It is somewhat surprising that many litigators who try cases seeking recovery of damages for lost profits are unfamiliar with the basic structure of an economic analysis of lost profits.  This lack of understanding can interfere with the attorney’s communication with the damages expert or with cross examination of an opposing expert.  This article presents a simple paradigm, hopefully to improve understanding of the basic principles involved in this type of calculation.  The litigator trying a case involving lost profits should consult Robert L. Dunn’s Recovery of Damages for Lost Profits (Lawpress) for a comprehensive legal analysis of this subject.

It may help to follow the exposition by drawing a square on a handy piece of paper.  Then draw a horizontal line inside the square about half-way down and another vertical line about half-way across.  There are now four quadrants in the square.  Write the following labels in the quadrants: upper-left (UL) “But-For Past;” upper-right (UR) “But-For Future;” lower-left (LL) “With Past”; lower-right (LR) “With Future.”  (See fig. 1.)  The calculation of lost profits damages involves performing calculations within each of the quadrants and then combining them, all according to economic and financial principles applied within a legal framework.

But-For Past	But-For Future
With Past	With Future

Fig. 1.  Lost-Profits Grid

The horizontal mid-line is a time scale.  The intersection with the left border is the date of the incident that indicates the onset of damages.  The intersection with the vertical mid-line is the valuation date, usually the date of trial.  The intersection with the right border is the end of the time scale for calculation of damages.  Full mitigation of damages, after which damages are zero, may occur at this time.  Even if full mitigation does not occur, future damages can be calculated.

“But For” means: if the incident had not occurred.  “With” means: with the incident, i.e., what actually happened in the past before the valuation date or what is projected to happen in the future after the valuation date, given the actual events that have occurred.  These may be abbreviated BFI (but for the incident) and WI (with the incident). 

Any profits earned by the plaintiff that are enabled by the occurrence of the incident must be offset against BFI profits.  Such WI profits count toward mitigation of damages.  If, however, the WI profits would have been earned regardless of the incident, there is no offset of the BFI profits for the WI profits earned after the incident in the calculation of lost profits.

This concept of lost profits corresponds to the economic concept of opportunity cost, which is the difference between the highest available income and that from the next best opportunity.  In the calculation of lost profits, the highest income would have been derived from the activity interrupted by the incident and that from the next best opportunity derives from the mitigating activity. 

The damages that may be recovered for lost profits are lost “net” profit, which is revenues less all costs of goods or services sold and less all expenses.  Some costs and expenses, however, may not change if revenues are reduced, for example, because of lost sales caused by the incident.  These are called “fixed” costs or expenses.  Other categories of costs or expenses are proportional to revenues and can be expressed as percentages of revenues.  These are called “variable” costs or expenses.

In each of the four quadrants, at periodic time intervals, net profits can be calculated as revenues less variable costs and expenses and less fixed costs and expenses.  At a specific time, fixed costs and expenses are equal in the BFI and WI quadrants.  They are not changed by the incident, but variable costs and expenses are different because revenues are different BFI and WI.  Therefore BFI net profits minus WI net profits—the lost profits—is equal to BFI revenues less variable costs and expenses minus WI revenues less variable costs and expenses.  Fixed costs and expenses are redundant to the calculation.  Revenues less variable costs and expenses may be labeled “variable profits.”

If it is appropriate to consider offset for mitigation of damages, past lost profits in each past time interval are calculated by subtracting WI or actual variable profit (LL) from BFI estimated variable profit (UL).  Future lost profits in each future time interval are calculated by subtracting WI estimated variable profit (LR) from BFI estimated variable profit (UR).

The amount of award needed to compensate the plaintiff for the lost profits is not simply the sum of past and future lost profits.  The part of the award that compensates the plaintiff for the future loss is available for investment whereby the return on the investment will be available to contribute to the compensation.  Even BFI, the generation of future profits is accompanied by assumption of business risk, characterized by uncertainty of future profits, as reflected in historical variability of profits in general. 

A calculation called “discounting to present value” is used to discount or reduce projected future lost profits to “present” value at the valuation date.  A rate of discount is estimated to match the risk of the plaintiff’s business, which adds a risk premium to an otherwise riskless interest rate, such as that on a U.S. Treasury bond.  The amount of the award for future loss calculated in this way, as if the award is invested in an asset having similar business risk, makes the plaintiff whole by modeling the recovery of the expected future lost profits as if the plaintiff faces the same business risk as BFI.

Proof of lost-profits damages requires reasonable certainty of the fact of damages, but proof of the amount of damages requires only a reasonable estimate, not an exact calculation.  Such an exact calculation is not possible because the incident changes the course of history, so that what would have happened BFI cannot be determined with certainty.  A reasonable estimate of past and future profits BFI or future profits WI can be determined by basing the estimate on the financial performance of the plaintiff before or after the incident, by the financial performance of a comparable business, possibly also owned by the plaintiff, that is unaffected by the incident, or by indicators of performance of the plaintiff’s industry.  

---

ABOUT THE AUTHOR:

Dr. Jules Kamin obtained his M.B.A. and Ph.D. from the University of Chicago Graduate School of Business in finance, business economics and management science.  After fifteen years conducting financial and economic analysis in corporate and banking settings, he entered the practice of forensic economics.  In over twenty years he has been retained in more than 500 cases involving monetary damages to businesses and individuals and testified in more than 60 trials in federal and state courts.

Dr. Kamin can be reached via phone at (323) 653-9555. For more information about Dr. Kamin, please visit his website at
www.valu-econ.com.

BACK TO TOP