Page 46 - Calculating Lost Profits

In contrast, variable costs increase with an increase in sales. For example, if a company pays commis-
sions of 15% of sales, the commissions represent a variable cost. Similarly, a restaurant would typically
have variable costs, such as food and beverage, given that as restaurant sales increase, food and bever-
age costs would also likely increase. Variable costs are often defined by accountants as the costs that
would increase with a one-unit increase in sales, but, as can be seen in the preceding commissions ex-
ample, this is not always the case. For example, commissions would increase with a price increase, even
without an increase in sales volumes.

Incremental costs are those costs that are incurred with a change between two scenarios (for example,
what actually occurred versus what would have occurred "but for" the unlawful act). fn 2 What the "in-
crement" is depends on the purpose of the calculation. In some situations, incremental costs may be the
same as variable costs (for example, if the increment is to add one more unit of sales). However, incre-
mental costs can also be evaluated using other measures, such as one or more additional products of-
fered for sale, one or more additional stores opened, or one or more additional lines of business operat-
ed.

Although fixed costs do not change with a change in volume (for example, unit volume), that is not to
say that fixed costs necessarily remain constant across all time periods. For example, rent expense may
increase due to lease escalations, but the rent expense (in a given month) that does not change based on
changes in sales volume would be considered a fixed cost. However, if there were a need to increase rent
space to accommodate additional sales, then rent could become an incremental cost.

In a lost profits calculation, costs are typically categorized as incremental, saved, or avoided (hereafter
simplified to incremental), or fixed, in which fixed costs in a lost profits calculation are those that do not
change with the increment of the change between the but-for and actual scenario. As a result, because
the increment in a lost profits calculation may be different from a one-unit change (the increment used in
cost accounting for "variable costs"), fixed costs in a lost profits calculation may differ from those seen
in a cost accounting exercise to estimate fixed versus variable costs.

In this context, experts are normally tasked with the estimation of which costs were saved (avoided) as a
result of a disputed event or events: incremental costs not incurred because the lost revenues in question
were not earned. As can be deduced from the preceding discussion, this is typically not a simple analysis
and varies from case to case. The analysis of costs frequently calls for some combination of tools and
analyses used by the practitioner, including

 evaluation of specific cost line items using accounting records,

 statistical analysis (for example, regression), and

fn 2 There is not a unanimous and clear definition of incremental costs. For example, some define incremental costs to be synonymous
with variable costs, whereas others use the definition discussed in this chapter, which is consistent with the GAAP definition. The
AICPA's Working Draft: Time-share Revenue Recognition Implementation Issue (AICPA Audit and Accounting Guide: Revenue
®
Recognition,§ 3.7.03, January 2019.) explains that the FASB Accounting Standards Codification defines incremental costs to be
those that are incurred with an additional event (not just an additional unit sold): "Paragraphs 1-3 of FASB ASC 340-40-25 explain
that the costs of obtaining a contract should be recognized as an asset if the costs are incremental and are expected to be recovered.
Incremental costs of obtaining a specific contract are those costs that the entity would not have incurred if the contract had not been
obtained."

44 © 2020 Association of International Certified Professional Accountants