by Brent McDade
CALCULATING LOST PROFITS
In difficult economic times, there is an increased likelihood that one of the parties to an agreement will default on their contractual obligations. Aggravating this situation, the likelihood decreases that the other party to the contract will be able to fully mitigate damages. The resultant situation is one where breach of contract claim filings increase, and where we as financial experts are called upon to calculate lost profits. While the specifics of lost profits calculations vary as widely as the facts and circumstances that give rise to the underlying causes of action, lost profits calculations, in general, can be classified into four major groups: before and after calculations, sales projection models (also known as accounting for profits models), yardstick calculations, and market share calculations. Naturally, each of these uses a different approach.
In a before and after calculation, the analyst compares the profits (or sales or other income measure) of the plaintiff before and following the alleged bad act. The underlying argument is that but for the defendant’s alleged bad act, the profitability of the plaintiff would have been consistent with (or at least related to) prior periods. So, if the plaintiff had profit of $100 per year prior to the defendant’s action and only $75 per year thereafter, a before and after analysis would result in a calculation of lost profits of $25 annually. Because this analysis relies on past performance as an indicator of future results, it is most suitable when the measured profit stream is relatively stable or predictable over time. On the other hand, the method can lead to incorrect results if other potential causes of profitability are ignored. Take as an example a pizza shop that alleges damages due to its pepperoni supplier’s failure to deliver pepperoni pursuant to a supply contract. A cursory analysis reveals that the pizza shop’s profits declined from $100 per week to $33 per week after the pepperoni supplier stopped delivering the ingredient. While damages may well be $67, it is important to consider whether or not other factors may have contributed to the decline. Did the road in front of the pizza shop close for renovation about the same time? Did the shop receive an unusually low health rating? Was there other negative publicity that may have affected sales? The answers to these questions may complicate the determination.
The sales projection method, which is also known as the accounting for profits method, relies on the financial results of the defendant in the calculation of damages. This method has many variations, but most involve calculating either the incremental profits earned by the defendant as a result of the alleged bad acts or the incremental sales earned by the defendant as a result of their actions less the costs that would have been incurred by the plaintiff had the plaintiff made those sales. While there is a certain intellectual appeal to awarding the wrongfully earned profits of the defendant to the plaintiff, it is not necessarily true that those sales or profits are exactly the same as the sales or profits that the plaintiff would have earned. I once worked on a lost profits analysis in a raiding case. Due to the negative publicity associated with the event and its aftermath, sales by the raided employees were nearly nothing (and negative profits were earned by the defendant), even though the raided employees had generated and presumably would have continued to produce substantial profits for the plaintiff.
The yardstick method uses market or other external evidence to project sales or profits. The profitability of many types of businesses, oil refiners for example, are tied closely to a measurable, external yardstick—crude oil prices. In this technique, the analyst establishes a relationship between the plaintiff’s sales or profitability and the yardstick, then uses that measurement to predict what sales or profits would have been but for the alleged bad act. Forensic accountants frequently rely on this method to determine lost sales from fraud. Using our hypothetical pizza establishment, suppose that one of the carryout window cashiers is suspected of pocketing cash rather than ringing sales. A forensic accountant might look at reported sales per pizza box used on nights when the suspect was not working versus when they were on the job. If the employee was pocketing cash, it might show up as lower sales per pizza box used. This method is useful when relevant yardsticks are available, but it is difficult to utilize in cases where a clear relationship between an appropriate yardstick and the plaintiff’s sales or profitability cannot be established.
In the market share method, the analyst determines a market share that would have been realized by the plaintiff but for the alleged bad act. That share is then multiplied by the overall size of the market to determine the plaintiff’s lost sales. Then, the lost profits are calculated. This approach can be quite useful when it is practical, but for many types of businesses, the overall size of the market and the appropriate market share can be difficult to determine. Taking the pizza business from our earlier example, there is not, to my knowledge, an accepted and credible source for data regarding the total market for pizzas broken down by locality across the nation. Therefore, it would be difficult to discover an appropriate market potential and market share for any single pizza shop. For other types of businesses, the market share method might be an option, especially for those industries where good data about the overall market is available. To complicate matters, these four methods are not necessarily mutually exclusive; many lost profits calculations combine elements of multiple methods. In addition, it is entirely possible that a credible lost profits analysis might not fit neatly into any of the four categories defined above.
WE CAN HELP
The professionals at Decosimo Advisory Services have substantial experience not only in lost profits calculations, but also in forensic accounting and business valuation. If you wish to discuss a lost profits matter, please call us in confidence at 800.782.8382.