Page 45 - Calculating Lost Profits

Chapter 7

Costs

Overview

As described in chapter 2 of this practice aid, lost profits are generally calculated as lost revenues less
incremental costs and expenses, also called avoidable expenses. fn 1 These are the expenses avoided as a
result of lost revenues not having been earned. In the American Kitchen example, if Franchisee, with 10
restaurants and stores, was unable to open an 11th restaurant as a result of Franchisor’s unlawful refusal,
the lost revenues notably include the revenues at the location in question. See chapter 6.

In preparing the lost profits calculation, the practitioner analyzes which costs would have been incurred
in the but-for world but have been avoided without these revenues. In the American Kitchen example,
without additional stores, these avoided costs would likely include the cost of food and beverages that
would have been served, labor (for example, servers, food preparation, and management), cleaning,
maintenance, electricity and other utilities, construction costs, financing costs, and legal fees. Other
costs might include sales and marketing expense, such as promotions for the new location.

In addition, a lost profits calculation may be performed in a situation in which there has been no effect
on revenue, but costs have increased as a result of the unlawful acts of the defendant. For example, if a
cleaning service was under contract to clean a restaurant, but the cleaning service refused to perform as
called for under the contract, the restaurant may be required to obtain a replacement cleaning service at a
higher price. In this scenario, the additional costs incurred for the replacement cleaning service would be
a form of lost profits because the plaintiff has experienced lower profits as a result of the higher costs,
even with no revenue effect.

From the examples described previously, the estimation of incremental or avoided expenses to be de-
ducted from revenues in an estimate of but-for profits or deducted from lost revenues to arrive at lost
profits is dependent on case-specific facts and circumstances. For example, adding a restaurant to a
chain is going to add costs such as building construction — costs that adding 1 hour per day or 10 more
customers per day at an existing restaurant will not include. As detailed more fully in the following text,
practitioners are frequently tasked with performing analysis to support the estimation of incremental
costs.

Variable, Marginal, Incremental, Saved, Avoided, and Fixed Costs

In cost accounting, costs are often categorized as fixed or variable (also sometimes referred to as mar-
ginal costs, although hereafter, the term variable costs is used in this practice aid). Fixed costs are gen-
erally referred to as those that do not change with an increase or decrease in sales. For example, a con-
tractually defined lease payment on office space would typically be viewed as a fixed cost because the
cost will be incurred whether sales are $0 or $100,000.

fn 1 Costs and expenses are used interchangeably in this practice aid, referencing costs incurred, regardless of whether the amount is
expensed in a period or is a cost incurred but not expensed until some later period. Issues pertaining to lost cash flow, as compared to
lost earnings, are addressed in chapter 2 in this practice aid.

© 2020 Association of International Certified Professional Accountants 43