Avoiding pitfalls when estimating lost profits

From the March/April 2017 issue of BCC Advisers Litigation & Valuation Report

hen calculating lost profits in commercial litigation, it’s critical to understand how costs are treated in the relevant jurisdiction. In general, avoided variable costs should be deducted from lost revenue to arrive at lost profits. But the treatment of fixed costs may be less certain.

Defining lost profits

In a financial reporting context, the term “profits” refers to the difference between gross revenue and the costs incurred to produce the revenue. This includes variable costs — which increase or decrease in proportion to production or sales volume — and fixed costs, such as rent or insurance, which are incurred regardless of volume.

In a litigation context, defining “lost profits” is more complicated. That’s because, when a defendant’s misconduct damages a plaintiff’s business, it not only deprives the business of revenue, but it also allows the business to avoid certain variable costs that it otherwise would have incurred to produce the revenue, such as materials, direct labor and shipping expenses.

Allowing a plaintiff to recover its lost revenue without deducting avoided costs would give the plaintiff a windfall. For this reason, most courts require plaintiffs to deduct variable costs associated with the revenue lost as a result of the defendant’s actions.

Generally, fixed costs aren’t deducted in lost profits calculations. By definition, they’re not affected by changes in volume and, therefore, not avoided as a result of the defendant’s actions. (However, certain fixed costs may become variable or step-variable over the long run.) Arguably, if costs that the plaintiff will continue to incur are deducted from lost profits, the plaintiff will be undercompensated. Nevertheless, some courts do require deductions for fixed costs when calculating lost profits.

Revisiting relevant case law

Fixed costs were the subject of debate in a significant 2008 breach of contract case in Florida (RKR Motors v. Associated Uniform Rental & Linen Supply). Here, Associated Uniform alleged that RKR had breached three contracts to rent and launder its employees’ uniforms. Associated Uniform’s expert calculated lost profits of approximately $82,000, but RKR’s expert concluded that lost profits were just over $10,000. The experts agreed on lost revenue, but they disagreed about which costs to deduct.

Both experts deducted the variable expenses that were directly avoided by not having to fulfill the contracts. RKR’s expert also deducted a portion of Associated Uniform’s administrative and other fixed expenses, reasoning that these expenses were “involved with rendering services to RKR Motors.”

The appellate court accepted the lost profits calculation prepared by RKR’s expert, holding that deducting a portion of fixed costs “allows for a true measurement of the amount the non-breaching party would have earned on the contract had there been no breach.” The court explained that Associated Uniform’s average net profit margin was 8% and failing to deduct fixed costs from lost profits would result in a net profit margin of 64% on the breached contracts, providing Associated Uniform with a windfall.

Arguably, the court’s logic ignores the fact that the lost revenue caused by RKR reduced Associated Uniform’s net profit margins on its remaining contracts, negating the windfall argument. Nevertheless, it remains the law in Florida.

Doing your homework

It’s critical for attorneys and experts to understand the methodology a particular court uses to compute lost profits. The treatment of fixed costs can have a significant impact on the amount of lost profits that are recoverable.