In the typical lost profits analysis, certain costs are deducted from projected revenues. This analysis often employs a combination of skills and may involve the interaction of economists and accountants. A common area of analysis for economists working in the field of microeconomics is the relationship between revenues and costs. Much economic research has been done on the various types of cost analysis, including the separation of variable and fixed costs, how costs vary over time, and the relationship between average and marginal costs. For most economists, this analysis is a theoretical exercise, although practicing litigation economists working on commercial damages necessarily deal with these issues on a regular basis.

Accountants, particularly cost accountants, are regularly involved in the pragmatic measurement of costs and how they vary with the operations of the firm. Accountants who report on financial statements for public use must understand issues involving consolidation of financial entities, the components of various costs in financial statements, and various costing methods, all of which have a significant influence on the reported profitability of the firm. Therefore, the services of accountants can be invaluable in computing the costs associated with lost incremental revenues.¹

Presentation of Costs on the Company’s Financial Statements

An examination of the appropriate expenses to be deducted from projected revenues begins with a review of the company’s financial statements – especially the income statements, which list gross revenues and the various cost deductions necessary to arrive at net income. An example of a typical consolidated income statement is presented in Table 6.1. It shows the total revenues and costs of Pfizer Corp. for the year ending 2019.

In the right‐hand column of Table 6.1, the cost components of the income statement are expressed as a percentage of revenues. Such an expression is often used in financial analysis for what is known as percentage of sales forecasting.² The expression of costs as a percent of revenues can be very helpful for quickly discerning the average relationship between a company’s revenues and its specific costs. This, in turn, can be useful when attempting to apply a cost percentage to projected revenues. However, considerable care needs to be used when employing such percentages, as they imply that all costs are variable; in reality, though, some are variable and some are not. A “percentage of sales” representation merely shows all costs as a percent of revenues regardless of whether they are fixed or variable. As is discussed later in this chapter, the distinction between fixed and variable costs depends on the time interval being considered.

Measures of Costs

A preliminary step in understanding cost analysis is defining some basic terms. Often these terms are used interchangeably although they can have different meanings in different contexts. To avoid confusion, these basic terms are defined in Table 6.2.

Profit Margins and Profitability

Several different profit margins are regularly used in financial analysis. Among the most frequently cited are the gross margin, defined as sales minus costs of sales divided by sales, the operating margin, defined as earnings before interest and taxes (EBIT) divided by sales, and the net margin, defined as earnings after taxes divided by sales. These margins differ from one another in that they incorporate different cost components. The gross margin includes the fewest costs (costs of goods sold only) while the net margin incorporates all costs including taxes. Although these margins are the ones most often cited in financial analysis, none of these necessarily coincides with the precise margin that is used in a business interruption lost profits analysis. In this chapter we discuss how the profitability measure that is used in business interruption loss analysis is different from these standard margins.

Appropriate Measure of Profitability for a Lost Profits Analysis

The true economic losses of a firm are its lost incremental revenues minus the incremental costs associated with these revenues. The margin associated with these lost incremental revenues is usually less than or equal to the gross margin but is greater than or equal to the net margin. In effect, the lost incremental revenues minus the associated incremental costs becomes the definition of net profits appropriate to commercial damages litigation.³

There are abundant legal precedents to support the proposition that gross incremental revenues without a deduction for the costs that would have been incurred to achieve these revenues are an invalid measure of damages.⁴

In order to prove lost profits a party must prove income and expenses of the business for a reasonable time prior to the alleged breach [citations omitted]. If the party presents evidence only of gross receipts or fails to prove expenses with some specificity, an award of damages relating to lost profits will be reversed [citations omitted]. While an inability to prove an exact or precise amount will not preclude recovery [citations omitted], the evidence must establish lost profits with reasonable certainty such that an impartial and prudent mind would be satisfied.⁵

Other cases show that even gross profits, which do not include all the relevant costs associated with the lost incremental revenues, are also an inaccurate measure of damages.⁶ The court wording in Lee v. Durango Music is instructive:

… the word profits has a definite meaning. It means the net earnings, or the excess of returns over expenditures, and relates to any excess which remains after deducting from the returns the operating expenses and depreciation of capital, and also, in the proper case, interest on the capital employed. “Profit” in the ordinary acceptation of the law, is the benefit or advantage remaining after all costs, charges, and expenses have been deducted from the income, because, until then, and while anything remains uncertain, it is impossible to say whether or not there has been a profit.⁷

In cases involving a breach of contract, lost profits are the lost revenues from the contract minus the costs of performance. These costs may in general be considered as “savings” to the plaintiff in that the plaintiff did not have to expend them. This, however, is not always the case. If the plaintiff incurred certain costs for items that could not be utilized for other revenue‐generating activities, then this may be another element of loss.

