By Stephen L. Ferraro, CPA/ABV/CFF, MAFF, CVA, CEPA
Commercial damages can occur in breach of contract and business tort cases and result in claims for lost profits or diminished business value. Intellectual property infringement cases, securities fraud and antitrust cases also can involve such loss claims. Measure of damages in commercial cases follows basic and generally accepted methodologies. This article covers the basics of calculating lost profits in commercial damage cases from a forensic accounting perspective. There are variations in measurement in intellectual property and securities cases and these variations will be detailed in subsequent articles.
In general, lost profits are determined by first estimating the lost gross revenue (or lost sales) due to an event. The lost revenue is then reduced by the avoided (or saved) costs, which entails evaluating all the direct and other costs related to providing goods or services. This results in the lost profit that would have been enjoyed had the loss of sales not occurred.
Some experts like to use lost gross margin or profits as the of measure of damages. This usually isn’t the correct way to value damages. Gross margin only comprises revenue reduced by cost of goods sold. Such a calculation fails to consider other costs of a business that may be directly, or indirectly, related to providing a good or service and avoided.
Another important aspect of a damage calculation is correctly assessing the loss period. The loss period normally begins on the date the event occurred, which should be easy to determine. The ending date of the loss period may be more difficult to estimate. It will likely be based upon the date the business resumed to normal operating levels or the end of the term of a contract. The requirement for mitigation could also come into play in the determination of the loss period.
As mentioned, the first, and probably primary, element of a lost profits calculation is the determination of revenue lost due to the event or action. 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 few typical methods for calculating lost revenue. A brief description of each follows:
- The “Before and After” Method: Under this approach, the expert compares the revenue of the business before and after the event. The underlying theory is that “but for” the event, the business would have experienced the same level of revenues and profits after the event as the business did before that event. Some consideration for other factors that could have affected the level of revenues is also warranted, such as the potential future impact of the trends in revenue in place prior to the event.
- The “Yardstick” (or “Benchmark”) Method: Under this approach, the expert utilizes a “yardstick” to estimate what the revenues and profits of the affected business would have been. Examples of potential yardsticks that could be used include; comparing the revenue trends and results of the business to a similar business; comparing to other unharmed locations of the business; utilizing the actual experience versus budgeted results or industry averages.
- Contract Terms: In some instances, the expert can reference a specific contract that may set forth terms which determine anticipated revenue levels. A model might be developed that calculates the revenues and profits anticipated under the terms of the contract.
- Defendant’s Profits: In cases involving unfair competition or the intellectual property infringement an accounting of the profits realized by the defendant may be used as the measure of damages. The plaintiff is entitled to receive the value of unjust enrichment of the defendant through disgorgement. We will provide much more information related to this method and measure of damages in a subsequent article.
Direct Costs and Other Expenses
To arrive at an accurate lost profit amount, the forensic accounting expert must determine the direct costs and other expenses associated with generating revenue. For example, many businesses incur direct material costs, labor costs, utilities, supplies, and other costs and expenses to make and deploy their product and services. To the extent that the company lost sales, the company also did not incur the expenses associated with those sales. These avoided (or saved) costs need to be calculated and factored into the lost profits.
It’s important for the forensic 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 separating the cost structure are many, and require thoroughness on the part of the expert.
As with the calculation of lost revenues, it is always important for the expert to examine the calculated expenses for reasonableness. They must be satisfied that the numbers make sense considering the information available in the case.
Other Important Considerations
One critical part of the damage calculation process is the assessment of causation. If a company suffers a loss of sales compared to “expected” levels, the expert should consider all possible reasons for the reduction in sales. All, or part, of the reduction could be the result of something completely unrelated to the alleged event. While the sales loss may be related to the event, it is also possible that certain market or industry conditions may have impacted sales. It is important to examine how things such as economic conditions, competition, expiration or loss of a key contract, government regulations, weather patterns, company reputation, and the desires of the marketplace may have impacted a sales loss. Any reduction in sales related to these types of factors should be evaluated, and in most cases, excluded from the lost profits calculation.
The expert must also consider the potential for sales “make up” at other locations, or after the loss period, as well as, other ways to 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. Since the plaintiff is required to mitigate, the expert must also evaluate whether mitigation was possible, even if the plaintiff did little or nothing to mitigate the damages.
While the mitigation efforts are required and could help the loss situation and may ultimately serve to preserve sales levels, they may come with additional costs that should also be evaluated by the expert. These costs could result from temporary operating locations, subcontracting expenses or expediting expenses incurred to receive or ship product.
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 other 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 profits. This information should only come from sources that are known to provide generally accepted, reliable and accurate data.
The calculation of lost profits can be a very subjective, detailed and time-consuming process. It is necessary to be as thoughtful and accurate as possible when estimating lost sales and the related saved costs or expenses. Maybe most important, is the fact that this is not an exact process, and relies on significant estimates. A forensic accounting expert must calculate damages that are reasonable and that use reliable information and widely-accepted methodology.