By Mike Cordova, MBA, CVA

When a plaintiff alleges that a defendant’s actions impaired its operations in some manner, it often leads to a lost profit damages claim. Determining lost revenues is a critical component in calculating lost profits Since the lost profits are based primarily on the lost revenues net the costs associated with generating the lost revenues.

In simple terms, lost revenues are the net difference between the plaintiff’s projected (“but-for”) revenues, assuming no incident, and the plaintiff’s actual and projected revenues following the defendant’s actions.

This blog discusses some of the common methods used to calculate lost revenues and the importance of facts and data to support such calculations.

Loss Period

Lost revenues are typically calculated from the date when the defendant’s actions first impact the performance of the plaintiff’s business (“the incident”) to a specified date following the subject incident. The post-incident date can be based on the time required for the plaintiff’s projected operating performance to return to a level it would have achieved but-for the defendant’s actions. This date can also be based on other factors, such as the terms of a particular contract.

The length of the loss period is often a source of contention. Calculating lost revenues (lost profits) on an annual running total basis allows this measure of damages to be quickly evaluated at various points in time.

But-For Revenues

Assuming the plaintiff’s business has enough operating history and revenue data to evaluate pre-incident trends, projected post-incident revenues but-for the defendant’s actions are usually based on the average annual pre-incident revenues (basis) and revenue growth rate.

If a plaintiff’s business does not have enough operating history prior to the defendant’s actions, lost revenues can be based on a comparison between the plaintiff’s revenues and those of comparable companies or industries over the same time period.

Revenue Basis – The basis should reflect the average annual pre-incident revenues as of the date of the incident. The pre-incident period used to determine the basis should be long enough to account for the most recent pre-incident revenue trend.

For example, if revenues were consistently trending up (or down) over a multiyear period prior to the incident, the revenues for the 12 months prior to the incident could be used as the basis. However, if pre-incident revenues fluctuated from year to year with no clear trend, it might be more appropriate to use a multiyear average, or weighted average, for the revenue basis.

The pre-incident period used to determine the basis should also be long enough to account for any seasonality related to revenues. Seasonality, or regular fluctuations in business performance that recur every calendar year, can only be determined if there are at least 12 months of pre-incident revenue data. For example, if a plaintiff’s business typically generates 75% of its annual revenues during the second half of each calendar year, projecting post-incident revenues based only on data for the second half of the most recent calendar year prior to the incident could overstate future revenues.

Revenue Growth Rate – The average annual change in pre-incident revenues, or growth rate, is typically applied to the pre-incident revenue basis to determine projected post-incident revenues.

The appropriate pre-incident time period should be used to determine both the growth rate and basis. For example, assume a plaintiff’s business started in Year 1 and achieved average annual revenue growth of 30% from Year 1 to Year 3, before leveling off to a more sustainable 10% average annual growth rate for Year 4 through the date of the incident in Year 8. In this case, the revenue basis and growth rate for Year 4 through Year 8 would be a better indicator of post-incident performance than Year 1 through Year 8, since Year 4 through Year 8 represents the most recent period of operations prior to the incident and the growth rate for Year 1 through Year 3 did not appear to be sustainable over the long term.

In certain cases, a plaintiff will claim that, but-for the incident, a future event would have occurred, necessitating a deviation from revenue projections based on pre-incident trends. For example, a plaintiff might claim that a distributor or client contract was signed just prior to the incident that would have accelerated the growth of revenues going forward. However, unless supporting documentation and analysis can be produced, this type of claim could be dismissed as overly speculative.

Actual/Projected Post-Incident Revenues

The next step in calculating lost revenues is to determine the actual and projected post-incident revenues, assuming the plaintiff’s business was impaired as a result of the defendant’s actions. Actual post-incident revenues should be based on supporting documentation.

Assuming actual revenues do not extend to the end of the future loss period, revenues can be projected from the end of the “actual” period to the end of the future loss period based on various methods. If actual post-incident revenues exist over a multiyear period, a post-incident basis and growth rate can be used to project revenues to the end of the future loss period. If there is limited post-incident revenue data, industry or comparable company growth rates can be used for future projections. Any method used should result in projected post-incident revenues that are realistic given the but-for revenues over the same future period.

Conclusion

This blog has discussed some of the most common methods used to calculate lost revenues. Given the subjective elements of business projections and damage models, the appropriate methodology should be based on specific facts related to the plaintiff’s claim, along with the availability of data related to the plaintiff’s business, plaintiff’s industry, and comparable companies.

Mike Cordova is an assistant vice president in J.S. Held’s economic damages and valuations practice. He specializes in the calculation of economic damages in complex commercial litigation and personal injury matters related to lost profits, business interruption, and business valuation. Cordova can be reached at mcordova@jsheld.com.

^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}