Full Absorption vs. Variable Costing in Lost Profits Calculations

Full Absorption vs. Variable Costing

In lost profits calculations, a key consideration is choosing between full absorption or variable costing:

• Full absorption: Allocates both variable costs and some portion of fixed expenses (e.g., rent, salaries, insurance)
• Variable: Allocates costs that vary with sales volume (e.g., labor, materials, commissions.) and treats fixed expenses as unavoidable costs incurred regardless of sales volume

Courts generally prefer variable costing because it measures lost profits by subtracting the costs avoided as a result of the lost sales (i.e., variable costs) and excludes fixed costs that are incurred regardless of sales volume. In comparison, full absorption costing typically understates lost profits by deducting some portion of fixed costs.

When measuring lost profits, variable costing aligns with “but-for” calculations’ incremental loss principle: only expenses saved because of the wrongful act (avoidable costs) reduce damages. By excluding fixed costs that a business continues to incur, variable costing helps ensure lost profits are not understated and better reflects the income a plaintiff may have generated. By contrast, a full absorption approach can conflict with the incremental loss principle by including non-avoidable fixed expenses.

A simple example shows how this works:

Common Pitfalls

A frequent error in lost profits analyses is failing to properly analyze cost behavior. This can understate or overstate lost profits, but it most often understates lost profits by incorporating excess expenses.

To avoid these pitfalls, each expense should be classified as fixed, variable, semi-variable, or step-fixed using cost or account analysis. Overhead, when semi-variable or step-fixed, can be included as incremental costs when lost revenues are significant enough that additional cost is necessary in the but-for world. For example, if the lost sales volume requires additional manufacturing capacity/equipment or additional sales/customer support staff, those incremental costs may be necessary to support the lost revenue.

The goal of a credible lost profits analysis is to match the economic reality of such expense; if additional expense is necessary to support the but-for sales, it should be treated as incremental and deducted. If not, it should not reduce the lost profit calculation.

Conclusion

In summary, full absorption and variable costing differ in how they treat fixed costs, and that difference can significantly impact lost profits calculations. Full absorption costing, by including fixed costs, can understate lost profit if mechanically used. Variable costing focuses on costs tied to lost sales and generally produces a sound measure of lost net profits, which is why it is widely preferred by damages professionals and courts.