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Computing Lost Profits in Business Interruption Litigation: A General Model

Originally published in Journal of Business Valuation and Economic Loss Analysis Volume 7, Issue 1, May 2012.

By: Dr. Stanley Stephenson, David A. Macpherson & Dr. Gauri Prakash-Canjels
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Abstract

This paper focuses on business interruption litigation and how to compute lost profits as a remedy. The main contribution of the paper is development of a general model of economic damages which assesses lost profits by measuring the incremental changes in revenue, variable costs, and fixed costs. Prior treatments can be understood as special cases to this general model. Several sources of economic damages can now be considered due to business interruption, including changes in prices, quantity sold, variable cost structures, fixed costs, and extraordinary expenses. We also offer case examples using the proposed framework and provide practitioners with suggestions for damages estimation.

Introduction

High impact events such as Hurricane Katrina, the 2010 Gulf Oil Spill or tornadoes draw attention to the fact that business operations can be severely interrupted by man-made or natural disasters, and are associated with large collateral damages. Natural catastrophes like fires, floods, and high winds can be disruptive events that lead to economic losses for many businesses. Other operational disruptions can arise due to a breach of contract, a tort, a fraud, a condemnation, misappropriation of intellectual property, or an antitrust violation. This paper focuses on business interruption litigation and how to compute lost profits as a remedy, assuming that liability for a loss has been established.

Lost profits arise when some wrongful conduct or omission by one party causes harm to another party, in which case the wronged party may recover lost profits as a compensation for the loss. Measuring lost profits for business interruption has been discussed in other articles, books, and book chapters.

We believe the prior literature has been too narrowly focused, and suggest a broader analytical framework is a more appropriate place to begin before making limiting assumptions as to what factors are driving lost profits. This lost profits framework should address three key questions: (1) is the interruption permanent or temporary?; (2) what profits would have been expected "but-for" the interruption?; and (3) what underlying changes in economic factors cause lost profits damages? 2 We also offer case examples using the proposed framework and provide for damages practitioners some practical advice.

Temporary and Permanent Business Interruptions

. . .Continue to read rest of article (PDF).


Stanley P. Stephenson, Ph.D. Economics, has provided Economic Litigation services in more than 300 cases. His experience includes Business Valuations, Economic and Quantitative Analysis and Market Assessments.

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