Core Elements in Quantifying Lost Profits
Reminders from an Experienced Expert that Go Beyond a Checklist
Calculating lost profits is a crucial aspect of many legal and financial matters, particularly in the realm of business disputes, insurance claims, and litigation. Lost profits represent the financial harm suffered by a plaintiff due to a specific incident or event. In a business context, lost profits aim to restore the injured party to the financial position they would have been in had the incident not occurred. This article delves into the core elements of quantifying lost profits, providing insights into methodologies.
Calculating lost profits is a crucial aspect of many legal and financial matters, particularly in the realm of business disputes, insurance claims, and litigation. Lost profits represent the financial harm suffered by a plaintiff due to a specific incident or event. In a business context, lost profits aim to restore the injured party to the financial position they would have been in had the incident not occurred. This article delves into the core elements of quantifying lost profits, providing insights into methodologies, considerations, and examples to help you understand this complex process.
Understanding Lost Profits Calculation
Lost profits calculations serve a primary purpose—to make the damaged party whole (within the bounds of legality). This means compensating the injured party for the financial losses incurred due to the defendant’s wrongful actions or inactions. In essence, it seeks to bridge the gap between the financial outcome “but-for” the damaging event and the actual financial outcome. Businesses may encounter lost profits in various scenarios, including:
- Reduced Income but Continued Existence: When a business experiences a reduction in income but continues to operate and may potentially regain previous income levels. For example, a thriving family-owned bakery, “Sweet Delights,” encountered a significant reduction in income due to unforeseen circumstances (a major construction project by a neighboring business directly in front of the bakery disrupted Sweet Delights’ regular flow of customers). The construction project, initially slated for a short duration, was extended unexpectedly due to unforeseen challenges. As a result, Sweet Delights experienced a substantial decline in foot traffic and a subsequent reduction in income. The bakery’s owners faced a challenging decision—to temporarily close their doors or persevere through the adversity; hopeful that they could regain their previous income levels once the construction was completed. The lost profits analysis revealed that Sweet Delights had suffered financial losses during the construction period.
- Ceasing or Terminating Operations: When a business decides to cease or terminate specific operations. When a business opts to discontinue specific facets of its operations, such as in the case of “Smithville Hardware”, a longstanding family-owned hardware store. In this hypothetical scenario, Smithville Hardware, a company deeply rooted in its community and known for its extensive inventory of tools, home improvement supplies, and gardening equipment, confronted a challenging situation. A fire, sparked by an electrical issue, inflicted damage upon the store’s nursery section, prompting the management to make a tough decision of discontinuing this segment. Previously a profitable part of their business, the garden and nursery section had become non-operational.
- Business that Never Commenced Operations: In cases where a business planned but never commenced its operations. In this illustrative scenario, “GreenTech Innovations,” a startup company with a vision of revolutionizing renewable energy solutions, was founded by a group of passionate entrepreneurs. They secured substantial investments and diligently drafted a comprehensive business plan outlining their innovative energy-efficient technology. Unfortunately, despite meticulous preparation, unforeseen supply chain disruptions prevented the company from ever commencing its operations.
At a high level, lost profits are quantified by measuring what would have occurred “but-for” the damaging event, subtracting what transpired as a result of the breach or incident. Irrespective of the methodology used, the plaintiff’s loss is calculated as the difference between projected (but-for) and actual (projected) results.
The expert analysis must eliminate other potential causes of damage or adjust for their impact to ensure the accuracy of lost profit calculations. Additionally, the principle of reasonable certainty discourages speculation or conjecture. Assumptions and projections used in calculations must have a “reasonable basis.”
Methodologies for Lost Profits Calculation
Several methodologies are employed to calculate lost profits, including:
- Before-and-After Method: A before-and-after method analysis aims to assess damages by examining a business’s performance before and after the occurrence of a wrongful act. Use the before-and-after method when you have access to historical financial data for the business before and after the damaging event. It is suitable for situations where a clear cause-and-effect relationship exists between the event and the financial impact.
- Yardstick Method: The Yardstick method compares the financial performance of the affected business after the damaging event to a comparable benchmark or “yardstick.” This benchmark represents what the business’s performance would have been “but-for” the event. The difference between the actual performance and the benchmark is used to estimate lost profits. It is applicable in situations where finding a suitable benchmark or yardstick for comparison is feasible.
- Sales Projection Method: This method relies on creating “but-for” financial projections and comparing them to actual performance. Both internal and external factors are considered, including historical and industry information.
- Market Model Method: Incorporating historical and industry information, this method is sometimes referred to as a hybrid approach and is suitable for explaining different theories in a complaint.
Understanding the specific industry is vital in the lost profits analysis. For instance, in the medical practice industry, analyzing relative value units (RVUs), staffing ratios, average reimbursement rates, and CPT codes is crucial. For manufacturing companies, factors like capacity utilization rates, inventory turnover, defect rate, lead times, and other metrics are essential considerations.