Burden of Proof for Demonstrating Costs

As part of its lost profits presentation, the plaintiff must prove its lost revenues as well as the costs associated with these revenues. That is, the plaintiff bears the burden of proving what expenses it would have incurred while generating the lost revenues. Plaintiffs may try to argue that proving expenses is similar to mitigation of damages (which may be considered the responsibility of the defendant to prove). However, courts have rejected this reasoning. The plaintiff must focus as closely on the costs associated with the projected lost revenues as on the projected revenues themselves. An example of this is shown in the decision of the U.S. Court of Appeals in the Third Circuit in Bruks v. Sinclair Refining Co. In this case, evidence of gross profits was provided by the plaintiff, but not enough information was made available to the jury regarding what other costs would have been incurred. The court had a problem with this, as the passage from the opinion shows:

There was no testimony as to the costs of the operation of the station. It would seem that an approximation of this could be supplied. In other words, the proof of loss of profit on gasoline sales, while it was not the speculative type of testimony frowned upon by the cases, was incomplete. The jury was charged concerning the operative costs to be deducted but did not have sufficient evidence before it to enable it to arrive at an amount which would reasonably represent net profit on the estimated gasoline sales.¹⁰

Fixed Versus Variable Costs

Fixed costs are those costs that do not vary with output. Variable costs, however, do vary as output changes. Courts have recognized this simple definition, which is standard in economics. For example, in Autotrol Corp. v. Continental Water Systems Corp., the court adopted this definition when providing the distinction between fixed costs and variable costs:

Economists distinguish between a firm’s fixed and variable costs. The former, as the name implies, are the same whether or not the firm does anything; a good example is the fee that a state charges for a corporation charter. The fee is paid before the firm begins operations and is utterly invariant to the firm’s fortunes. It would be an improper item of damages for the breach of contract because the breach could not have caused the expense to be incurred. Variable costs are those that vary with the firm’s activity – more precisely they are caused by fluctuations in that activity.¹¹

In many cases, the distinction between fixed and variable costs is straightforward. For example, rent, lease payments, and other overhead are often treated as fixed costs. Other costs, such as costs of materials or commissions on sales, are categorized as variable costs because they vary according to output. Exhibit 6.1 depicts a simple total cost function where total costs (TC) are equal to fixed costs (FC) plus variable costs (VC). Variable costs per unit produced are reflected in the slope of the straight‐line total cost function.

Regression analysis can be used to estimate both fixed costs and variable costs.¹² Such a simple estimated function is depicted in Equation 6.1 and Exhibit 6.2.

The regression analysis allows the estimation of a fitted regression line based upon the following equation:

(6.1)

where:

• C_t = Total cost
• F = Fixed cost
• v = Variable cost percentage
• Q_t = Quantity of output
• u_t = error term

It would be expected that v varies between 0 and 1. That is:

The value v captures the relationship between costs and revenues.¹³

In Exhibit 6.2 a regression line is fitted to the data to arrive at estimate of both the variable costs per unit produced (v) and fixed costs (F). However, caution needs to be applied when considering the regression estimate of fixed costs. We can see that estimated fixed costs is an extrapolated amount that is outside of the data set. Being an intercept term, it is a value that corresponds to an output level of 0. Our data set may not contain such an output level or even one close to it. Therefore, more basic accounting analysis may yield a more reliable estimate of such costs.

Incremental costs are reflected by the coefficient of the units produced variable – v. It reflects incremental costs for the range of data that was used to estimate it. The “tighter” the data set, in relation to the estimated line, the more confident we are that v is a reliable measure of such costs. In statistical terms, we say that the standard error of this estimate is relatively low. In regression analysis this can be measured by the t statistic, which is the value of the coefficient, v, divided by its standard error. Specifically, the t statistic reflects how confident we are that the coefficient is really not 0, which would mean no discernable relationship between changes in output and changes in total costs. A value of the t statistic equal to 2 (really 1.96) or above is interpreted as being confident that there really is a relationship between the independent variable, output, and total costs. We can also look to other measures, such as R² (and corrected R²) to determine the percent of the total variation in the dependent variable, total costs, that can be explained by changes in the independent variable, units produced.

