Lost profits are a typical element of damage claims in legal actions. They seem fairly straightforward, yet opposing experts can come up with vastly different numbers. Often, the calculations are in fact not straightforward, and the process of estimating lost profits can become very detailed and cumbersome.
In general, lost net profits are calculated by first estimating the lost gross revenue or sales due to the act. The lost gross revenue is then reduced by the avoided costs, which include all of the normal costs related to providing a good or service. This results in the net profit that would have been realized if the sales would not have been lost.
Some experts like to use lost gross profit as a measure of damages. This usually isn’t the correct way to value damages. Gross profit only includes figures for revenue and cost of goods sold. Such a calculation fails to consider other costs of a business that may be closely related to providing a good or service.
Another key aspect of a damage calculation is correctly estimating the period of loss. The loss normally begins on the date the act occurred, which can be fairly easy to determine. The ending date of the loss period may be more difficult to estimate. It will likely be based upon the date business resumed to normal levels or the end of the term of the contract.
Calculating Lost Revenue
The first component of a lost profits calculation is the revenue lost due to the matter in litigation. The method used for calculating lost revenue will vary depending upon the industry, the data available for the calculation, and the type of loss. There are several common methods for calculating lost sales.
One method compares a company’s performance prior to the event, to the performance after the event. The theory behind this calculation is that “but for” the defendant’s actions, the company would have achieved sales and profits similar to those before the event. This calculation relies heavily on the company’s historical accounting records as a basis for the lost profits calculation.
A second method for calculating losses uses benchmark data to calculate the revenues and profits a company should have had. Benchmarks may include data from another company, financial results from a different location operated by the plaintiff, industry averages and norms, or the company’s budgets and projections. If the expert uses this method, she or he must first demonstrate that the benchmark is applicable to the plaintiff and therefore the proper measure for the damages.
Other approaches for calculating lost revenues and profits may certainly be appropriate, and should be evaluated on a case-by-case basis. A method that may be reasonable in one case might be totally inappropriate for another matter. It is wise for the expert to step back from the calculations and consider whether or not the numbers appear reasonable under the circumstance.
To arrive at lost profits, the expert must calculate the costs associated with generating revenue. For example, a company that manufactures a widget incurs material costs, labor costs, utilities, supplies, and other costs to make each widget. To the extent that the company lost sales, the company also did not incur the expenses related to those sales. These avoided costs need to be calculated and factored into the net loss.
It’s important for the financial expert to understand the company’s cost structure, but the degree of detail required in estimating costs will vary from business to business. It is necessary to understand how the company’s costs relate to the sales and what factors affect the costs. The accounting concepts involved in understanding and dissecting the cost structure are many, and require diligence on the part of the expert.
As with the calculation of lost revenues, it is important for the expert to examine the calculated expenses for reasonableness. She or he must be satisfied that the numbers make sense in light of the information available in the case.
One critical part of the damage calculation process is the determination of causation. If a company suffers a loss of sales compared to “normal” levels, the expert should consider possible reasons for the drop in sales.
While the sales loss may be related to the legal matter at hand, it is also possible that market conditions may have impacted sales. It is important to examine how things such as economic conditions, government regulations, company reputation, and desires of the marketplace may have impacted a sales loss. Any reduction in sales related to these types of factors should be excluded from the calculation of lost profits in a litigation matter.
Lost profits for new businesses are difficult to estimate because of the lack of operating history. In these cases, other sources of data must be sought to help calculate damages. Sometimes business plans or budgets are used, even though these may be regarded as somewhat speculative. The expert is often left to make many assumptions about the new business, but ought to seek as much support for those estimates as possible.
If statistics or outside data are used to calculate damages, they should be derived from widely-respected and reliable sources. Experts often look for outside information to support assumptions made in the calculation of lost profit. This information should only come from sources that are known to provide reliable and accurate data.
The expert witness must consider whether the plaintiff was able to make up sales or in some other way mitigate the damages in the matter at hand. If a company can find alternative ways to produce a product or locate a new supplier of raw materials, these types of things might reduce the damages. The expert must also consider whether mitigation was possible, even if the plaintiff did little or nothing to mitigate the damages.
The calculation of lost profits can be a very detailed, time-consuming process. It is necessary to be as accurate as possible when estimating lost sales and avoided costs. Yet it is important to remember that this is not a precise process, and does rely on estimates. The expert must calculate damages that are reasonable and that use reliable information and widely-accepted methodology.