When providing litigation support in commercial disputes, Chartered Business Valuators (CBVs), are tasked with estimating the revenues that would have been generated but for the alleged breach and the costs that would have been incurred to generate those lost revenues as well as any increased overhead costs incurred as a result of the alleged breach.
Previously, methodologies for establishing causation and estimating costs in general were introduced. It is also important to understand methods for allocating fixed and semi-variable costs to products, processes, departments or divisions.
Absorption and Direct Costing
Absorption Costing
Estimating costs through absorption or conventional costing requires treating all manufacturing costs as product costs, thereby mingling fixed and variable cost elements within individual accounts. Fixed production costs are then applied to the product itself, forming part of the Cost of Goods Sold. In providing litigation support, CBVs note that absorption costing entails having less distinctions between fixed and variable costs.
Direct Costing
On the other hand, direct costing – also known as variable, marginal, or incremental costing – impacts net profits differently, since fixed manufacturing is considered a period cost instead of a product cost. Direct costing factors in actual prime costs plus predetermined variable overhead costs, while excluding its fixed counterpart.
Applying the direct cost method in calculating lost profits, variable expenses are then deducted. Increases or decreases in sales volume also result in proportionate increased or decreased incremental income, since only variable costs are assigned to the cost of units produced and sold. Using direct costing entails examining in greater detail the amount of units sold and resulting income or loss moving in the same direction as the sales volume. The result is the absence of increasing or decreasing net income or loss figures in direct correlation with the sales volume, because unit fixed costs do not remain constant.
Overall, the key difference between absorption and direct costing stems from the amount of fixed manufacturing costs allotted for under production and finished goods inventories of a business. As part of civil litigation support, CBVs are required to calculate lost profits, resulting in the deduction of the plaintiff’s Cost of Goods Sold and other variable overhead expenses from the Gross Profit.
Recovering Overhead Costs
In civil litigation, plaintiffs often claim damages pertaining to increased costs they incurred as a result of the alleged breach, such as interest and additional expenses (general and administrative, manufacturing overhead, and more). With the help of litigation support provided by an expert witness, counsel must be able to prove that said increased costs incurred would have been lower if not for the alleged damages caused by the defendant.
A business’ expenses can include extraordinary or non-recurring expenses, as well as those that may not be essential to, or effectively connected with the ongoing operations of the business.. CBVs providing litigation support may consider these expenses incurred by the plaintiff in their damages claim:
- Extra or one-time consulting or professional fees
- Foreign exchange losses
- Losses on the sale of assets
- Moving or relocation expenses
- Unusual bad debts.