In cases where a company produces more than one product, an obviously often occurring situation, we could consider using multiple regression analysis to determine the variable costs of producing the various products. This is depicted in Equation 6.2.

(6.2)

• Where:X₁ = output of product 1
• X _i = output of the ith product

Using regression analysis in the multiproduct case presents its own econometric problems. It may be the case that the products that are produced are interrelated. To the extent that is the case, a statistical interrelationship may be affected by multicollinearity. We briefly mentioned this statistical condition in Chapter 5. It is a condition that violates the required characteristics of regression analysis – that there be no linear relationship between the explanatory variables.¹⁴ When multicollinearity exists, certain explanatory variables are correlated.¹⁵ While a full discussion of the problems of this statistical condition is beyond the bounds of this chapter, let us just note that regression analysis assumes that any change in one variable is unrelated to a change in another variable. However, when the production of the products is interrelated, such as when the sale of one includes another product or when they are “complements” (they go together), the condition is clearly violated.

Multicollinearity can vary in degrees. That is, we can have perfect multicollinearity where the two variables move exactly together. However, we can also have imperfect multicollinearity where one explanatory variable is closely correlated to another one but where the relationship is not perfect and where variation in one does not fully explain variation in the other. With imperfect multicollinearity, there is a strong linear relationship between the explanatory variables – just not a perfect one.

The main consequence of multicollinearity is that, while the estimates of the coefficients are still unbiased, the estimates come from distributions that have high variances. These high standard errors for the coefficient estimates bring down their t scores and confidence intervals are wider.

In the face of multicollinearity there are a few options. One is to do nothing because it could be the case that the standard errors did not go up too much. Another is to eliminate the redundant variable. The effectiveness of this solution can be seen if the t score of the remaining variable goes up significantly. However, if we are trying to measure the variable costs of various products, this may not be that workable a solution. Another solution could be to increase the sample size, which normally allows for more accurate estimates and lower variances of the estimated coefficients.

Using Regression Analysis to Estimate Costs as Opposed to More Basic Methods

Although regression analysis can be used to measure the relationship between fixed and variable costs, it is more common in a litigation context for the expert to present such costs as a percent of revenues. In corporate finance, one of the more frequently used financial forecasting techniques, percentage of sales forecasting, predicts costs and the resulting profits as a percent of a separately forecasted sales level.¹⁷ However, if the expert can use both approaches and arrive at similar results, the analysis is even more impressive.

When the damages analysis is conducted by both an economist and an accounting expert, the work is divided according to the respective expertise of the team’s members. Typically, the economist conducts an analysis of the economy and of the firm’s relevant industry and constructs a projection of “but for” revenues. This projection is then handed off to the accountant who computes the costs associated with the incremental lost revenues. This latter exercise falls within the domain of cost accounting. When the analysis is done in this manner, the accountant typically does not use regression analysis to measure costs but instead relies on more traditional accounting methods.

Pitfalls of Using Regression Analysis to Measure Incremental Costs

Regression analysis can be a powerful tool in estimating relationships among variables and in creating projections. However, it has certain limitations, and its usefulness varies from case to case. It is very important that the user of this tool understand both its potential complexity and limitations. As noted in Chapter 5, too often experts with little training in statistical analysis and econometrics blindly use the regression analysis features built into spreadsheet software packages without any appreciation of the complexity or limitations of the techniques employed. The next section briefly discusses some issues that may arise when using regression analysis to estimate costs and cost functions. Experts and attorneys should be aware of these issues and make sure that, where relevant, they are discussed in advance of the report’s submission.

Possible Nonlinear Nature of Total Costs

If a company’s production function is characterized by economies of scale over a certain range of output, then the per‐unit costs of production decline over that range. Certain industries, particularly capital‐intensive industries like public utilities, may have significant ranges of output over which per‐unit costs decline. This occurs when a company leverages its fixed costs. In financial analysis, this is referred to as operating leverage.¹⁸ In other industries, the range over which economies of scale are realized may be small. At some point, however, per‐unit costs stop declining and may even increase, resulting in diseconomies of scale. The relationship between total costs and per‐unit costs is shown in Exhibit 6.3a and b. For output levels up to x = 8, per‐unit costs decline. This implies that total costs increase at a decreasing rate. However, beyond the output level of 8, the firm begins to experience diseconomies of scale with a resulting increase in per‐unit costs. This causes total costs to increase at an increasing rate.

