By Jason Bogniard, MBA, ASA, CVA, EA | Principal, Business Valuation
May 11, 2021
Damages can be calculated with reasonable certainty, and are most often done so using “Lost Profits” as the measure of the alleged damages. Much like it sounds, Lost Profits represent the amount of money that the plaintiff requests the court to award to make them in order to offset any historical or future profits the plaintiff was unable to earn due to the alleged actions of the defendant. Typically, Lost Profits are calculated in what is referred to as a “but-for-scenario,” meaning the plaintiff would have earned the calculated profits, but-for the alleged actions of the defendant.
In a previous article, we introduced the concept of calculating lost profits in civil litigation as a measure of damages to compensate the complaining party. The previous article focused primarily on the established methods for analyzing the lost revenue in a damage calculation. We now turn our attention to the analysis of expenses or costs as they are appropriate to deduct from lost revenue.
Business or contractual damages are most commonly (but not always) calculated as lost revenue less incremental expenses, which are also referred to as avoidable expenses. In other words, these incremental expenses are ones which are avoided as a result of lost revenues not having been earned, and therefore have actually not been incurred.
For example, if an auto dealer plaintiff alleged that but-for the actions of the defendant their business would have sold 10 more trucks, than the avoided incremental costs would include the cost to purchase the trucks from the manufacturer and any associated sales commissions paid to employees.
All Lost Profit analyses are dependent on the specific facts and circumstances of the particular situation from which the civil litigation arose. However, in most cases, the appropriate starting place for a practitioner estimating incremental expenses, is a determination of the fixed and variable expenses of the subject business. Fixed expenses are those that do not change with an increase or decrease in revenue. An example of a fixed expense in the short-term is monthly rent payments for office space. Alternatively, variable increases tend to increase or decrease with revenue, such as the commission paid to a salesperson for selling the new truck in the example above. However, even fixed expenses can become variable over longer periods of time as a business reacts to changing sales.
Due to the importance of considering case specific factors, the analysis of fixed and variable expenses could also include the consideration of the following factors:
- Changes in cost structures due to technological changes.
- Industry specific changes such as increased/decreased regulatory expenses.
- Seasonality of business and related impact on monthly expenses.
- Legislative impacts such as change in sales taxes or minimum wage.
- Analysis of general industry survey and other benchmark expense structures. This is particularly useful in situations where the business has limited historical financial results.
- The market value of payments to related parties, such as office rent to paid to the owner of a business.
The above is not a comprehensive list, rather illustrative of common items an analyst will consider if appropriate to do so given the facts of the particular litigated matter. Some damage calculations may completely exclude an analysis of lost revenue and avoided incremental expenses, such as a situation whereby a plaintiff was forced to purchase a key raw material at a higher price because the defendant failed to provide the raw material at a lower contractual price. In this situation, the increased costs paid for the raw material would be a form of lost profits as the plaintiff experienced lower profits as a result of the higher costs, even if revenue was unchanged.
Partnering with experienced damage experts can help ensure defensibility of any legal claims made, along with forecasting damages expected to be received. Apple Growth Partners’ litigation experts consist of trial-experienced professionals, utilizing the appropriate methodologies to estimate financial damages while collaborating with legal teams.