Articles

The Dynamics of Fixed and Variable Costs when Calculating Lost Profit Damages by Adam J. Lang, CPA/CFF, CFE


Posted on September 30, 2014

A plaintiff filing suit to recover lost profits resulting from a defendant’s wrongful action must estimate with reasonable certainty the amount of the loss caused by the defendant’s misconduct. When calculating lost profits, the damages expert establishes an amount of lost revenues and then determines the costs that should be deducted from that amount. Despite the simplicity of this equation, the actual computation is rarely so easy. Both parties must consider causation, the plaintiff’s efforts to mitigate his or her risks, the proper length of the damage period and external factors that may have further contributed to a plaintiff’s loss of revenue. Additionally, these calculations can be complicated further by how the courts differentiate between fixed and variable costs and treat those expenses when calculating damages. While most courts agree that plaintiffs should deduct variable expenses from lost revenue, opinions on the deductibility of fixed costs vary from one jurisdiction to the next.

 

Dynamics of Fixed and Variable Costs

Variable costs are those that fluctuate with the rise and fall of sales, such as labor and materials. Conversely, fixed costs, which may include rent and insurance, are incurred regardless of production or sales volume. There are times, depending on the business and the loss period, when the characteristics of these expenses can change. For example, the rent a manufacturing business pays for space to store its inventory is a fixed cost. However, if the business introduces a new product and quickly ramps up production, it may require additional space, either in the same building or at another location. This increase in production will subsequently lead to an increase in rental costs, and rent would now be considered a semi-fixed cost. In this example, the deductibility of rental costs for a lost profits calculation may depend upon the case law in the jurisdiction where the case is tried.

 

Florida Case Law

In 2008, Florida’s Third District Court of Appeals overturned a lower court ruling addressing the issue of fixed versus variable costs in lost-profit calculations. In RKR Motors, Inc. v. Associated Uniform Rental & Linen Supply, expert witnesses disagreed on which expenses should be deductible in lost profit calculations. On appeal, the court ruled that certain fixed overhead costs are integral to parties carrying out a contract and therefore should be deducted in lost profits calculations to “allow for a true measurement of the amount the non-breaching party would have earned on the contract had there been no breach.” Not requiring such an allocation of fixed costs, the court reasoned, would lead to “absurd results.” In its opinion, the court noted that the “correct method in determining lost profits is not to subtract only those expenses that would not be ‘saved’ or reduced by not performing the breached contract. . . . [but] to subtract all costs related to performing the contract.” Because Associated failed to identify any costs that were not required to perform the contract, the court in this case accepted an allocation of all variable and fixed costs to calculate lost profits.

 

Calculating lost profits is a complex process that relies on facts and circumstances unique to each case and each state. While some courts have ruled that apportioned overhead expenses must be deducted from an award of lost profits, other courts have taken the view that general fixed expenses, such as overhead, should not be deducted unless they are directly attributable to the lost transaction and would have been saved by not performing the contract. When identifying fixed and variable costs, counsel must analyze the clients’ historic financial data and the relationship between expenses and revenue in determining whether costs are fixed or variable and therefore deductible. Doing so often requires the assistance of experienced forensic accountants who understand the nuances and dynamics of calculating lost profits and can apply the relevant state law to each specific matter.

About the Author: Adam J. Lang, CPA/CFF, CFE, is an associate director in Berkowitz Pollack Brant’s Forensic and Business Valuations Services practice. He can be reached at the Miami CPA firm’s office at 305-379-7000 or via email at info@bpbcpa.com.