Exhibit 6.4 and 6.5 depicts two costs functions. The cost function in Exhibit 6.4 shows a linear relationship between costs and output; the cost function in Exhibit 6.5 shows a nonlinear relationship.

Over a range of output where per‐unit costs are either declining or increasing, the cost function may be better estimated using nonlinear regression analysis rather than the more standard linear regression. For the cost values in the next table, the equation underlying such a nonlinear cost function is shown in Equation 6.2. The resulting graph is shown.

(6.2)

Over a range of output where per‐unit costs are either declining or increasing, the cost function may be better estimated using nonlinear regression analysis rather than the more standard linear regression. The equation underlying a nonlinear cost function is shown in Equation 6.3.

(6.3)

Costs may be estimated inaccurately if the expert uses linear regression when the true cost function is nonlinear. This is shown in Exhibit 6.6: Linear regression analysis is used to estimate the cost function, thereby implicitly assuming that costs increase at a constant rate as output increases. In this example, however, the true cost function first exhibits economies and then diseconomies of scale. Because of the misspecification of the relationship between output and costs, the true costs are higher than the estimated ones for low and high levels of output, whereas they are lower than the estimated ones for intermediate levels of output. The solution is to use nonlinear regression analysis to estimate costs.

As noted earlier, care must be exercised in reviewing the regression analysis that is included in many economic damages reports. Some “experts” have had very little exposure to regression analysis and may not even know of nonlinear regression models. It is not uncommon for users to simply utilize the linear regression functions included in most spreadsheet packages without being aware of the existence of other, more sophisticated methods that result in more accurate costs estimates. This is why it is useful to have either an economist with a background in econometrics or an econometrician review any regression analysis included in an opposing expert’s report.

Limitations of Using Unadjusted Accounting Data for Measuring Incremental Costs

It may not be accurate to include all of the costs shown on the company’s financial records when measuring incremental costs. Certain costs, such as depreciation, may be important for the computation of taxable income but may not be an accurate measure of costs of the depreciable assets in the period for which the depreciation is measured. The Delaware Supreme Court confirmed this when it reversed a lower court finding that depreciation was an appropriate costs measure to include in a lost profits computation.²⁰ The court stated:

In this loss‐of‐profits case, we conclude that Barcroft is entitled to recover for any actual loss caused by Cannon’s breach, including any actual decline in value or “depreciation” of the plant while it was out of production. But Barcroft’s obligation is to establish that loss by showing what, in fact, the decline was. In our judgment, decline (measured by before and after values) cannot be established entirely by reference to an accounting technique, no matter how reliable it is for other purposes.

We recognize that the straight‐line method is commonly used in financial statements, tax returns, and other similar documents, but it is an improper basis for computing damages in this case, which is not concerned with the recovery of costs over useful life, nor with an equitable allocation of use costs over their shutdown period. In short, proof by reference to an arbitrary accounting rule is not an acceptable way of establishing actual loss resulting from depreciation in this litigation which seeks to compensate for lost profits.

This inaccuracy of using depreciation as a cost measure may be even more pronounced in cases where the depreciation charge is unusual, such as when there is accelerated depreciation. This highlights the artificial nature of depreciation as a measure of actual costs.

Other examples of accounting data deficiencies include the case when one is trying to measure losses over a less‐than‐one‐year period but the data on employee compensation do not vary evenly with output or revenues.²¹ This can occur when the firm pays year‐end bonuses, which may reflect work performed over a much longer period – possibly an entire year. In this case, the compensation data should be adjusted to more accurately reflect the time period under consideration.

Treatment of Overhead Costs

There is some confusion in commercial damages analysis regarding the treatment of overhead costs. This is evident when reviewing the case law and attempting to reconcile certain decisions with basic economic principles. The economic theory, however, is clear on the issue. For example, in the case of contract litigation, the costs of performance should be deducted from the incremental revenues to be derived from such performance. If overhead costs in the form of fixed costs (such as rent and administrative expenses) were incurred anyway by the ongoing business, it would make little sense to deduct even a portion of these expenses that were already paid. However, if the business closed due to the acts of the defendant, then some or all of the overhead costs may not have been incurred. In this case, the net margin, which includes all expenses including overhead, is a more appropriate measure of cost to apply to projected lost revenues.