Company-specific factors are also critical in the analysis and may include gross profit margin considerations, volume and price concerns (rate-volume analysis), new product introductions, supply and demand dynamics, substitute products, growth and attrition rates, discounts, returns and allowances, capacity and product lifecycles, expense considerations, etc.
The analysis must also factor in expenses, including incremental or variable costs and semi-variable costs, and identify and analyze fixed costs.
Variable expenses, also known as direct costs, are costs that fluctuate in direct proportion to a company’s level of production or sales. In other words, these costs increase as production or sales increase and decrease as production or sales decrease. Variable expenses can vary on a per-unit basis or in total. Common examples of variable expenses include the cost of raw materials, direct labor (wages of production workers), and the variable portion of utilities (e.g., electricity used in manufacturing).
Semi-variable expenses, also known as mixed costs, are costs that have both fixed and variable components. A portion of these expenses remains constant regardless of production or sales volume (the fixed component), while another portion varies in direct relation to production or sales (the variable component). An example of semi-variable expenses is a utility bill that has a fixed basic service charge plus a variable charge based on usage. The fixed portion remains constant, while the variable portion changes with consumption.
Fixed expenses are costs that remain constant regardless of changes in production or sales levels. These expenses do not fluctuate with business activity. Examples of fixed expenses include: rent or lease payments for facilities, salaries of permanent employees (not directly tied to production), insurance premiums, and property taxes. Regardless of whether a company produces one unit or a thousand, fixed expenses remain the same.
Lost revenues are offset by costs that would have been incurred but were saved or avoided due to the damage. Ultimately, only “net” lost profits are considered allowable as economic damages. Fixed costs, which remain constant regardless of revenue or activity levels, are typically not deductible when calculating lost net profits. Instead, the focus is on direct expenses incurred to generate sales. Regardless of whether a business operates at full capacity or experiences a decline in revenue, fixed costs remain the same. As such, they are considered ongoing and are not directly affected by the specific incident or event that led to the economic damages claim. However, it should be noted that each economic damages analysis is specific to the circumstances of the case, and financial experts ought to carefully consider the relevant costs and revenue components to provide an accurate assessment of the economic harm allegedly suffered by the plaintiff.
Discounting Lost Profits
Future profits must be discounted to their present value, considering the time value of money concept. The time value of money (TVM) concept, in the context of lost profits analysis, refers to the principle that a sum of money has a different value at different points in time. To determine the economic damages or lost profits suffered by a plaintiff, future expected net profits must be reduced to their present value. This process involves discounting the projected future cash flows (lost revenues less avoided costs) back to the present date (measurement date). By doing so, the analysis accounts for the fact that money received or incurred in the future is worth less than the same amount today.
When discounting list profits, two approaches are commonly used:
- Ex-Ante Approach: The term ex-ante translates to “from a thing done afterwards,” which aptly describes this approach. When employing the ex-ante approach, damages are quantified as of the date when the loss initially occurred. This method adheres to a crucial principle—only information that was known or reasonably knowable at the time of the harmful act is considered.
- Ex-Post Approach: Contrastingly, the ex-post approach, stemming from the Latin “before the event,” takes a retrospective perspective. In this method, an expert assesses the loss backward in time to the date when the harmful act occurred but quantifies it as of the date of the trial. This means that the analysis considers all available information, including economic data from the period leading up to the trial.
Every lost profit calculation relies on the facts, circumstances, and documentation available to support the economic damages calculation. The expert must clearly define the facts and assumptions used in the calculations, ensuring they are credible and relevant to the case. Quantifying lost profits is a complex process that demands careful consideration of numerous factors, methodologies, and industry-specific variables. It involves bridging the gap between what would have occurred “but-for” a damaging event and what transpired. By adhering to principles of reasonable certainty, eliminating other causes, and employing appropriate methodologies, experts can provide valuable insights to support lost profits claims in various legal and financial matters.
Nataliya Kalava, CVA, ABV, MAFF, CMEA, is an expert in the fields of business valuation and finance, with about 15 years of experience. She has led and contributed to numerous valuations for diverse purposes, including gift and estate tax planning, management planning, M&A transactions, SBA valuations, financial reporting, and litigation support. Ms. Kalava’s passion lies in helping business owners navigate ownership transitions, guiding them through challenges, and uncovering opportunities for growth. Her expertise is honed through a rich career journey, having worked with renowned organizations such as Equinix Inc., Humana Inc., BDO LLP, Sigma Valuation Consulting Inc., and PwC. Ms. Kalava’s dedication to her profession extends to education and community engagement. She has been an Adjunct Finance faculty member at the University of Tampa, imparting her knowledge to undergraduate students on corporate finance and investment. Furthermore, she organizes Continuing Legal Education (CLE) courses on business valuation topics accredited by the Florida Bar.
Ms. Kalava can be contacted at (813) 999-1144 or by e-mail to nkalava@one10firm.com.
