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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.
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?
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?
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.
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