A key part of quantifying economic damages in commercial legal disputes is estimating the lost revenues and costs to determine whether a plaintiff claiming lost-profits damages due to another party’s alleged wrongdoing has, in fact, suffered a loss, and if so, its resulting amount.
To determine the lost revenues and costs, that must factor into an assessment of lost profits, lawyers representing involved parties in Toronto and the GTA often seek expert reports from Chartered Business Valuators (CBV), who can quantify economic damages as part of the litigation support services they provide to business owners involved in commercial disputes.
In quantifying lost profits, the expert CBV must consider the lost revenues suffered, including the causation of such losses, as well as the costs that would have been incurred to generate those lost revenues.
Lost Revenue – Causation Considerations
In a case wherein a plaintiff is claiming lost profits from a loss of revenues, the party must be able to prove that the alleged acts of the defendant directly caused a reduction in sales, rental income, gross professional fees, and other forms of revenue. Counsel and the CBV, acting in capacity as an expert witness providing litigation support, must be able to show factual causation and prove that the defendant violated a legal right of the plaintiff in a manner that caused injury.
Additionally, the plaintiff must be able to establish that external, unrelated factors did not cause the revenue loss, such as:
- Economic downturns
- Seasonal or cyclical market fluctuations
- Mismanagement on the part of the plaintiff
- Loss of a key employee
- Loss of a major customer
- Introduction of a significant competitor or replacement
If the plaintiff is unable to prove that, for the period in question, the revenue loss was due to the defendant’s alleged wrongdoing, then they will not be compensated for lost profits that can be attributed to the external factors.
In providing litigation support, CBV’s use the following analytical methods to establish whether the revenue loss was indeed due to the alleged damaging acts of the defendant:
- Comparison to overall statistical data of the industry
- Comparison to similar companies in the same sector
- Comparison to segments of the business that were not adversely affected
To establish a connection between the loss of revenue experienced by the plaintiff and the alleged acts of the defendant, a CBV can convert the plaintiff’s market share into the sales volume they would have earned, if not for the defendant’s said acts. Alternatively, they can also compare sales volumes before and after said act was committed to establish fault or negligence.
Aside from establishing links, the plaintiff’s sales volume during the affected period may also be compared to that of another firm, or to other indicators from published statistics in the industry, noting that the plaintiff’s business would have performed up to par or according to industry trends, if not because of the defendant’s alleged acts.
Estimating Costs
After establishing the plaintiff’s loss of sales with “reasonable certainty”, the actual amount of lost net profits must be determined.
Despite extensive examination of financial records, it can be challenging to arrive at an accurate determination of the costs that would have been incurred by the plaintiff to generate the lost sales. To avoid under- or overestimating costs, CBVs must analyze the plaintiff’s cost patterns or behavior, while considering both fixed and variable components.
In quantifying damages for civil litigation, the CBV can use the plaintiff’s historical financial data to estimate the “but for” (cost that would not have been incurred if not for the alleged act) or incremental costs. The issues of the case lie within having to require the CBV to estimate complex costs for a specific situation, which may be different from cost data normally gathered. For this, the expert must rely on available company data, as well as empirical data from industry and government sources.
Cost patterns in the operation of a business are divided into the following categories which must be considered by the CBV:
- Variable expenses: classified as expenses that vary directly in relation to gross revenues, and apart from fixed expenses (e.g. sales commissions or cost of good sold);
- Semi-variable expenses: those that are between fixed and variable, and may be conceived as comprising both fixed and variable components due to the relationship between cost and volume (e.g. overtime on a production line);
- Fixed expenses: fixed amounts regardless of gross revenue. Some “fixed” expenses can also be just fixed to the extent that they will not vary in cost up to a certain revenue threshold (e.g. rent expense);
- Semi-fixed expenses: those that are fixed over a wide range but can change at various levels (e.g. administrative salaries/wages).
Since most variable costs can be traced to the product or service itself, cost allocation is typically concerned with fixed costs and only certain variable components. Because fixed costs are usually incurred for the benefit of the entire business, most of these are joint or common, and thus, require allocation to processes, departments, products, and other identifiable units or profit sources.