Costing in Damage Calculations
How to keep them from sinking you.December 1, 2011
by Cathie Cameron CPA, CFF
For those of us in litigation support, damage calculations are our bread and butter. On a basic level we compare the income stream that would have occurred but-for an alleged damage to the actual income after the alleged damage occurred. The difference between the two income streams represents the damages. The comparison of two sets of income streams doesn’t readily bring costing to mind. Accountants usually think of costing in terms of fixed costs, variable costs, standard costs, job costs and others that assist in management decision making. But the way costs behave is very important in damage analysis.
Let’s consider a lost-profits calculation in which but-for profits are compared to actual profits with the difference representing the damages. Analysts usually calculate but-for profits by determining what the sales revenues would have been but-for the alleged damage and then deducting the costs that would have been incurred to generate those revenues. The actual profits can usually be readily extracted from the financial records because they actually occurred.
As noted above, analysts first determine the level of but-for sales to calculate but-for profits. Then they analyze the nature of the costs in the actual profits to determine whether costs are fixed, variable and semi-variable. Using this information they calculate the costs associated with the but-for sales assuming that the nature of the costs, whether fixed, variable or semi-variable, remains unchanged in the but-for scenario without considering that the nature of the costs may change between the but-for and actual scenarios.
Most corporate financial professionals and CPAs already know that fixed costs are only fixed over a given range of activity, usually sales, yet many damages analysts forget that fact when considering the nature of the costs associated with the higher-than-actual but-for sales revenues. Costs that may have been fixed in actual profits may become semi-variable or step costs as the sales revenues increased in the but-for scenario. So, the nature of costs may be different in the but-for and actual-profit calculations.
The fact that the nature of costs may change depending on the level of sales revenues may also lead to situations where one expert may treat a but-for cost as variable or semi-variable and the opposing expert may treat the same cost as fixed because the level of but-for sales calculated by each expert is different. Costs need to be analyzed by considering their nature and how they behave over a given level of sales revenues. Too many damage analysts merely analyze common sized financial statements and apply their findings in all cases, without factoring in how costs change as sales revenues change.
And it is not just fixed and variable costs that are treated incorrectly in damage analyses. I recently came across an expert report where an economist considered sunk costs in his analysis. Sunk costs are costs that should not be considered in management decision making because they have already been expended and no decision made by management can recoup the cost. Neither should they be included in damages calculations.
Consider the scenario where management must decide whether to make a new product. The expected revenues, costs and discount rate over the life of the product are shown in the table (assume the capital costs have no residual value):
At the start of year zero, management would make the decision not to make the new product. However, assume we are now at the end of year zero and that the capital had already been purchased and cannot be sold i.e. the $600,000 was a sunk cost. In that event, management would decide to make the new product because the future cash flows are positive.
Sunk costs should never be considered in a lost profits calculation because if costs are sunk by the damage date, the damage could not affect sunk costs. Furthermore, costs cannot sink in the future — so during the period of lost profits (which must begin after the damage date) there can be no sunk costs.
Assume that the damage date was at the end of year zero in the table, i.e., the capital costs were sunk. I have experienced analysts attempt to claim lost profits for years one through three plus the $600,000 costs. This claim is incorrect; the profits in years one through three would not have been generated if the $600,000 had not been spent. I have also experienced analysts claiming the $600,000 instead of the profits in years one through three. This claim is again incorrect; in this scenario the return on the capital investment was $535,298. Plaintiffs should only be compensated for lost profits not for the fact they made a bad investment before the damage date. At the end of year zero, the capital costs are sunk and do not affect lost profits.
When calculating historical profits we may only need to quantify costs, but when forecasting, which includes calculating damages, the nature of costs needs to be understood and considered.
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Cathie Cameron, CPA, CA, CMA, ABV, CFF, is the president of Ness Consulting, LLC, which provides forensic accounting, damages analysis, business valuation and management consulting.