If a deduction for overhead is deemed appropriate, then it can be measured in a number of ways. One of the simplest is to compute overhead costs as a ratio of some output measure, such as production. This is shown next:

(6.4)

(6.5)

The ratio form is convenient in that it can be mathematically applied to various performance measures, such as revenues, that are projected to occur according to events that are the subject of the litigation. One danger in using such ratios is that they make overhead costs look like variable costs; in fact, over a large range of output, they are usually fixed. As output increases, overhead may be fixed until some relevant capacity constraint is reached. Some or all the components of overhead may then increase. If the expert is seeking to measure the increase in overhead, the ratios expressed in Equations 6.4 and 6.5 may not be very relevant, as they reflect total overhead including those portions that are fixed over the range considered.

It is helpful to compute the overhead ratios over several ranges of output to see how they vary as output varies.²⁴ This allows us to see how the ratio changes as output increases (see Exhibit 6.7). A plot of the trend in these ratios reveals how stable they are over multiple output ranges. The more stable these ratios are, the easier it is to use them over several projected output ranges.

Must a Plaintiff Be a Profitable Business to Recover Damages?

It does not seem reasonable that a previously unprofitable business can recover damages. However, it could be the case that a business would have been profitable had it not been for the actions of the defendant. While actual revenues were insufficient to cover all fixed and variable costs, it is possible that if the business had reached the projected “but for” levels, total costs would have been surpassed and the company would have enjoyed positive profits. The situation becomes more complicated when it can be shown that even if the plaintiff had reached the projected revenue levels, it would still show a loss. The defendant may then try to argue that its improper actions prevented losses. It is difficult to state one catchall rule that applies to a virtually infinite number of situations. However, the plaintiff’s burden in a case such as this is significant. One way the plaintiff can recoup damages is if it can show that its loss was even greater due to the fact that the defendant’s actions prevented it from generating the projected levels. For example, the plaintiff may owe monies to various parties as a result of losses incurred. The plaintiff can use the proceeds of an award to meet part of these obligations.

Another way that a plaintiff can recover lost profits, even if it were never profitable during its existence, is to show that revenues would have risen above costs but for the actions of the defendant. That is, one way to show losses is to project revenues using a nonspeculative growth rate. If that results in a revenue level in excess of costs, there would be evidence of lost profits. Certain courts have allowed such reasoning. For example, in Heatransfer Corp., the court stated:

The court does not believe that a going concern, which is the victim of an anticompetitive practice, must forego [sic] damages for sales it would have made as the result of the natural expansion of its business simply because it was victimized early in its existence before its attempts to expand could ripen into evidence of preparedness and intent to increase its output.³⁵

Other courts have looked even more favorably on the ability of an unprofitable business to claim losses. In Terrell v. Household Goods Carriers’ Bureau, the court allowed for the recovery of losses for an unprofitable plaintiff. It stated that “to deny recovery to a businessman who has struggled to establish a business in the face of wrongful conduct by a competitor simply because he never managed to escape from the quicksand of red ink to the dry land of profitable enterprise would make a mockery of the private antitrust remedy.”³⁶

The main issue in projection of revenues and costs for a previously nonprofitable plaintiff that show profits over some part or all of the loss period is that of speculation. There needs to be a basis to show that the revenue and costs projection is not speculative. This may be difficult to do, but the courts in Heatransfer and Terrell have opened the door to its use.

Mitigation of Damages

In computing losses, any cost savings that the plaintiff enjoyed (by not having to undertake whatever activities it would have normally undertaken in order to realize the “but for” revenue stream) needs to be deducted as an offset. For example, if the plaintiff does not have to incur all of the costs needed to achieve the projected revenue stream, such as those associated with a larger workforce and facilities, this cost saving should be taken into account. The mitigation of damages should also include alternative opportunities to earn other profits. Using a contract litigation example,³⁷ if the plaintiff could mitigate its damages by substituting other business, then the profits from the alternative activities need to be considered. If, however, it was possible for the plaintiff to complete performance of both contracts, profits from the alternative contracts should not be deducted from the lost profits.

Though the plaintiff may be required to show that it has pursued other profitable opportunities, the law is less clear when the plaintiff chooses to pursue opportunities that are far riskier than the business that was lost. The plaintiff’s argument may be less persuasive if it can be shown that the plaintiff could have replaced the defendant’s lost business, without incurring significant search costs, with other lower‐risk business opportunities.

