In my last article, I discussed how to calculate lost revenue related to a fire in ABC Company’s manufacturing facility. In this article, I will complete the lost profits claim (as a reminder, lost profits are calculated simply as lost revenue less avoided costs) and discuss how to determine avoided costs.
Avoided costs are defined as the incremental costs that were not incurred because of the loss of the revenue. Unlike lost revenues, there are no specific methods that outline how to determine avoided costs. However, the starting point of an analysis of avoided costs is often the cost structure of the subject business, specifically, fixed versus variable costs. In general, if a cost is variable, it can be avoided (and thus should be deducted from lost revenue). If the cost is fixed, it cannot be avoided (and thus should not be deducted from lost revenue).
An analyst can estimate avoided costs using nonstatistical and statistical methods. Any analysis can be considered as long as it can be reasonably supported. While a review of all of the available (nonstatistical and statistical) methods is beyond the scope of this article, I will discuss one method within each category.
- Nonstatistical - The most basic nonstatistical method to estimate avoided costs is to review the detailed chart of accounts of a business and use judgment to assess which costs are fixed and which are variable. The benefits of this method are that it is easy to apply and results in a common-sense, yet thorough, consideration of all of the costs of a business. The downside to this method is that it is subjective.
- Statistical - The most common statistical method is a regression analysis where the relationship between historical costs and revenue is mathematically measured. The main benefit of this method is that it provides an empirical, supported estimate of avoided costs. The negatives of a regression analysis are that it is difficult to perform (regression analysis requires a significant amount of education and experience) and that history may not necessarily be a good indicator of the future, depending on the business being analyzed.
While the past two articles have looked at a lost profits (lost revenue and avoided costs) at a high level, the actual quantification of lost profits analysis requires detailed analysis and significant experience. Schneider Downs has prepared numerous lost profits analyses and reports that meet the needs of an insurance company or, in many cases, have been presented as evidence in court. If you have any questions on lost profits, please contact Schneider Downs and visit our Business Advisors webpage to learn about the other business advisory services that we offer.