Calculating Lost Profit
Here is a simplified case study of calculating lost profit for a business. The first step is to determine the company’s historical sales. These are presented in the graph below.
Sales increased during 2013-2016, dropped significantly in 2017, and ceased entirely thereafter. XYZ Company sued Defendant, claiming Defendant’s acts wrongfully caused XYZ Company’s sales to decline and the company to close down. The question is, what would XYZ Company’s sales have been absent Defendant’s wrongful acts? There are a variety of methods to project sales, including:
- Historical Growth Rate
- Exponential Smoothing
- Comparable Sales
- Related Products
In this example, we chose the linear regression approach to projecting sales, as shown in the graph below.
An alternative approach to projecting sales could have been the historical growth approach, as shown in the graph below.
In this example, the historical growth rate approach results in significantly higher lost sales than the linear regression approach. This is shown in the table below.
Factors Contributing to Lost Profit
The appropriate method to project “but-for” sales depends on the XYZ Company’s individual facts and circumstances. The analyst should consider all factors, including and other than Defendant’s wrongful acts, that may have affected XYZ Company’s sales.These factors include:
- Capital Investment
- Damage Period
- Economic Climate
- Government Regulation
- Industry Trends
- Lead Time
- Market Saturation
- Market Trends
- Price Changes
- Product Life Cycle
- Product Mix
- Sales and Distribution Methods
- Service Responsiveness
Regardless of how lost sales are determined, it is important to understand that lost profit, not lost sales, is the appropriate measure of damages.
Understanding Marginal and Average Profit
Two of the most commonly used measures of profit are “marginal profit” and “average profit.” In calculating the marginal profit associated with lost sales, one subtracts all the additional costs that would have been incurred if the lost sales had been earned. Typically excluded are overhead costs like rent or officers’ salaries, which would not have increased if XYZ Company had earned the lost sales. In calculating the average profit associated with lost sales, one subtracts – on a pro-rate basis – all costs the company incurred.
As shown in the table below, using marginal profit versus average project may result in significant difference in calculated profit as a percentage of sales.
The final steps in calculating lost profit are to apply the appropriate profit percentage to lost sales and to discount projected future lost profit to present value.The choice of discount rate has a significant impact on the resulting calculated lost profit.The table below shows lost profit in which lost sales were determined using the linear regression approach, to which the average profit percent is applied.Calculated lost profit is discounted to present value at two alternative rates, 8% to 15%.
Lost Profit (8%)
Lost Profit (15%)
An alternative calculation determines lost sales using the historical growth rate approach, to which the marginal profit percent is applied.
Lost Profit (8%)
Lost Profit (15%)
Contact a CPA Expert Witness for Help with Lost Profit Cases
These tables show that the following choices all have a material impact on lost profit calculations:
- Approach to projecting but-for and currently-expected sales,
- The measure of profit (marginal profit versus average profit), and
- The rate at which projected future lost profits are discounted to present value
When you need a CPA expert witness to perform these calculations, and to justify them to the judge and jury, look for an expert with experience: Thomas M. Neches, CPA/ABV/CFF, CVA, CFE.