Tax Effects

An expert’s computation of damages typically is calculated on a pretax basis. This is due to the fact that the plaintiff will be taxed on the award. As the court stated in Polaroid Corporation v. Eastman Kodak Company:

An award based upon after‐tax amounts could result in double taxation. Any award will certainly be scrutinized by tax officials at both the state and federal levels who will determine the correctness and applicability of any rate employed.⁴²

In some instances, the plaintiff may receive certain tax benefits from the losses incurred as a result of the defendant’s actions. These benefits could be in the form of tax losses used to offset positive income in future periods. Robert L. Dunn reports that in most recent cases, the tax benefits a plaintiff enjoys are not considered in computing damages.⁴³ Among the reasons the courts cite are that the awarded profits are themselves taxable and that knowing what the relevant rates are going to be in the year the award is made is difficult. The reason why the relevant rates may not be known is that the full income and other tax‐related factors that enter into the determination of the firm’s average tax rate for the year of the award may not be known until after the year is over.

The courts even indicate that the plaintiff should receive the benefit of any lower rates it enjoys after possibly including these offsetting tax benefits. This is in opposition to the defendant’s receiving the benefit of these offsetting gains that the plaintiff enjoyed in the year the plaintiff incurred the loss that was caused by the defendant. Courts seemingly want to ignore the issue of differential tax effects. Indeed, in cases where the plaintiff contended that its tax rates in the year it would receive the damages award were higher, the court stated that this was not a valid area of damages.

It seems that the court’s theory is that when an award is made, the tax effects of that award will more or less offset any tax benefits that may have been incurred since the interruption; it is, therefore, not an issue. That the amount in question may be different or that the time value of the respective amounts may exacerbate these differences does not seem to be an issue that the courts want to examine in considering the appropriate amount to award in a lost profits case.

A good explanation of the court’s reasoning on this issue can be found in Hanover Shoe, Inc. v. United Shoe Manufacturing Corp., which was an antitrust lawsuit again a shoe machinery manufacturer.

The view of the Court of Appeals is sound in theory, but it overlooks the fact that in practice the Internal Revenue Service has taxed recoveries for tortious deprivation of profits at the time the recoveries are made, not by reopening the earlier years. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955). As Hanover points out, since it will be taxed when it recovers damages from United for both the actual and the trebled damages, to diminish the actual damages by the amount of the taxes that it would have paid had it received greater profits in the years it was damaged would be to apply a double deduction for taxation, leaving Hanover with less income than it would have had if United had not injured it. It is true that accounting for taxes in the year when damages are received rather than the year when profits were lost can change the amount of taxes the Revenue Service collects; as United shows, actual rates of taxation were much higher in some of the years when Hanover was injured than they are today. But because the statute of limitations frequently will bar the Commissioner from recomputing for earlier years, and because of the policy underlying the statute of limitations – the fact that such recomputations are immensely difficult or impossible when a long period has intervened – the rough result of not taking account of taxes for the year of injury but then taxing recovery when received seems the most satisfactory outcome.⁴⁴

One can challenge the court’s reasoning in the cases that advocate ignoring tax issues. The argument that taxes cannot be computed due to the inherent complexity of such a computation makes little sense. Courts allow testimony on revenue estimation using complicated models, so it would only be reasonable that testimony be allowed on the projection of taxes. The tax rate involved usually is the maximum tax rate; the incremental lost income in larger commercial cases is most often taxed at the highest corporate marginal rate. The expert can then compute the incremental taxes associated with the lost incremental profits in this way:

(6.6)

where:

• IT = Incremental taxes
• LITI = Lost incremental taxable income
• t = Relevant marginal tax rate

Some argue that unless there is a basis for assuming a change in tax rates, future taxes can be computed using current tax rates.⁴⁵ In computing historical losses when tax rates have changed and the rates in the year of the award are different from the period of the loss, the goal of the expert is to compute an award that leaves the plaintiff whole. This involves computing the incremental taxes using tl, the tax rate from the loss period, and determining what the net income of the plaintiff would have been had it received the projected lost profits during the loss period. The award on the trial date, which will be taxed at current rates, tc, may have to be adjusted to equal what the plaintiff would have received “but for” the action of the defendant:

(6.7)

• where
• NLI = Net lost income

Cash Flows Versus Net Income: Effects on the Discounting Process

It can happen that, in order to achieve the forecasted revenue levels, the plaintiff needs to invest certain monies in capital items. These monies are treated differently depending on what the measurement is: cash flows or net income. Consider the example shown in Table 6.4. Damages are computed using incremental operating cash flows and incremental net income. The damages computations are equal over the four‐year loss period. The difference is a one‐time capital expenditure of $60,000, which occurs in year 1. This expenditure is assumed to be necessary in order to achieve the projected cash flows/net income.

