Product recalls impact thousands of companies each year — putting people and brands at risk. The consequences to a company’s reputation, market share and bottom line can be devastating. While the cause behind recalls can vary widely — from salmonella cases to quality control issues — one common concern is the complexity of assessing the financial components of a loss.

Financial elements

Costs associated with removing product from the market can quickly increase following a recall — from labour to shipping, handling and disposal costs. Not to mention, there could be manufacturing costs to consider and time spent on additional review processes if the recalled product requires remanufacture. Lost profit claims for relevant parties involved may include the manufacturer and retail customers, all of which adds to the potential exposure of the Insured and Insurer.

The basis of most claims

Most product recall claims are submitted with the product valued at ‘standard cost’. This encompasses the business’ cost of the product, including raw material costs, labour hours and associated costs, along with allocations of other manufacturing and overhead costs (both direct and indirect). However, the indemnifiable insurance costs can vary dramatically from the claimed standard costs reported by the insured and/or claimant.

A common reason for this difference is that standard costs are typically set by a business at the start of its financial year, based on its expected manufacturing output and quantities produced over the course of the year. The expected manufacturing costs are then converted to a standard cost-per-unit based on the expected output. For example:

Possible factors

The standard cost is typically created after reviewing historical costs adjusted for some future production planning; it is a prediction of what the cost-per-unit will be during the upcoming year. However, the output and costs which eventuate can vary considerably from what was planned. For example:

• Costs may change due to global supply/demand.
• Production output may fall short or exceed targets depending on customer requirements, operational efficiencies, mechanical and manufacturing capabilities.
• Operational changes in the business impact actual costs, such as changes to the number of manufacturing shifts or employees rostered on.

Potential scenarios

Any of these factors can result in a manufacturing cost that is higher or lower than the standard cost — requiring an adjustment to a claim prepared based on standard costs. For example:

• Variable costs per unit have increased due to global shortages, increasing total variable costs by $650,000
• The business was able to run more continuous shifts, making the output greater than expected by 150,000 units
• Due to a new EBA, labour costs increased by $100,000 over the year

The actual cost of manufactured product (but not necessarily the indemnifiable cost) would be recalculated as:

Loss assessment guidance

As forensic accountants, our team in Australia and around the world are skilled in identifying factors that may impact the standard cost following a product recall. We ensure that costs not directly attributable to the manufacture of the affected product do not form part of the claim. This means:

• Overhead cost allocations are identified and excluded.
• Adjustments are made to account for actual cost, including adjustments for manufacturing variances unrelated to the Insured event.
• Cost of the insured’s product or componentry in finished goods is excluded (subject to policy exclusions).
• Cost of product is calculated in alignment with gross profit definitions.

Sedgwick’s forensic advisory experts establish the actual losses sustained — subject to the relevant policy wording — giving those involved peace of mind that the losses have been indemnified accurately. Our team of product recall and product liability loss quantification specialists have extensive experience in assessing product recall and product liability claims across many industries. For more information about our liability services related to product recall, read the brochure or contact jillian.pancott@au.sedgwick.com.

This blog is the first installment in a series where our experts explore current themes and share insights on liability claims — ranging from trip and slip personal injuries to multimillion dollar product recall and professional indemnity claims. No matter the focus, our team in Australia and around the world is committed to working closely with specialty areas of our business, including forensic accountants, chartered engineers and building consultants to create synergies. Stay tuned for the second blog, which is coming soon.