In estimating damages, are overheads fixed and does it matter?

Issues with what costs should be deducted from revenue in assessing damages and account of profits

Introduction

Faced with the task of estimating damages to be awarded or profits to be disgorged courts and lawyers are often confronted with the question of which costs should be deducted from the revenue that was or would have been earned. In this edition of Damages Matters, Owain Stone, Partner and Justine Power, Senior Business Analyst in our Melbourne office look at a recent decision in the New South Wales Court of Appeal which dealt with the complex issue of the treatment of overheads when assessing damages, and considers the extent to which the treatment of overheads may be the same for damages or profits to be disgorged.

Which costs should be deducted?

"It depends"

As with many complex questions, whether 'overheads' should be deducted in estimating damages or profits to be disgorged, initially must be answered with "it depends". So what does it depend on?

Damages are estimated "so as to place a party, who has sustained loss by reason of a breach of contract, in the same situation with respect to damages, as if the contract had been performed." 1 That is, it aims to estimate the monetary impact the alleged breach or wrong has had (and will have) on the Plaintiff's cash flows 2 .

An account of profit is aimed at disgorging the profits which the wrongdoer has made as a result of the alleged breaches or infringement. Whilst this is slightly different in nature from damages, the treatment of 'overheads' is something that impacts on both exercises.

There is therefore often debate regarding what costs are to be taken into account when arriving at damages or profit estimates, particularly for what are sometimes referred to as either 'overheads' or 'indirect costs'.

What are 'overheads'?

There are a number of terms or jargon used in accounting which most lawyers might assume are 'terms of art' with fairly strict definitions. However, many such terms are not specifically defined by accounting standards, legislation or usage, and therefore it is important to understand these terms and how they are being used.

Direct or indirect costs?

One characterisation of costs is between 'direct' and 'indirect' costs. Direct costs are "related to the particular cost object and can be traced to it in an economically feasible way". They are costs which are directly related to the production of specific goods for sale or services, sometimes referred to as 'cost of sales'. This contrasts with 'indirect' costs. Indirect costs are "related to the cost object but cannot be traced to it in an economically feasible way" 3 .

Fixed versus variable costs?

This is another way of classifying costs. Fixed costs are those that, over a period of time, are not expected to vary with levels of production or activity. Rental may be an example of a fixed cost. Variable costs vary with levels of production or activity. Over longer periods of time all costs are variable, but over short periods many costs are fixed in nature. There are some costs that are 'step-fixed' i.e. they...