Is There Capacity? Mitigating Revenues Versus Additional Revenues in Breach of Contract Damages Claims
By Jesse LaGrossa, Manager, Business Valuation, Forensic & Litigation Support Services
In our field, we often hear measures of economic damages (i.e., lost profits) offered by a plaintiff’s expert. They sometimes suggest that, but for the defendant’s actions, the plaintiff would have purchased a winning lottery ticket (metaphorically speaking). This invariably raises the question: Does the plaintiff have (or did they have) the ability to achieve the historical and future sales figures being purported? In other words, did the plaintiff have the resources needed to meet the “but for” sales being proffered?
It is no surprise, then, that there exists a plethora of technical guidance for experts on the alleged reasonability of lost revenues and whether a company has the capacity to fulfill projected sales. “Capacity” can be defined as:
- The maximum amount that something can contain; and
- The amount that something can produce.
Here is a relatively straightforward hypothetical scenario illustrating a breach of contract.
A company (buyer one) contractually agrees to purchase 500 units of product per year from a manufacturer (seller) at an agreed-upon price per unit for a specific commitment term (i.e., five years). Accordingly, the seller expects to earn profits equal to the estimated profit (i.e., price per unit, less incremental costs) per unit x 500 units x 5 years.
After year one, buyer one decides it no longer wants to purchase the seller’s product, and terminates the contract. While there may be a myriad of legal issues for counsel and the court to consider, let’s assume the seller has an enforceable breach of contract claim against the buyer and is seeking lost profits as a measure of compensatory damages.
The seller now has available production capacity previously reserved to produce goods for the buyer, so it finds a new customer (buyer two) to purchase 500 units per year for the next four years. Assuming the seller secured the same pricing terms with buyer two as defined in its contract with buyer one, the seller has successfully mitigated their losses and incurred (all things being equal) no actual1 lost profits. Correct?
Let’s assume the seller, despite landing buyer two, continues to pursue damages claims against buyer one.
Did the seller have the practical capacity to honor its commitments to both buyer one and buyer two simultaneously? This question touches upon a couple of damages concepts.
Lost Volume Seller
As defined by case law, a “lost volume seller is one who has the capacity to perform the contract which was breached as well as other potential contracts, without resource or capacity constraints.”2 The relevant question here: Did the seller have the capacity to service both buyer one and buyer two, before buyer one’s breach?
- If yes, then the seller may be a “lost volume seller.”
- If the seller only has available capacity because of buyer one’s breach, then they are not a lost volume seller.
Theoretical Capacity Versus Practical Capacity
All businesses, regardless of the industry, have capacity constraints in some form. Each industry has its own nuanced “capacity” terminology generally expressed in terms of input (i.e., quantities of available materials, availability/productivity of labor, shop space, etc.) and output measures (billable hours, units per day, etc.).
There is also a concept of “practical” capacity — usually some percentage of “maximum” capacity. For example, a manufacturer may be able to produce 100 units in a day if their equipment and team are operating 24 hours per day. However, for various reasons, this may not be practical (i.e., employee breaks, equipment maintenance, etc.).
Compensatory damages claims in breach of contract matters are predicated upon the theory that damages are the amount required to restore the plaintiff (the seller, in this example) to the same economic position “but for” the breach. Any amount in excess may be considered a “windfall.” When assessing economic damages, both theoretical and practical capacity should be considered. Without such an analysis, a measure of damages could be considered speculative.
- “Actual” damages in this hypothetical are intended to mean lost profits. Seller may have incurred direct costs before and after the breach which are deemed to be “actual” damages.
- Penncro Assoc. v. Sprint Spectrum. 499 F.3d 1151 (10th Cir. 2007) quoting from Bill’s Coal Co. v. Board of Public Utilities of Springfield, Mo.