Calculating Lost Sales in Business Interruption Claims
The most important element in most business interruption claims is the calculation of lost sales. The lost sales calculation establishes the foundation for determining costs and lost profit. The nature of the lost sales calculation will depend on the purpose for which lost sales is being determined.
If the purpose is to prepare an insurance claim for lost sales then the first step will be to read/understand the insurance policy. If the purpose is to prepare a damage claim resulting from the defendant's breach of contract, then the first step will be to read/understand the contract. And finally, if the purpose is to prepare a damage claim based on the defendant's negligent or tortious acts, then the first step will be to understand what the law allows for damages resulting from the alleged acts.
For this article, we will take the perspective of a businessperson who is trying to determine the total financial impact of a business interruption event. Therefore, we will focus on quantifying all the damages that are suffered by the business due to the interruption of its operations for whatever reason. We will not address how insurance language, contract language, or legal precedent will pare down actual damages to an amount that may be asserted within the parameters of these different worlds.
Lost sales caused by business interruption is the difference between 1) the sales that should have been achieved had the interruption event (the "Event") not occurred ("But-For" sales), and 2) the actual sales that were achieved ("Actual" sales).
The damage expert will start by preparing a baseline But-For sales projection ("Baseline Projection") by looking at the historical sales trend prior to the Event and extrapolating this trend into the future using a statistical tool such as regression analysis. This can be done using sales dollars as the unit being trended. It can also be accomplished by trending each of the two variables that make up sales dollars (i.e., units sold and price per unit), and then taking the product of units sold and the price per unit to get sales dollars.
Next the damage expert will have to look at specific business factors that will impact the Baseline Projection. These factors will have to be considered assuming the Event did not occur and will generally include:
- Demographic trends
- Manufacturing capacity
- Trends in technology
- Changes in the competitive landscape
- Economic trends
- Product obsolescence
- Customer loyalty to purchase experience
- Other factors
Each of these, and other factors, will have to be considered and analyzed, in order to quantify its impact on the Baseline Projection.
Actual sales is generally, but not always, the sales achieved by the enterprise subsequent to the Event. Actual sales will usually be less than the But-For sales during the time between the Event and the point in time when the enterprise returns to normal operations.
Actual sales may also lag the But-For sales after operations are returned to normal because of continuing detrimental factors. If continuing detrimental factors affect future sales, then the damage expert will have to project Actual sales into the future. Therefore, it is important the damage expert search of the existence of continuing detrimental factors and, if found, to determine the impact of these factors on future sales. Usually continuing detrimental factors are specific to the enterprise and/or its customer base. They often involve damage to a business' brand image or its customer purchase patterns. The business may choose to mitigate the impact of these detrimental factors by repairing the damage by investing in items such as brand advertising, or sales promotion. The cost of this mitigation is a cost to the business that is directly attributable to the Event and therefore a damage caused by the Event (we will discuss this element of damages in a later blog).
Actual sales may have to be adjusted for other factors, such as:
- Postponed sales: Postponed sales are sales that should have occurred during the interruption period but were delayed until sometime after the interruption period. In the But-For scenario, the postponed sales are actually accounted for in the interruption period. Therefore to show these sales as Actual Sales in a period not covered by the lost sales calculation will actually count these sales as lost sales, when in fact they were not lost.
- Long term loss of customers: A business interruption event, such as a data breach that effects customer's personal information, can result in long term loss of customers. The But-For sales projection should include these sales and the Actual sales projection should not. Therefore, when lost sales is calculated by taking the difference between But-For sales and Actual sales, these long term lost sales will be counted.
- Unit Price Erosion: A business may suffer long term unit price erosion due to the introduction of new competition, new buying patterns, or loss of brand loyalty caused by the Event. In this situation, unit sales volume may return to its But-For level, but actual sales dollars will not, because the unit price has declined due to the Event.
The preceding discussion covered only some of the considerations the damage expert will take into account with evaluating lost sales associated with business interruption. The relevance of these considerations and numerous others will always depend on the specific facts of the matter being evaluated.
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