The Basics of Lost Profits

Lost profits is a form of compensatory damages, and a potential remedy in most commercial litigation cases including breach of contract, business interruption, theft of trade secrets, and most business torts. Lost profits seek to compensate plaintiff with the benefits they were denied due to alleged wrongdoing.  At the highest level, lost profits are the difference between (i) what should have or will happened and (ii) what actually happened.

A calculation of lost profits involves (i) identification of revenue, and (ii) identification of deductible costs, both of which are discussed below.

Lost  Revenue

There are several accepted ways to identify revenues in a lost profits calculation. 

  • Lost revenue can be identified by specific customers and/or products.  This method of calculating lost profits is more appropriate cases involving limited numbers of customers/products and requires consideration of the specific circumstances surrounding each customer/product. 
  • Lost revenue can be ascertained through a comparison of  before-and-after events/amounts.  The basic assumption is that the plaintiff would have experienced similar revenues absent the wrongful conduct.  This calculation requires analysis of historic financial statements.  This is generally best applied when identification of specific customers/products is not practicable or if there are large numbers of customers/products at issue. 
  • Revenue can be based on company-specific projections.  It is preferable that these be contemporaneously created projection in the normal course of business.  Ideally,  the projections should  be compared against historic performance, to measure whether company expectations are an accurate reflection of what actually happened.
  • Revenues can be estimated using a trend analysis, such as a regression analysis, benchmark data from comparable companies in the market, and/or market share data.

Deductible Expenses

Costs that would have been incurred to service the lost revenues, but were saved because the revenues did not occur, must be deducted.  Accountants and managers call these “Variable Costs.”  Litigators know these as “Avoidable Costs.”  Deductible expenses are notably different than all a company’s costs.  If a cost would have been incurred regardless of the wrongful action, with or without the lost sales, then it is not a deductible cost; accountants generally call these “Fixed” costs.

Avoidable costs generally fall into two categories, both of which are potentially deductible depending on the facts at issue:

Direct Costs – There are the costs that are incurred as part of the sales.  These are generally considered to be 100% deductible (but a damages expert should still analyze it).  To an accountant, these are the costs sometimes recorded as “Cost of Goods Sold” or “Cost of Sales”, and used to calculate the company’s gross profit.

Selling, General & Administrative Costs – These costs are incurred in running the underlying business.  Certain of these costs increase with revenue and are a variable cost.  Several administrative costs are the same regardless of revenue, which accountants call “Fixed Costs.” Selling, General & Administrative Costs are only deductible if they were incurred because of the at-issue revenue. 

As with identification of revenues, there are several methods to calculate avoidable costs.  The appropriate method to use requires careful consideration on the facts of the case.

  • Regression analyses is generally the most common tool to identify variable in a lost profits calculation.  Regressions are a statistical analysis tool that establishes the relationship between revenue and the costs. 
  • Identification of avoidable costs can also be done on an account-by-account basis.  This generally relies on the company’s past experience and the expert’s professional judgement.
  • It is also possible to identify variable costs in a lost profits calculation using company projections.  As with using projections for identifying revenue, it is important to consider whether company projections have been accurate measures of future performance. 

Time Value of Money

While not the subject of the current article, it is routinely necessary to discount future lost profits to current value to avoid over-compensating a plaintiff.  This discounting considers the timing of these future lost profits and the risks inherent. 

What should I do?

Hire an expert (like us).  As an expert, we will save you time and money because:

  • We know the sorts of financial information that are needed to calculate both revenues and costs in a lost profits scenario.
  • We are intimately familiar with the financial information upon which lost profits calculations rely
  • We know how to perform the analyses described above
  • We have the experience and professional judgement to identify expenses are likely to be variable or a fixed expense
  • We know how to perform and interpret the results of the statistical analyses that might be required

We can provide expert witnesses testimony in a simple, efficient manner so that triers of fact can understand otherwise complicated subjects