*Clemenceau failed to
note, of course, that the Ten Commandments themselves actually contain more
than ten commandments**. (Sorry, I am an accountant).
**Now, in fairness, the
Hebrew Bible actually does not use the term “Ten Commandments” at all.
By far the most common error I encounter, especially from
claims prepared by non-experts but also in occasional decisions of trial judges[1], is the failure
to deduct saved expenses. People are generally well aware of their loss of
revenue; they are generally less conscious of the fact that the event that
caused them to lose revenue has also caused them to save certain expenses. The
fact is, almost all situations involving a loss of revenue will also involve a
savings in expenses.
All lost profit analyses can be expressed in the following
equation. It is so fundamental that I have shown it in a red box:
Now, not everyone thinks in terms of red boxes; I, for one,
prefer examples. So consider a simple example of a retail store that is forced
to close by flooding originating from a neighbouring property. The store’s annual financial
statements for the year preceding the flood are as follows:
The closure results in a loss of revenue. But it will save some expenses.
The store will certainly experience a savings in variable costs. Variable costs are costs that – you guessed it – vary in proportion to the level of business activity. For example, to make a sale, the store must give the purchaser the item he or she purchased; it incurs a “cost of sales”. This cost, in our example, has historically been equal to 2/3rds (or 66.66%) of revenue.
The store will also likely experience a savings in its fixed costs. Fixed costs are those that do not vary directly with small fluctuations in business activity, but which are affected by large changes in the business, such as a prolonged shutdown. In the case of our store, if the store is closed long enough the lease may contain a clause relieving the business from paying rent while it is closed; the store may lay off its staff. If the business closes permanently, the annual loss of profit may simply be the difference between the normal revenue and the normal expenses, which in the example of our store is $184,000.
This is, of course, a very schematized example. Calculating saved expenses can be very challenging in practice, in particular when the projected revenue levels contemplate significant growth (or contraction). I will discuss this issue more in future posts, but for now I leave you with this basic lesson:
Lesson: When a business experiences a loss of revenue, it will almost always also experience a savings in expenses. This savings must be offset against the revenue loss to arrive at a proper assessment of lost profits.
[1]
For example, see 1397868 Ontario Ltd. v. Nordic Gaming Corporation (Fort ErieRace Track), 2010 ONCA 101, where the failure to deduct saved expenses resulted
in the Ontario Court of Appeal ordering a new trial. It noted that:
[34] I appreciate that the trial judge was confronted with a difficult task in assessing damages in this case. However, her reasons explain how she came to the damages award and it is apparent that she did not account for the cost of sales. Clearly, the cost of sales is an integral part of any loss of profits calculation. Importantly, a deduction for the cost of sales could have a significant impact on the calculation of 139’s loss of profits. In oral argument on appeal, 139’s counsel indicated that if 40 percent of revenues is used to calculate the cost of sales it would “decimate” the damages award. Whatever the case, the failure to deduct the cost of sales could be significant.
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