If damages are computed on a cash basis, there is no loss in year 1; if computed on an income basis, however, there is a loss of $35,000. The cumulative amounts are the same – $230,000. This simple example does not address the balance sheet effects of the differences in the cash versus income basis analysis. These effects are quite complex and, fortunately, are often not necessary for the damages analysis.⁵⁰

One major difference between the cash basis and income basis analysis is in the timing of the damages – it can significantly affect the present value computation. Consider the extension in Table 6.5. A 15% risk‐adjusted discount rate is used to convert the projected damages amounts to present value terms in year 0. In Table 6.4, the cumulative amounts were equal over the four‐year loss period, but the differences in the timing of the damage amounts leads to a difference in the cumulative discounted amounts. Because the full impact of the capital expenditure is felt in year 1 under the cash basis treatment, lower damages are projected in the early years for the cash basis treatment. This results in lower cumulative discounted damages. The opposite is true for the projection under the income basis treatment. The higher damages in the early years result in higher discounted damages for the income basis damage computation.

On a discounted basis, the damages are different depending on which accounting approach one uses. These differences are greater the higher the discount rate, the longer the loss period, and the greater the differences in the timing of the damages.

Recasted Profits

In closely held corporations, the net income may not reflect the true compensation to the company’s owners. For example, the company may be controlled by a small number of key shareholders, perhaps even one, who extract a significant component of the profits of the business so that taxable income and tax are minimized. These monies can be extracted in several ways, including officer’s compensation, fringe benefits, and other “perqs.” The after‐tax net income (bottom line) may show limited profitability, while the company generates very different positive returns for its owners. Unfortunately, this tax avoidance process, one that may be quite consistent with prevailing tax laws, may present problems for the plaintiff in a lost profits case.

Professional Corporations

In cases involving a professional corporation, the issue of using recasted profits may be even clearer. In a professional corporation, the shareholders and the principals are the same. In order to avoid the double taxation associated with the corporate business structure, the professional corporation can distribute earnings in the form of officer’s compensation so as to have a lower taxable income. Courts have treated this officer’s compensation as relevant to the computation of the lost profits of the corporation.⁵⁵ They have correctly realized that very profitable entities that paid out these profits in the form of compensation could never otherwise claim lost profits. However, courts are not consistent in this view. While the court in Bettius & Sanderson, P.C. v. National Union Fire Insurance Co. took the position that owner’s compensation should not be deducted as a cost, some other courts have not shared this view. For example, the court in Taylor v. B. Heller & Co., a case involving the destruction of a business that the plaintiff’s expert was (incorrectly) attempting to value, stated:

Unless compensation for management is deducted as expense, the income statements do not accurately reflect the inherent value of the business itself as a going concern and cannot be considered relevant evidence.⁵⁶

Case study prepared by Professor Henry Fuentes.

Year	Sales	Net Income	Cash Flows (used) in Operations		Interest Expense
1966	5,800	40	45	–20	1
1967	6,000	50	170	–90	0
1968	6,900	75	90	–40	0
1969	9,100	90	–60	70	6
1970	11,000	120	–140	240	6
1971	12,100	130	–300	370	10
1972	14,300	160	–250	200	13
1973	17,600	190	–150	120	25
1974	19,000	300	300	–250	25
1975	18,000	125	–130	200	22
1976	19.000	100	–1,300	1,450	100
1977	21,800	100	200	–275	200
1978	25,400	155	–10	190	270
1979	27,700	115	–1,000	1,600	450
1980	32,000	170	300	–400	670
1981	37,000	170	–800	1,000	1,000
1982	34,400	90	–60	100	900
1983	41,800	500	350	–170	700
1984	47,700	550	–900	930	800
1985	49,700	300	–500	1,100	900
1986	56,600	250	–350	1,050	750
1987	60,400	150	–600	1,020	890
1988	57,500	–185	–4,500	4,450	1,460
Totals
1966–88		3,745	–9,595	12,845

