Lost profits are a key component of damages in all kinds of litigation. In breach of contract and commercial tort cases, for example, a plaintiff may claim it suffered lower revenues, higher costs or both because of the defendant’s wrongful conduct.
To accurately calculate lost profits, financial experts consider a number of factors, including lost revenues and variable costs, appropriate loss periods and discount rates, and mitigation of damages.
Financial experts use a variety of methods to sniff out lost revenues, often applying more than one in a single case. Among the most common are:
The before-and-after method. Here the expert compares the plaintiff’s revenues before the defendant’s act (or omission) to its post-act revenues, under the assumption that any decrease in revenues was caused by the defendant’s conduct.
Generally, the expert assumes that operations and other relevant factors are comparable before and after the act. Adjustments may be necessary, however, for significant internal or external changes, such as a substantial cutback in the owner’s hours or an industry downturn. To ensure a fair comparison of before-and-after business results, financial reporting methods should be consistent over time.
The yardstick method. With this approach, the expert compares the plaintiff’s revenues to those earned by similar businesses or products, estimating the revenues the business would have earned if it had followed trends derived from comparable companies, market data or industry results.
But regardless of the method used, lost revenues are only part of the story. To arrive at lost profits, the expert also deducts variable costs — such as the costs of goods sold — that the plaintiff would have incurred in generating those revenues. There are a variety of techniques for estimating costs, including cost accounting, industrial engineering and statistical methods, such as regression analysis.
Lost profits damages have their limits. They may be reduced, for example, if the plaintiff failed to take reasonable steps to mitigate its damages. Financial experts can identify steps the plaintiff could have taken to mitigate damages and estimate their impact on the damage calculation.
In addition, plaintiffs generally can’t recover lost profits damages into perpetuity. They’re limited to the time period during which lost profits are directly related to the defendant’s act. The loss period ceases when the plaintiff’s business reaches the profit levels it would have attained but for the defendant’s conduct.
As time goes by, of course, the causal connection between the defendant’s act and the plaintiff’s loss becomes more attenuated and more difficult to prove. Further, when forecasting damages into the future, an expert must account for inflation, fluctuating customer demand, and marketplace competition, and must discount lost profits to their present value.
Business valuation professionals are particularly well suited to calculate lost profits. The processes and analyses closely mirror those used in business valuation, and valuators may possess extensive knowledge of the relevant industry and factors that affect a company’s performance.