Lost Profit in Business Litigation

Lost profit in business valuation

Personal injury and wrongful death cases are the bread and butter of every forensic economist’s practice. In most such cases, I’m either calculating lost earnings for a plaintiff’s attorney or reviewing a lost-earnings analysis that was conducted by the plaintiff’s expert.

Like many forensic economists, I also work on commercial cases. The goal in commercial work is generally to calculate lost profit. The alleged loss might result from a claim of breach of contract, unfair trade practices, or the violation of a non-compete agreement. Here are some of the basics of forensic economics when applied to commercial cases.

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Avoided Cost

Typically, a lost-profit analysis first identifies the lost sales or revenue resulting from the claimed action, and then subtracts “avoided costs,” which are the expenses the company did not have to incur when its sales fell. Avoided cost is related to, but not quite the same as, the economic concept of variable cost.

What qualifies as an avoided cost varies from case to case. It can make up a large percentage of sales in a business with low capital spending. It can amount to a very low percentage in industries like real estate management, in which most expenses are fixed and the key to profitability is generating a return on a large initial capital investment.

Gross Profit is Gross

It’s not always easy to calculate avoided cost, which I presume is why a few experts I’ve encountered framed their conclusions in terms of easy-to-calculate gross profit. Gross profit is an intermediate measure that’s defined differently for different companies and industries. It takes into account top-line costs that can be associated with each unit of sales. For a manufacturer, gross profit might be total sales minus the “cost of goods” (e.g., materials and shipping). For a retailer, it might be the gap between retail sales and wholesale costs.

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Gross profit isn’t a reliable measure of lost profit because it misses those avoided costs that appear as operating expenses in an income statement. As a result, gross profit usually overstates the true lost profit in a commercial case.

Forever is a Long Time

An injury can leave a worker disabled for life, and of course a wrongful death is forever. But a commercial loss usually has a start and a finish. Courts expect business owners to mitigate their losses to the degree possible. That means identifying new markets, products, or customers; or winning back lost customers. It’s hard to justify a claim of permanent lost profit.

An exception of sorts can occur when the owner-operator of a small business is permanently injured. The analysis is a lost-profit calculation, but it’s part of a personal injury case.

Best-Case Scenarios

Suppose a company faces a business interruption right before it lands a contract that could expand its market dramatically. What kind of future is reasonable to assume for that company? A lost-profit analysis that considers only the best- or worst-case scenario is unlikely to be persuasive. When possible, one should find a reasonable model for that company’s future, such as the average performance of companies in similar circumstances.

History Bites

A related principle applies when a company’s loss period includes historic twists and turns in the economy. Think of a residential development opening during the 2008 housing crisis, or a restaurant near the beginning of the Covid-19 pandemic. The near-term profitability of these ventures would have been affected by what was going on in the economy. 

I’ve seen experts who assume no connection between a company’s results and the overall economy, but I prefer not to ignore history. In a case involving a furniture retailer, my projection of sales during the Great Recession was based on the depressed industry sales at the time.

Discount Rate

When lost profits are in the future, say after the trial is scheduled, a discount rate is used to express the loss as a present value. As the saying goes, a dollar today is worth more than a dollar tomorrow. The discount rate in commercial cases is chosen to reflect the riskiness of a company’s future cash flows. As a result, the discount rate is higher than the risk-free rates typically used in personal injury and wrongful death cases. One of the most common errors in commercial cases is to define the discount rate in terms of Treasury Bill yields. When you see that, you know the expert has little experience in business litigation.

Commercial cases are extremely interesting, mostly because they’re all so different. These key principles can serve as useful guides for forensic economists and the attorneys who hire them.

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