Understanding Lost Profits
Hi, everybody. Welcome to another New Jersey Forensic Accountant discussion. Today, we're going to talk about lost profits. Lost profits affect lots and lots of businesses. And there's many ways they can be affected. Often there's a situation involving a supplier or they had a fire or something like that. They lose sales. They lose profits. But the big misconception a lot of people have about this is that... I'll have someone come into my office and say, "The supplier didn't provide us the material and we had no sales for three months and we lost $10 million." But that's sales. It's not lost profits. Because when you don't have a sale there are costs that were avoided because you didn't have the sale. The cost to produce the widgets, the commissions, all that did not have to be paid.
The formula for calculating lost profits is right here. Lost profits equals loss revenues minus avoided costs. That's the formula. Now, when we have an engagement, the first thing we do is we go in and do in a cost analysis. What are the variable costs? What are the fixed costs? What are the semi-variable costs? We do this because once we calculate the revenues, we can then calculate and subtract the avoided costs. That is their lost profits.
Now, let me go through an actual case because it is a little bit confusing without understanding how this actually works. For example, a while back we had an international retailer call us and they said, "Listen, we have a store located on a major thruway in New Jersey. And the state came in and they had this major reconstruction project. And they covered this massive billboard that was outside the store. And there was also an access ramp, a little way up on the highway and cars would pull in and pull into the parking lot and go into the store and some people would buy furniture." So anyway, they lost the access ramp too. And sales were down by like $20 million. So we had to go in and calculate, figure out what costs were associated with the furniture. I think the cost of the furniture was like 30%. So that was $6 million. And then there was commissions and things like that. So the actual lost profits were somewhere around $10 million. But this was a lot more complicated because this also occurred at the same time as a recession. So some of those $20 million in sales were not because people could not get off the highway. Some of those were because of the recession. And the other thing was that the location actually ended up going out of business because this happened for a period of years.
So we had lost profits, but we also had lost business value. But here's the thing. Now, in order to calculate the cost, and prove that this was the result of recession, and this is a result of losing the sign, and the access ramp, I actually brought in a sign expert to assist us in testimony. What he did was, he had formulas that showed with this kind of traffic, you can expect this many people to pull off the highway. And then, of those, this many would buy furniture. So we were able to calculate... because we both had to testify, under at least depositions, in order to prove that the sign resulted in this amount of lost sales. And then we also had to go in and look at the recession. Well, this is the portion of the sales we lost because of the recession. And we did a lot of calculations, we went through a couple depositions, this actually ended up settling at a court. But this is just, kind of, when you have lost profits, this is what you have to do.
Now, anytime you're dealing with lost profits, you want to go to the expert. We are the expert testifying, but the expert on actual is Robert Dunn. Here's two of his... Here's his books. These books are great. And it gives you a really good background, a legal background, and also, some forensic accounting in there. But basically what Dunn says on here is that, "The proximate cause rule." And what this basically says is, for example, we had to prove in this case, the furniture retailer case, that the sales were lost directly because of what the state did. And we were able to prove that, because you can't... You have to have some causation. And again, this is more legal than forensic accounting. But as a forensic accountant, we can't testify, unless it's clear to us that those damages resulted from some action. And the other thing is that you have to have reasonable certainty. Now, I can't go up and testify and say, "Well, maybe, it could be..." I have to be reasonably certain. Now, you can't be absolutely certain about anything, unfortunately, but you can be reasonably certain. And Dunn goes into it... Basically, the whole book is about these two concepts here. And he talks about different methodologies and stuff like that. But we go through this constantly, anytime we get a pretty complex case in-house. And it's important to understand not only how to do it, and the formula we talked about, but also the proximate cause rule and the reasonable certainty rule.
Now, let's talk about some key elements of a lost profits claim. One, plaintiffs loss is proved with a reasonable degree of certainty. That's from Dunn's book. Two, the trier of fact, they have to be satisfied, because even if you think it is, and everybody else thinks it is, if the judge does not or the jury does not, then you're not going to win. And three, there has to be some basis for the claim. Pretty basic stuff.
Now, three things that must be proven by the plaintiff. One, defendant breached a legal duty. Two, defendant's actions or failure to act damaged the plaintiff. And three, the plaintiff's damage are proximately related to the defendant's action. Now, remember, we are, as forensic accountants, really just focused on preparing a report for the actual damages, the money claim. But this other stuff has to back it up and a lot of times what we will do, is discuss this with the attorneys to make sure that we have all this going into court. And a lot of times they will build a foundation and establish all this before we even testify. And also we can rely on their expertise in this area when under deposition and say, "Yes, I discussed this with X attorney, and I'm satisfied, based on bla bla bla bla."
So, now, the first step in computing lost profits is determine the lost revenue, because remember the formula, lost revenue minus avoidable costs. This is basically revenue they would have earned but for the actions of the defendant. In the furniture case, they would have had additional $20 million of sales. And again, this happened over a period of years, so it was like $60 million, but those sales would have been earned. And we were reasonably certain that they would have, based on our calculations and reliance on other experts and stuff like that.
But there's three basic ways to calculate these damages. One is "before and after method." The year before the furnitures, they had sales of X amount, and they were increasing in prior years. All of a sudden they fell off a cliff. So we had a before and after, we compared the before the state took the sign down and removed the access ramp and after. And, in addition to that, we had the sign expert who was able to back it up too. But remember, we had a recession. So some of those lost sales were traceable to the recession, and we're able to go into other stores and see what their sales decrease was and then compare it to ours. And really just isolate the sales that were lost because of losing this sign, and the billboard and, the access ramp.
The other method is the "yardstick method." And what this is is ratios or that type of stuff. And this is typically done when you have, like, a startup company, no history. There's ways to like... We have companies call us and they never had a sale and they were put out of business. Something happened where somebody reneged, or someone stole their code, and they never opened up their store. They never opened up their business. Happens a lot in software. So they never had sales. But how do you have damages? Well, you can calculate damages based on what other companies did and using this, what we call the yardstick method. And these methods are accepted, throughout the country in all courts.
Now, the other thing is the "but for method" and what that... it's, kind of, like adds on to these damages. And what you're basically saying here is, "Listen, this client had to spend X amount of time and X amount of money on this legal issue, because you guys did X." And these damages are added on to the other claim. So you have this "but for" claim.
So listen, we went through this pretty quick but again, this is just a quick overview. If you guys have any questions, leave them below. If you do like this YouTube, I appreciate if you guys would sign up for our YouTube channel. Thanks for listening.