When Every Minute Counts
Article, AICPA - CPA Insider – October 2009
Insurance / Property
Derek Royster, Partner, explains how as forensic accountants, we are often asked to calculate lost profits for a manufacturing facility that has suffered short-term shutdowns or intermittent production losses.
As forensic accountants, often we are asked to calculate lost profits for a manufacturing facility that has suffered short-term shutdowns, or intermittent production losses. The disruption may be due to a loss of power, fire damage, mechanical breakdown of equipment, as well as a variety of natural disasters such as earthquake, hurricane, and flood.
In some cases, the actual production downtime is limited to only minutes or hours, not days or weeks and therefore it is common for the affected facility to quantify its damages based on the associated lost profit from projected lost production for the specific downtime. For example, the facility controller calculates the sales value of production for five minutes of downtime and then subtracts avoided costs to quantify damages.
Demonstrating Actual Loss
However, in order for the facility to demonstrate that it sustained an actual economic loss, it will still need to identify specific lost sales or orders as a direct result of the incident in order to establish an actual loss sustained. If the entity is unable to identify any specific lost sales or orders, it will need to demonstrate that production operations are at constant full capacity and any loss of production will ultimately result in a lost sale at some point in the future.
Example. If a facility operates 24-hours-per-day/seven-days-a-week, with constant production volume, it is likely operating at full capacity. However, it is common for a business to operate 24-hours-per-day/seven-days-a-week with some idle capacity due to operating efficiencies or varying product mix.
In many instances, a manufacturing facility with a minimal downtime period is able to mitigate any lost sales orders by shipping from finished goods inventory on hand. In the event idle capacity exists, the facility is able to make-up any lost production and restock inventory levels by boosting production in the post-loss period. In some cases it is able to do so during the normal course of a production day upon the resumption of operations, which will likely result in no additional out-of-pocket costs incurred.
However, in other cases it may run an extra labor shift during the course of a normal work week or produce on a weekend (when it normally only produces five-days a week). In these cases the business will not suffer a loss of production, but will rather incur additional out-of-pocket costs to make-up the lost production. These costs normally consist of the following: increased production costs including, but not limited to, additional labor costs for overtime and associated fringe benefits, utilities expense and other variable manufacturing costs. This is commonly referred to as a loss of “efficiency.”
Additionally, companies with multiple production facilities may be able to offset lost production through the use of production capacity at other locations. Sometimes, if the alternate plant is not tooled or set-up to produce the lost production at the affected facility, it may incur some unexpected costs to set up appropriately to accommodate production of the lost product. In addition, it may also incur additional freight and handling costs to ship the product or raw materials, from one facility to another.
A manufacturing facility may also be able to mitigate any lost sales and associated lost profits by outsourcing partial or complete production to a competitor in order to meet their ongoing sales demand. Although the manufacturer will incur additional costs to outsource production, these costs will need to be reduced by the avoided — or saved — variable manufacturing costs not incurred as the products would no longer be produced internally.
Lastly, a company may elect to never make up the lost production if sales orders and demands do not warrant them doing so. If this is the case and idle capacity exists, production losses may be due to a management decision as opposed to the incident that caused the downtime, because the facility does have the ability to mitigate but chose not to do so. In preparing a calculation for lost profits for a manufacturing facility, it is important to consider the following:
- Was the facility able to identify any specific lost sales or orders?
- Are sales and production seasonal?
- Was the manufacturing facility operating at full capacity prior to the incident?
- For example does the facility operate 24-hours-per-day/seven-days-a-week with constant production volume?
- Is post-loss production consistent with pre-loss levels or did the facility generate additional production immediately following the loss period? If so, the increase in production may be an attempt to make-up lost production and mitigate any potential loss.
- If the facility was able to make-up production, did they incur any additional costs to mitigate their production downtime?
- Does it normally maintain significant amounts or inventory or “safety stock,” of the specific product(s) that were not produced?
- Does it have any other unaffected locations that may absorb the production downtime or have inventory on-hand to meet existing sales?
- Is there an understanding of the production process and have any potential bottlenecks in production been identified?
- Are there any contractual sales agreements with customers and if so, what was the impact resulting from the downtime?
- Was the facility able to perform maintenance during the downtime period which was scheduled in the future?
When preparing or reviewing an economic damage calculation for a manufacturing facility with a very short down-time (minutes to days), lost or intermittent production does not necessarily always result in a lost sale and therefore an actual lost sustained. As such, it is important to consider the factors referenced above, as the facility may have incurred only additional out-of-pocket costs to make up the lost production, or may have idle capacity available to completely mitigate the loss, or have sufficient finished goods inventory to meet any sales demand.
As appeared in AICPA – CPA Insider, October 2009.