiums.

The provisions of the CP 15 10 endorsement and its proper use will be detailed more fully in a future article.

Special Deductions for Mining Operations - A Required Deduction

Certain expenses are deducted when the insured is a mining operation. These are: royalties (unless specifically included), actual depletion, welfare and retirement fund charges based on tonnage and hired trucks. The sum of these expenses is moved to the last line of Section "I" deductions.

Obviously, if the insured is not a mining property, this section (found on page 5 of the CP 15 15) does not apply.

How All Deductible Costs and Expenses Apply

Non-continuing, sales-related operational costs (detailed in the previous article) PLUS the non-continuing, production-related expenses discussed here are the only COSTS/EXPENSES specifically subtracted from gross sales and total revenues (respectively) in the development of the insured's 12-month business income exposure. This is important when viewed in context with the definition of Business Income (net income (net profit or loss before tax) PLUS continuing normal operating expenses).

Section "E" and Section "I" are the only expenses relevant to the business income worksheet. Until a loss occurs, the insured is not charged with knowing or deciding which operational expenses will or will not continue, in whole or in part. Trying to pinpoint continuing and non-continuing expenses prior to a loss serves only to complicate and confuse the process and is pointless and unnecessary. Not contemplating continuing and non-continuing operational expenses at this point does create a difference between insurable business income (ratable) and compensable business income. The difference can confuse or anger the insured if not properly explained, thus this concept is discussed and detailed in an upcoming article.

The Next Step

All income and expenses have now been calculated. The next step is the summation of the 12-month business income exposure and the development of the correct coinsurance. Both will be discussed as in the next post, with particular emphasis placed on the development of the correct coinsurance percentage.

For all the information on Business Income coverage, take a look at Insurance Journal's book, "Business Income Insurance Demystified: The Simplified Guide to Time Element Coverages."