Double Extension Method
The double extension method is a valuation technique used primarily in the context of business interruption insurance claims. It involves calculating the claim by determining what the business would have earned without the interruption and then subtracting from that amount what the business actually earned during the interruption period.
Here’s a simple step-by-step process of the method:
- Calculate the rate of gross profit earned by the business during a previous comparable period (often this is a percentage of turnover).
- Apply this rate of gross profit to the turnover that was lost during the period of interruption to determine the gross profit that the business lost.
- Deduct any saved expenses. These are the costs that the business did not incur because it was not operating normally.
- Add any additional costs that the business incurred as a result of the interruption. These might be costs that the business incurred to mitigate its loss, such as extra advertising to bring customers back.
This final figure represents the amount that the business is claiming under its business interruption insurance policy.
The method is named the ‘double extension’ because it requires extending the accounting period of the business both before and after the interruption to perform the calculations. However, it’s essential to note that the approach may vary depending on the specific terms of the business interruption insurance policy and the nature of the business interruption itself. As always, this kind of calculation should be performed with the assistance of a financial or insurance professional to ensure accuracy.
Example of the Double Extension Method
Imagine a retail store suffered damage due to a fire, causing it to close for three months for repairs. The store had an annual turnover of $1,200,000 and gross profit margin of 40% before the incident.
Let’s also say that, during the three months it was closed, it would have normally made $300,000 in sales (given that $1,200,000 / 4 quarters = $300,000 per quarter).
We can apply the double extension method as follows:
- First, we calculate the gross profit rate, which in this case is 40% as stated.
- We then apply this rate to the turnover lost during the three-month period: $300,000 * 40% = $120,000. This is the gross profit the store lost due to the business interruption.
- Next, we subtract any saved expenses. Let’s say the store saved $20,000 on payroll expenses because it didn’t have to pay staff while it was closed.
- We then add any additional costs incurred as a result of the interruption. Let’s say the store spent an extra $10,000 on advertising to announce its reopening.
So, the calculation would be: $120,000 (lost gross profit) – $20,000 (saved expenses) + $10,000 (additional costs) = $110,000.
According to the double extension method, the retail store would claim $110,000 under its business interruption insurance policy for the loss suffered during the three-month period.
Remember, this is a simplified example and actual business interruption calculations can be much more complex, often requiring the expertise of an insurance professional or an accountant.