Page 26 - Calculating Lost Profits

Chapter 4

Calculation of Lost Profits

On a conceptual level, lost profits damages are generally based on one of the following two models:

1. Calculation of net incremental revenues lost, offset by net incremental costs avoided. In this
model, the net incremental revenue that would have been realized but for the unlawful act is cal-
culated and then reduced by related net incremental costs avoided. For example, using the Amer-
ican Kitchen case study, suppose Franchisor was unable to meet its obligations to supply Fran-
chisee’s eateries with a key menu item for a period of one month, in violation of the franchise
agreement’s exclusive supplier terms. As a result, for 30 days, Franchisee was unable to sell a
popular menu item. Assuming the only effect on Franchisee’s stores was the inability to sell a
key menu item for 30 days, lost profits, under this model, would be the incremental revenues
from the sale of the popular menu item for 30 days, reduced by the incremental avoided costs of
producing and selling that menu. If other items were determined to be affected (adversely or fa-
vorably) by the lack of availability of the menu item, a similar analysis of the incremental reve-
nues lost (or gained), offset by the net incremental costs avoided (or incurred), would be neces-
sary for each of these items, as well. fn 1

2. Calculation of but-for profits, net of actual or mitigating profits realized. In this model, the net
profits that would have been achieved but for the unlawful act are calculated and then offset by
the actual or mitigating profits (or increased by the actual losses) following the unlawful act. Us-
ing the same preceding example, the total but-for profits associated with the menu item for that
30-day period would be calculated and then reduced by the actual or mitigating profits realized
from that menu item during the same 30-day period. This might be accomplished by examining
but-for profits for the single menu item and comparing those with the actual profits for that item
during the 30-day period. Alternatively, a broader assessment of the whole affected American
Kitchen location and its but-for and actual or mitigating profits might be performed.

In theory, these two models should render the same calculated undiscounted lost profits damages. The
models should be based on an accepted methodology for estimating the incremental revenues lost or but-
for profits. fn 2 When the two models provide differing estimates of lost profits, the practitioner should
evaluate the reasonableness of the analyses under each approach. Depending on the facts and circum-
stances surrounding the wrongful acts, one or both preceding models could be appropriate.

For example, suppose the practitioner determined that, as a result of the aforementioned supply disrup-
tion, Franchisee failed to sell 1,500 units of the popular menu item (actual sales were 0 units, compared
to but-for sales units of 1,500) during the 30-day period. The item had a sales price of $3 per unit and a
cost of $1 per unit. The practitioner applied the first methodology, calculating undiscounted lost profits
damages of $3,000 (that is, $4,500 of incremental revenues based on 1,500 units at $3 per unit, less

fn 1 Other complications might include running the calculation beyond 30 days, if customers or sales were lost even after the supply
was resumed.

fn 2 See chapter 6, "Estimating Lost Revenues," in this practice aid.

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