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Calculating Lost Profits in Commercial Litigation

Reprinted from the New York Law Journal

Written by: David M. Beckman, CPA, CFF, CFE

Calculating Lost Profits in Commercial Litigation

Overview

Lost profits (or lost earnings) are economic damages suffered by a plaintiff as the result of a defendant’s harmful act. Economic damages are measured as the earnings the plaintiff would have received had the harmful event not occurred less the earnings the plaintiff actually received or will receive after the harmful act. This calculation can include determining lost earnings before the trial date (past losses) and after the trial date (projected future losses). Lost profits calculated up to the trial date may have prejudgment interest added to the lost profit calculation. Lost profits projected to be incurred subsequent to the trial date (i.e., future losses) are typically discounted back to the date of trial.

The determination of lost profits starts first with the estimation of revenues that the plaintiff would have earned had the harmful act not occurred. Thereafter, revenues are offset by a calculation of the costs saved (i.e., avoided costs) as a result of the plaintiff not generating those lost revenues.

Calculating Lost Revenues

There are various methods for calculating lost revenues, each of which can be more or less relevant to a particular case based on the facts and circumstances of the case and the information available. The “Before and After” method compares the plaintiff’s business’ performance before and after the event or action causing the damage. This method relies on the theory of “But for” the defendant’s action, the plaintiff’s business would have experienced similar levels of revenues and profits after the harmful act.The plaintiff’s prior experience can be obtained from financial records, financial statements (internal and/or external), tax returns or similar records. The “Yardstick” (or “Benchmark”) method uses a benchmark to estimate what the revenues and profits would have been for an entity had the harmful event not occurred. Examples of different benchmarks include, but are not limited to, the following: prior actual versus budgeted operating results, experience of similar businesses, industry averages, and pre-litigation projections. When applying this method, the plaintiff’s operations should be sufficiently comparable to the benchmark used.

In addition, there may be circumstances whereby the lost profits calculation considers clauses and terms in a specific contract and bases the calculations on number of units sold, unit prices, term of the contract, among other factors. When applying any of the above methods, the calculation of lost revenues should consider whether factors other than the harmful act affected the plaintiff’s revenues.

Future Lost Revenues

If the loss period extends beyond the date of trial, the plaintiff calculates future lost revenues as the difference between the (i) estimated revenues that would have been earned but for the wrongful act of the defendant and (ii) projected revenues estimated to be earned by the plaintiff.

Determining Costs Associated with Lost Revenues

Avoided Costs or (Saved Costs) should be determined and offset against lost revenues when calculating lost profits. Avoided costs are those costs that were not incurred as a result of the lost revenue due to the defendant’s wrongful act.  In other words, since a product was not manufactured and sold, there would be no revenues, and accordingly, no costs associated with this lack of sales revenue. Accordingly, these costs were avoided.

In addition, the plaintiff may incur costs that would not otherwise have been incurred had the harmful event not occurred. These costs should be accumulated and included as part of the overall economic damages suffered by the plaintiff.

When determining what costs should be included as Avoided Costs, costs are assessed to determine whether a cost is fixed, variable or has characteristics of both fixed and variable costs. Variable costs, such as costs of goods sold (materials and direct labor) tend to correlate with revenues and accordingly would be considered avoided costs and are deducted against lost revenues to determine lost profits.  Fixed costs, such as rent, are typically incurred whether or not there were lost revenues and these costs generally would not be included as avoided costs. However, each plaintiff will have distinct businesses, product lines and cost structures and the relationship of costs to revenues will vary depending on the facts and circumstances. Careful consideration should be given when making a determination as to whether costs are variable, fixed, or have attributes of both.

Assessing Reasonableness of the Calculation

When calculating lost profits, certain factors should be considered in assessing the reasonableness of the calculation. These considerations may include whether (i) the entity suffering the loss has the capacity to produce goods or deliver services in line with the amount of projected lost revenues during the period of loss, (ii) there is sufficient market share for the plaintiff to generate the projected lost revenues, and/or (iii) did the plaintiff attempt to mitigate its damages. The plaintiff has a duty to mitigate economic damages suffered, which requires the plaintiff to take appropriate actions to minimize the damage caused by the defendant’s actions.

Pre-judgment Interest on Past Losses

Depending on the jurisdiction, the application of pre-judgment interest may be allowed. Prejudgment interest is calculated by applying an interest rate (often defined by statutes) to lost profits from the date of the wrongful event to the date of trial.

Discounting Future Lost Profits to Present Value

There are a number of approaches for determining a discount rate and these methods tend to vary by state and jurisdiction.  Some courts have ruled that the discount rate used to calculate lost profits should incorporate inflationary and a risk component while others have required the use of a risk-free rate. Once the discount rate is determined, it is applied to future projected lost profits and discounted back to the date of the trial.

For more information on determining damages from lost profits, please contact your Anchin Litigation, Forensic and Valuation Services expert advisor.         

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