Lost profit is generally defined as the revenue the injured party would have made, but for the business interrupting event, less the costs saved.
According to Niamh Brennan and John Hennessy (1) the lost profit computation can be broken into the following steps:
1. define the damage period
2. estimate lost revenue for that period
3. subtract cost associated with the lost revenue
4. subtract net profits for efforts made to mitigate losses
5. express lost profits in present value terms
Lost Profit methods
Lost profits are often calculated using one or a combination of the following three methods (2,3):
1. Before and After method
2. Yardstick or Comparable method
3. Sales Projection or “But For” or Market method
Under the before and after method, revenue and profit are compared before and after the business interruption event.
A reduction in revenue and or profit may be ascertained based on the difference between performance in the two periods. The method assumes:
- sufficient historical financial information is available to construct a reliable forecast
- performance prior to the event represents potential performance during the loss period
The yardstick method makes a comparison of the financial performance during the loss period to comparable businesses during that period. The key issue is how comparable are those businesses.
Sales Projection method include a detailed analysis of relevant economic, industry and firm-specific factors (4). The method requires a justified assessment of revenue and costs and converting projected future profits to a current value.
Assumptions
Assumptions need to be made about what direction the revenues would have taken but for the interrupting event. Issues to consider include:
- were revenues, prior to the event, trending up or down?
- what other factors, apart from the event, would have impacted revenue?
- was anything done by the claimant to mitigate losses?
- how long had the business been trading?
- how well established and consistent was revenue prior to the event?
Once lost revenue has been established, the variable costs need to be calculated. These are the costs that would have been incurred had the revenue not been lost.
A common metric cited in lost profit matters is gross margin, defined as sales less cost of sales, divided by sales.
If the gross profit margin is adopted, then an appropriate rate needs to be calculated which is relevant to the claim. Consideration may be given to historical rates and rates at the time of or after the event.
The gross profit margin may not include all incremental costs. If the event had not occurred the claimant may have incurred additional overhead expenses to support the higher revenue, for example, rental of a larger office or factory.
Lost Profit v Lost Value
Lost business value tends to apply where a business or part of a business ceases permanently as a result of the alleged act. The intrinsic value of a business is the present value of the expected earnings stream for the expected life of the business.
A key difference between a lost profit calculation and a lost business value is the period. Whether the earnings are damaged for a limited specific period (lost profit) or earnings are damaged for the life of the business (lost business value).
That does not mean that the methods are mutually exclusive. There could be an instance where the claimant continued struggling with the business (lost profit) but the business eventually folded (lost business value).
1. Brennan, N and Hennessy, J (2001) Forensic Accounting and the Calculation of damages
2. Pratt, S (2008) Valuing a business -The analysis and appraisal of closely held companies, McGrath Hill. Fifth Edition, p.1023
3. Trugman, G (2017) A practical guide to valuing small to medium-sized businesses, Fifth Edition, p.1112
4. Gaughan, P.A (2009) Measuring Business Interruption Losses and other commercial damages, John Wiley & Sons, Second Edition, p73
Simon is an accredited business valuer and an accredited forensic accountant.
