The cost of recalling faulty or contaminated products can have damaging repercussions for manufacturers. Jarrod Baker reports

Imagine the following scenario: ABC, the manufacturer of a leading consumer product, develops a fault in its manufacturing process and the product becomes contaminated. As a result, production ceases while the contamination issue in the manufacturing process is rectified.

To protect consumers, ABC has no option but to recall the product. In the midst of a public relations crisis, ABC focuses its attention on the recall of the product, what went wrong and how soon it will be able to resume production.

But ABC neglects to consider the costs it is incurring as a result of the product recall, assuming it will be covered by its product recall insurance. But to what extent will these costs be covered?

The EU's General Product Safety Directive (GPSD) came in to force in the UK in October 2005 and placed greater emphasis on companies to be open about the safety of their products. Crucially, and to protect consumers, should a company become aware that one of its products is defective or dangerous, it is required under the GPSD to notify the relevant authorities within seven days. Failure to comply puts directors at risk of prosecution, which in the UK may result in a fine of £5,000 for each offence, and/or a term of imprisonment of up to three months.

Unsurprisingly, this has led to a sharp increase in the number of product recalls from 43 in 2005 to over 120 in 2006.

Costly experience
Costs incurred as a result of a product recall can be substantial. Cadbury estimated the recall of its chocolate bars last year due to possible salmonella contamination cost the company £20m.

It is, therefore, vital that important consideration is given to the cost (quantum) element of a product recall. Unfortunately, this does not always happen in a timely manner,

with the company quite often placing its initial focus on the cause of the recall and its associated fall-out.

Broadly speaking, the quantum of a product recall will be determined by the costs incurred in two major categories – the actual costs of the recall and loss of sales.

Loss of sales will not only include the losses associated with the product not being available for purchase, but also the effect negative publicity has on sales throughout the recall and beyond. The actual recall costs incurred (regardless of whether or not they are covered by the insurance policy or by extension cover) will generally fall under the following:

• Stock losses: this is the total amount of stock the company has to destroy as a result of the recall, whether on hand or returned by customers

• Transportation, storage and disposal costs: the costs incurred in taking recalled stock back and disposing of it

• Repair or replacement costs: these costs may include those incurred to fix the recalled product or those to fix the machinery and/or methods used to manufacture the product

• Marketing costs: advertising and special promotions are often needed to bring sales back to their pre-recall level

• Investigation fees: the company may need to engage consultants to assist with the testing of affected products and assist in managing the recall

• Professional fees: the company may need to engage lawyers to protect against lawsuits or regulatory actions or accountants to quantify the costs of the recall.

If there is product recall insurance, then the policy will provide the basis for calculation of the claim quantum and list those costs which may be submitted. However, this is not always straightforward and disagreement between the insurer and insured may arise, often relating to whether the appropriate insuring clause has even been triggered.

One area where discussion will most likely arise is the extent of costs incurred and their appropriateness. Accordingly, it is important to consider what costs are required to return the product to the market in the shortest amount of time while at the same time considering the effect on sales as a result of such costs not being incurred.

Two other areas, normally covered by way of extension cover only, where discussion may arise are described below.

Normally, the duration of loss will typically end when sales return to what they were before the product was recalled. But there could be factors not associated with the recall causing a delay in sales returning to their pre-recall level that need to be taken into account, including the company modifying an aspect of the product or changing the way it is produced, thereby increasing the time it takes to return the product to the market.

Alternatively, sales may have been increasing before the recall and this will also need to be considered when determining the effect of the recall on sales.

The other area is that the effect on sales cannot always be determined from the time it takes for sales after the recall to return to their pre-recall level, as the company may have been experiencing a variance in sales prior to the recall.

Alternative product
Likewise, the company may have another product customers switch to as a result of the recall and additional sales of this alternative product must be taken into account. The same can also be said if a competitor were to launch a similar product around this time. Accordingly, the individual circumstances of the company need to be considered.

The effect of disagreement will most likely cause delays in settlement and could ultimately expose the insurer to litigation. But this disagreement, as it relates to quantum, can be mitigated by either the insurer, insured or broker ensuring that a forensic accountant or quantum expert is engaged to calculate the quantum.

Their early involvement in the product recall process should mean that recall costs are captured in an accurate and timely manner. Their role will most likely include:

•Ensuring sufficient documentary evidence is captured to support the product recall claim

• Quantifying the volume and value of stock recalled

• Calculating the additional costs incurred during the recall, for example, transportation, destruction costs and advertising

• If covered by the policy or by way of extension, help determine the appropriateness of expenditure incurred in returning the product to the market and quantifying the loss of sales during the recall and beyond.

Returning to ABC and the crisis the company is facing – appointing a quantum expert is likely to be the most expeditious way of determining the appropriateness of their product recall claim; it should help with total recall. IT

Jarrod Baker is a manager at KPMG Forensic