BGBC: Calculating lost profits requires analysis

By Howard I Gross, Steven W. Reed and Casey L. Higgs

Computing the lost profits of a business as a result of a wrongful act is a complex task. And many times, the question to ask is: “But for” a wrongful act, what would the profits be? What would the value be?

Generally, lost profits are claimed as part of economic damages in litigation. A lost profits calculation, or economic damages analysis, is often performed to estimate the profits that were lost, or damages suffered, as a result of the wrongful act. In Robert L. Dunn’s 6th Edition of “Recovery of Damages for Lost Profits,” he writes that there are three requirements for damages recovery:

• The damages must be proximately caused by the wrongful conduct;

• The damages must be proven with reasonable certainty; and

• The damages must have been foreseeable at the time the contract was made (only for contract claims).

In calculating lost profits, net profits are recoverable. Net profits include the revenue the plaintiff would have earned “but for” the loss, reduced by the costs associated with generating the revenues. Gross profits are normally recoverable when net and gross profits are the same or if there is minimal or no additional costs necessary to realize the profits.

An important factor requiring identification is the damage period. Typically, the damage period begins on the date of the loss and ends when the company returns to the profitability or to the level of cash flow that it would have been at “but for” the loss.

There are several methods used to calculate profits that would have been attained “but for” the loss:

• Before-and-after method – This method projects operating results based off historical operating results as if there was no loss and then compares it to the actual results during the loss period to determine the damages.

• The Yardstick Approach – Under this method, the operating results from the loss period are compared to the operating results for the same period of a similar company for comparison purposes. The difference is used to determine the damages.

• Sales Project (But for) Method – Operating results are projected during the loss period absent the loss as if the loss did not occur. The projections are then compared to the actual results to determine the damages.

Which method is most appropriate depends on the circumstances of the issues at hand. Oftentimes, the calculation can use a combination of all three methods. The types and timeframe of financial data to be analyzed (e.g., actual, projections, etc.), the availability of competitor and industry information, among other factors, are all items that need to be considered when choosing the most appropriate method. Performing insufficient analysis of financial information, using an inappropriate growth rate to determine projections, and insufficiently considering other relevant factors can negatively impact the lost profits calculation.

Once a method of assessing damages is determined, the stream of lost profits needs to be discounted to their present values. Determining the appropriate discount rate is critical as a very small change in the discount rate can severely increase or decrease the amount of the lost profits calculated.

The process for calculating lost profits is based in sound and thorough analysis, but also requires the use of reasonable judgment and estimates. For these reasons, assessing damages can be a lengthy process. It is critical to be as accurate as possible when estimating cost revenues, calculating the costs associated with generating revenues and determining the appropriate discount rate. The calculated damages should be reasonable, based on reliable information using an appropriate methodology and performed by an experienced expert.•

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Howard I Gross, CPA/ABV/CFF, CFP; Steven W. Reed, CPA/ABV; and Casey L. Higgs, CPA/CFF, CFE, CVA are with BGBC Partners, LLP – Litigation, Forensic and Business Valuation. Contact BGBC at 317-633-4700 or visit www.bgbc.com. The opinions expressed are those of the author.