OUR THOUGHTS ON:

Lost Profits: Determining Lost Revenue (Part 1)

Business Advisors

By Stephen Thimons

One night, there is a fire in ABC Company’s manufacturing facility.  Although the fire department responds and extinguishes the fire, there is significant damage done, which closes the facility for six months.  ABC now must incur out-of-pocket costs to repair the facility and replace any damaged equipment.  Additionally, the Company cannot manufacture and sell its product for six months causing it to lose out on profits it would have earned. 

Luckily, ABC has an insurance policy that covers business interruption losses (including lost profits), although the insurance company requires a proof-of-loss claim that supports the losses incurred.  Company management sits down to prepare its proof-of-loss and easily documents its claim for out-of-pocket costs.  However, it quickly realizes that it has no idea how to quantify and document a lost profits claim.  How does one even begin to prepare such a claim?

Simply put, lost profits are lost revenue minus avoided costs. 

Common Methods Used to Calculate Lost Revenue in a Lost Profits Claim

  1. The “Before and After” Method – This method compares ABC’s revenue before the fire to ABC’s revenue after the fire.  This method assumes that, but-for the fire, the Company would have continued to earn the same level of revenue. 

    This method is nice because it considers the actual historical performance of ABC (which is more difficult to dispute).  However, the analysis must also consider if any other factors might have influenced the Company’s revenue.  For example, did ABC just lose a major customer?  Did it sign a new customer?  Is there significant seasonality in the business requiring an analysis of prior years’ data?

  2. The Yardstick Method – This method attempts to find a “yardstick” to compare to ABC in order to estimate lost revenue.  For example, an appropriate yardstick might be: (a) the performance of ABC at a different location; (b) a comparison of the Company’s actual experience compared to past budgeted results; (c) the experience of a similar business not affected by the fire; (d) industry averages; (e) pre-event projections.

    The most important part of the yardstick method is to illustrate comparability between ABC and the actual yardstick used.  The more similarities, the more supportable the yardstick method is.  For example, if you used the results of a similar business: Is that business the same size? Does it operate in the same market (geographic, product, etc.)?  Does it have a similar customer base?

  3. Underlying Contract – If ABC had contracts with all of its customers, lost revenue could be estimated under the terms of those contracts.  The presence of contracts creates more certainty that ABC would have the lost revenues it needs to estimate.

    Depending on the facts and circumstances of the case, any of these three methodologies can be used, in addition to any other reasonable methodology.  However, the claim must be supportable and follow the general premise that, “but-for” the fire, ABC would have earned the revenue it claims.  

Depending on the facts and circumstances of the case, any of these three methodologies can be used, in addition to any other reasonable methodology.  However, the claim must be supportable and follow the general premise that, “but-for” the fire, ABC would have earned the revenue it claims.  

While this article looks at lost revenue at a high level, the actual quantification of lost revenues in a 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, feel free to contact us.

Read Part 2 of this series and learn how to determine avoided costs to complete the lost profits claim.

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The Schneider Downs Our Thoughts On blog exists to create a dialogue on issues that are important to organizations and individuals. While we enjoy sharing our ideas and insights, we’re especially interested in what you may have to say. If you have a question or a comment about this article – or any article from the Our Thoughts On blog – we hope you’ll share it with us. After all, a dialogue is an exchange of ideas, and we’d like to hear from you. Email us at contactSD@schneiderdowns.com.

Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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