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Absorption Costing and Extra Expenses: Potential Pitfalls

Posted by Meaden & Moore on Jul 11, 2016 8:27:55 AM

absorption costingIn recent years, there has been an increased number of claims for extra expense (Expenses to Reduce Loss (ETRL) or pure Extra Expense (EE)) submitted on an absorption costing basis. What does absorption costing mean? 

Total absorption costing is a method of accounting that allocates all costs, across all segments of the business, to a manufactured product or provided service. These costs range from raw materials and direct labor to variable and fixed overhead. 

Many modular accounting software packages commonly used by manufacturers use absorption costing concepts to value or “cost” a product. Since many manufacturers use this method, it is important to understand how it can affect an extra expense claim.

An ETRL or EE claim can be prompted by the policy wording, “…additional costs in excess of normal operating expense…” Along those lines, there are two common claims made involving absorption accounting that need to be scrutinized, documented and questioned:

1) An unfavorable variance in per unit cost at the loss site, and

2) Higher per unit costs at the sister plant making up the production or sales. 

At the loss site, if dollar costs remain the same but units produced decrease because of a covered direct physical loss, it is important to understand what the “per unit” variance means and what it doesn’t mean. For example:

An insured normally produces 10,000 units per month and a covered loss causes production to decrease to 5,000 units per month.

Issue: A fixed overhead expense is $10,000 monthly. Prior to the loss, each unit produced absorbs $1 of that expense. After the loss, an insured might assert that the expense is now absorbed at $2 per unit. They may claim the $1 per unit variance from pre-loss experience as an extra expense. 

Q: Is the fixed overhead a “normal operating expense”?

Q: Did the fixed overhead expense increase?

Q: Did absorption cost make it appear that the fixed overhead expense increased?

If production is moved from the loss site to a sister plant, the absorption-costing-based measurement may compare unit costs and claim the differential times the units. Essentially, the premise of the claim is that the unit costs at both locations are variable, and that as the sister plant “incurs” unit costs with each unit produced, the loss site “reduces” costs with each unit not produced.

Q: Did the fixed overhead expense increase at the sister and decrease at the loss site?

More frequently, ETRL and EE claims are being prepared using absorption costing. Absorption costing may appear to support a claim.  The ETRL or EE may be an illusion. Think about what is variable. With experience, understanding and professionalism, these claims can be handled appropriately and result in a positive claims experience for all parties involved.

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Topics: Investigative and Forensic Accounting

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