Year	Sales	Accounts Notes Receivable	Reserve Doubtful Accounts	Ratio Reserve to Accounts Receivable (%)	A/R ‐ N/R over 120 Days
1966	5,812	1,719	30	1.7	N/A
1967	5,978	1,748	36	2.1	N/A
1968	6,896	1,833	45	2.5	N/A
1969	9,100	2,534	58	2.3	N/A
1970	11,051	2,494	83	3.3	N/A
1971	12,106	2,623	113	4.3	N/A
1972	N/A	N/A	N/A	N/A	N/A
1973	17,726	4,021	177	4.4	N/A
1974	19,244	3,753	249	6.6	N/A
1975	17,571	3,903	243	6.2	N/A
1976	18,960	4,362	198	4.5	N/A
1977	21,848	5,342	216	4	N/A
1978	25,394	6,362	216	3.4	N/A
1979	27,749	7,287	226	3.1	N/A
1980	32,024	7,409	231	3.1	N/A
1981	37,162	7,472	231	3.1	N/A
1982	34,437	7,227	230	3.2	N/A
1983	41,791	8,732	231	2.6	N/A
1984	47,683	9,272	230	2.5	N/A
1985	49,715	9,304	232	2.5	N/A
1986	56,641	11,143	243	2.2	1,512
1987	60,440	11,941	0	0	1,603
1988	57,549	14,451	0	0	3,001

This case clearly shows that, if proper accounting adjustments are not made, the resulting net income is not a reliable amount upon which to base a damages computation. In such a situation, the expert may have to use other variables, such as cash flows.

Firm‐Specific Financial Analysis

One issue that may be relevant to a commercial damages analysis is the financial condition of the plaintiff or the defendant. Most corporate finance textbooks contain a standard set of financial tools. Paramount among these is financial ratio analysis. This is the computation of financial ratios from data contained in the company’s financial statements. A financial ratio analysis can be used to assess the financial well‐being of a company. This is important in cases where it is claimed that a company would have failed anyway even if the defendant had not taken the actions the plaintiff asserts it did. However, this type of financial analysis may be unnecessary when there is a lawsuit between two companies that continue to be viable with the plaintiff alleging that it is simply less profitable due to the actions of the defendant. Each set of ratios examines a specific aspect of the company’s financial well‐being. The four categories of these ratios are:

These ratios are usually compared to readily available industry norms.⁵⁷ They may be supplemented by other ratios that the analyst uses to address specific issues.⁵⁸

Cross‐Sectional Versus Time Series Analysis

In addition to comparing the firm’s financial with industry averages (called a cross‐sectional analysis), it may also be useful to examine the trend in these ratios over time. This is called a time series analysis of financial ratios. Such a review enables one to determine if certain components of a firm’s financial condition are deteriorating or improving over time. This may indicate the start of problems that may be independent of alleged actions of the defendant.

Summary

This chapter explored the steps involved in the process of measuring lost profits that commence after the “but for” revenues have been forecasted. Incremental costs associated with lost incremental revenues have to be measured. These costs are usually only those that vary with output. That is, fixed costs usually are not included. The cost analysis is often done using the services of an accountant trained in measuring such costs. Typically, this expert submits either a schedule of specific costs or a simple percentage that embodies such cost schedule. Costs can also be measured using a regression analysis; it seeks to compute the variable component of costs by determining the coefficient in an estimated equation relating sales to costs. The coefficient of the cost variable in such an estimated equation then reflects to what extent costs would increase for a given increase in revenues. While regression analysis can be helpful in measuring variable costs, there are a number of factors one must consider in order to be assured that the analysis is reliable and truly quantifies what the expert is trying to measure.

In most lost profits analyses, fixed costs, such as overhead, may not be relevant. This is because much of what is covered by overhead, such as rent or equipment lease payments, may already have been incurred by the plaintiff. If that is the case, then it does not make sense to deduct such costs from incremental revenues. If, however, additional fixed costs or higher overhead would have to be incurred to reach the forecasted revenue levels, then such costs may enter into the loss computation.

In computing lost profits, net profits are the appropriate measure of the loss; the definition of net profits that is used, however, may not correspond to the net profits figure that appears at the bottom of an income statement. It may be equal to or lower than the gross margin but often is higher than the net margin. However, when such net profits do not eventually equate to cash flows, then the focus of the damage measurement process may shift to cash flows and away from net income.

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