Unfortunately, the proportion-of-sales method will not produce the correct result in all situations. It is defective in at least three ways:

1. It does not account for periods when the insured operates at a loss.

2. It assumes the cost of goods sold as a percentage of sales remains the same at all times.

3. It assumes that operating expenses are always proportionate to sales.

Operating at a loss

The proportion of sales method will understate Wonderful Widgets exposure if its business operates at a loss during some months of the year that are not included in the peak period. During its best months, Wonderful Widgets recoups the loss that occurred during the slow season, but those earnings are not factored into the proportion of sales method. An extreme example will clarify this point. Assume that Wonderful Widgets predicts a net profit of $100,000 for its peak 6 months but a loss of $90,000 for the other six. That would make just $10,000 net income for the year–the loss in the slow season all but cancels out the profit in the peak season. The proportion of sales method applies the percentage of sales in the peak period to the annual net profit. In this case that's 75 percent of $10,000, meaning only $7,500 would be included as the estimated net income loss. This is an incorrect result. If damage to its property shuts Wonderful Widgets down during its peak period, its possible net income loss is the $100,000 net profit it expected to earn during that period. Thus, $100,000 is the amount that should be included as the net income loss for the period of restoration, not $10,000.

Variation in cost of goods sold

Business interruption exposure calculations, including business income worksheets, deduct cost of goods sold because when sales are reduced, so are the cost of goods sold. Cost of goods sold problems will only affect merchandising and manufacturing operations; businesses that don't sell products, such as consultants, lawyers, architects and insurance agents, don't have a cost of goods sold item in their financial statements.

The proportion-of-sales method assumes that cost of goods sold as a percentage of sales is the same in all periods. This is not always the case. For example, seasonal variation in product mix may result in differences in cost of goods sold percentages from month to month. The proportion-of-sales method will understate the exposure if the cost of goods sold percentage is lower than the average for the year during the peak period and overstate it if the percentage is higher during the peak period.

Operating expenses, sales

The proportion-of-sales method uses a percentage of annual net profit equal to the percentage of sales expected during the peak period. This assumes that operating expenses vary directly with sales. That is, if Wonderful Widgets has an annual operating expense ratio of 25 percent, then its operating expenses in a month when it estimates it will do $1 million in sales is calculated as $250,000; and $500,000 when sales are estimated to be $2 million if we assume that operating expenses vary directly with changes in sales. This is rarely the case. For most businesses, some expenses (such as key employee salaries) remain the same no matter how little business the firm does. Other expenses vary directly with sales; an example would be commissions to sales people who are paid on a straight commission basis. Still other expenses increase or decrease when sales change, but not at a steady rate. For example, it may be possible to handle some increase in sales without increasing staff, equipment and space, but at some point added additional expense will be required. Similarly, when sales are dropping, there will be a lag before expenses are reduced–employees will not be immediately laid off, contractual obligations such as rent, will continue until the end of the contract, and so on.

A better way

It's better to calculate the loss exposure on a month-by-month basis rather than for the entire period of restoration. The steps for applying a month-by-month method that will more accurately estimate business interruption exposure include:

1. Have the insured estimate the maximum period of restoration (MPR) needed to restore covered property following total loss.

2. Have the insured estimate gross profit (gross profit equals net sales minus cost of good sold), total operating expenses and continuing expenses in the event of an interruption of operations by the month for at least the 12 months beginning with the policy renewal date. If the insured's net income is expected to increase in the following year, a month-by-month estimate for a period of time equal to 12 months plus the number of months in the MPR is a safer procedure. Indemnification for a business income loss does not end with the expiration of the policy. The loss might occur on the last day of the policy period, and the worst possible business income loss might be a period that extends into the following year.

3. Deduct operating expenses from gross profit and add continuing
expenses. This will give estimated business income loss by the month.

4. Select the period that begins during the policy term that contains the number of months equal to the MPR and produces the highest total estimated net income and continuing expenses.

5. Calculate the total net income and continuing expenses for the selected period.
In Exhibit 1, it's assumed that the continuing expense is a constant percentage the full operating expense projected for the month. In practice, the continuing expenses in the first month will be larger than in the following months. If significant, the insured could increase the continuing expense for the first month of the projected MPR and reduce the remaining months.

6. Add the insured's estimate of extra expenses that would be incurred during the selected period.

7. Add the insured's estimate of loss during the 30 days of extended business income coverage that is automatically provided by the policy plus the estimated loss during the extended period of indemnity, if the insured has purchased that optional coverage.

The total of lines 5, 6, and 7 is the business interruption exposure. Because of the many uncertainties involved in calculating business interruption exposure (how long will it take to restore operations, what will continuing expenses amount to, how much extra expense will be incurred, etc.) you might want to increase it to provide a margin of safety. Exhibit 1 shows how this monthly method works and compares it with the proportion of sales method.

Setting business income limits based on the proportion of sales during the peak period is better than using a method based the length of time needed to restore operations as a percentage of 12 months. Nevertheless, the proportion of sales method does not consider that the insured may operate at a loss during some months, the insured's cost of goods sold percentage may vary, and operating expenses do not vary directly with changes in sales volume.

An improved method involves estimating the maximum period that will be needed to restore operations and projecting monthly financial figures. The estimated reduction in net income can then be calculated directly by summing the net income during the peak period rather than using a percentage of net income based on either sales or time to restore.

Finally, continuing expense, extra expense and extended business income loss after operations have been restored have
to be estimated and added to the estimated net income loss to arrive at a maximum possible business interruption loss.