Calculating Damages for Lost Profit
The damages suffered by a plaintiff in a lost profits claim will be the dollar value, adjusted for the time value of money, required to return the plaintiff to the financial position it would have enjoyed "but for" the alleged bad acts of the defendant. There are three popular approaches to determining damages due to lost profits in a commercial dispute:
- Lost profits based on product profitability
- Lost profits based on diminution in business value
- Lost profits based on reasonable royalty
Theoretically, lost profit damages calculated using any one of the preceding approaches should result in the same dollar value of damages. However, these approaches are not easily substitutable because each approach is best suited to certain facts that may or may not exist in the specific matter being analyzed.
This article will focus on determining lost profit damages based on product profitability. Subsequent to this article will be two follow up articles focusing on lost profits based on diminution in business value, and lost profits based on reasonable royalty.
Lost Profit Damages
The lost profits approach is generally preferred, when the lost business can be easily identified and when the lost business occurs over a finite time period. The AICPA states, "Lost profits are recoverable only if the plaintiff can prove that the damages related to the lost profits are reasonable and that they have been calculated using reliable factors without undue speculation."
Generally, lost profits are determined based on an analysis of lost revenue (e.g., units times unit price, or planned completed-contract revenue), variable cost required to achieve the revenue lost, and the difference between lost revenue and variable cost (i.e., the lost profit associated with the lost revenue). Lost revenue can be based on lost production or sales (i.e., units times price) or lost contract revenue as in the case of a terminated service contract or a construction contract, will typically be the contract revenue.
The key element to determining lost profit damages is to determine lost revenue. The AICPA identifies the four most common methods of determining lost revenue. These four methods are the 1) "Before and After" method, 2) the "Yardstick" or "Benchmark" method, 3) an approach based on the terms of the underlying contract, and 4) an analysis of the defendant's revenue earned on the disputed product.
Once the forensic expert has determined lost revenue, the focus can turn to determining the variable cost of the units underlying the lost revenue. The variable cost is the cost that would have been incurred by the plaintiff in order to produce and sell the lost units claimed. A critical element of this analysis will be to determine if the plaintiff has the capacity to produce and/or sell the "lost" units. If the plaintiff has a capacity shortfall, the forensic accountant will have to determine the cost required to overcome this shortfall before the variable cost of production can be fully quantified. Alternatively, the plaintiff may consider using a reasonable royalty approach to determine the lost profit on the lost units that exceed its capacity (note that this method will be discussed in greater detail in a follow up article).
Once the variable cost for the lost sales is determined, the lost profits can generally be calculated by simply subtracting the variable cost from the lost revenue.
Continuing costs related to the lost units sold will generally be "absorbed" in the "but for" scenario and therefore are not an additive damage when lost profits are calculated in the manner described above.
Resolution Experts PC, "ResX, PC", provides independent forensic accounting services for complex litigation and contract compliance and fraud. ResX is based in Michigan and serves clients throughout the United States. For more information and to learn about working with ResX, please visit our website: www.resxpc.com.
The preceding narrative presents concepts that are dependent on facts and circumstances. These concepts can change depending on the specific facts and circumstances of an individual matter.