Australia: In estimating damages, are overheads fixed and does it matter?
Damages Matters

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 are fixed for smaller changes in levels of operation, but then might require a 'step' increase. An example might be factory rental; it is fixed until the capacity of the working area is fully utilised, at which time an extra factory (i.e. the next 'step' of cost) might be required.

Sometimes the phrases 'indirect costs' and 'overheads' are used to mean the same thing, however both 'direct' and 'indirect' costs can be a mix of 'fixed' and 'variable' costs; generally speaking overheads are mostly 'indirect' and are more likely to be 'fixed' in nature, but the categorisations are far from a perfect match.

Which costs should be deducted?

It is fairly straightforward that all variable costs should be deducted in arriving at damages or an account of profit. This is regardless of whether they are indirect or direct costs, or whether they have been classified as overheads or not. Whether costs are variable is a function of the scale of change in activity related to the change in that category of cost.

Difficulties arise however when categorising 'indirect' costs or 'overheads'. These may include both fixed and variable costs and are not properly defined by any accounting standards. These types of costs bear no obvious relationship to individual units of product, but they must be incurred for production to take place ⁴ .

The position is further complicated by the fact that different management accounting systems do not necessarily categorise costs as either fixed or variable. For instance, 'absorption costing' includes a proportion of fixed overheads as a part of the product's costs of production ⁵ .

So what should we do?

There is a lack of clarity in accounting practice and standards on how to address this issue, but the cases tell us that there is a need to look to the true nature of each specific cost, and be particularly careful to clearly set out the assumptions that are relevant to the case.

Case examples

North Sydney Leagues' Club Limited v Synergy Protection Agency Pty Limited [2012] NSWCA 168

Synergy Protection Agency ('Synergy') (the Plaintiff) provided security services to North Sydney Leagues Club Limited ('Norths') at the Defendant's premises. Following the early termination of its contract the Plaintiff issued proceedings against the Defendant for damages.

In the original case damages were awarded to the Plaintiff for a breach of contract. The Defendant appealed with the intention of reducing these damages (or revenue) awarded to reflect:

• inflation for costs
• "indirect or overheads costs".

The Appellant (Norths) in its appeal relied on a decision in the case of Dart Industries Inc. v Décor Corporation ⁶ (more on this later) where 'overheads' were taken into account to reduce the total profits awarded to the Plaintiff.

Alternatively the Appellant argued that "indirect or overheads costs" should reduce damages on a 'pro rata' approach in the same way that variable costs would, given that these costs "were necessary to be incurred in earning the contract sum". The Appellant contended that as the contract represented 30% of Synergy's total revenue that fixed costs would be apportioned to this revenue on a pro rata basis. His Honour (on appeal) stated "...it would be inaccurate to postulate that simply because a contract represents 30% of one's business, there will be a 30% saving if that contract ended."

The trial judge held that inflation should be applied to costs (except rent) at 2.4%, however on the issue of overheads, the Judge held that these should not be taken into account and the approach taken by the Plaintiff in the initial calculation of damages was the correct one as the Plaintiff had:

"looked at each expense individually, irrespective of whether it [was] a direct cost or overhead and determined what cost was saved as a result of the loss of the [contracts with the appellant]".

Costs such as rent and salaries of office staff were excluded as these continued to be paid at the same levels, even though the revenue received by Synergy was reduced by 30%. The underlying logic of the trial judge, which was upheld on appeal, is that the goal of damages is to "place Synergy in the position they would have been had the contract [not] been breached" thus to deduct from profits, costs which continued to be paid throughout the period by Synergy would be unfair.

Dart Industries Inc. v Décor Corporation Pty Ltd ('Lettuce Crisper Case') [1993] HCA 54A

This case dealt with an account of profits, and the Appellants in Norths attempted to rely on it as a basis to reduce the awarded damages. In Dart v Decor the Plaintiff elected for an account of profit for the infringement of a patent, the 'Lettuce Crisper', by the Defendant. The Defendant contended that as they used the method of absorption costing (i.e. fixed overheads were allocated to the products) that the profits to be awarded to the Plaintiff for the infringement should be reduced by such overheads. On appeal this case dealt with two issues:

• Is part of an infringer's overheads deductible in taking of an account of profits ordered as a result of the infringement?
• If so, what is the principle or rule which determines what proportion of the overheads is allocated to the infringing product?

The Judge in his findings, allowed for a deduction for overheads from the profits. In allowing these deductions Dart v Décor took into account the concept of opportunity cost i.e. if Décor had not produced the infringer's product it would have produced another, non-infringing, product and this alternative product would have absorbed part of the overheads and that:

"where the defendant has foregone the opportunity to manufacture and sell alternative products it will ordinarily be appropriate to attribute to the infringing product a proportion of those general overheads which would have sustained the opportunity. On the other hand, if no opportunity cost was forgone and the overheads involved were costs which would have been incurred in any event, then it would not be appropriate to attribute the overheads to the infringing product."

His Honour went on to state "the appropriate method of allocation will depend upon the nature of the business in question and the circumstances of the cases."

The Judge found:

"In determining an account of profits in respect of the infringement of a patent, any part of general overheads of the infringer which assisted in deriving gross revenue from the infringing product is a deductible expense".

Therefore if an infringer can prove overhead was allocated to a product and they are able to provide "a fair and reasonable method of allocation" a deduction for the allocation of overhead should be allowed in an account of profits. This issue was further clarified in Kettle Chips v Apand ⁷ where it was found that an allowance for overheads in an account of profit is only allowed to the extent that there was an "alternative non-infringing" product that would have been produced if the infringing product had not been produced and "the contribution that might have been made by [that] alternative product". The allowance for overheads was determined based on the percentage of actual profits that could be expected to be made from that alternative product and not the infringing product. Therefore a proportion of the overheads would have been 'absorbed' by the alternative product and this should be recognised in the account of profit.

Conclusion – it really does depend!

It is apparent from the above cases, that the approach taken by judges in considering the amount to award in damages is not dissimilar to the approach taken by a forensic accountant, although the language used by the two groups may not always be the same. When considering, in either the assessment of damages or an account of profit, whether overheads should be deducted, and if so how much, it is important to remember that there is not a one size fits all approach for the treatment of overheads. Indeed there is likely to be debate as to what constitutes 'overheads', even before agreeing on their treatment. The simple approach of categorising costs as either variable or fixed is not always sufficient to identify which costs and a more detailed investigation is often required to establish a causal link to the breach.

When looking at what are overheads and how then they are to be treated, it is important that the forensic accountant works with the legal and factual matrix of the specific case. Whilst this case, Dart v Décor and other cases on this point provide some guidance of what to do when looking at whether overheads should be taken into account it is important to understand the nature of the dispute, the nature of the business or industry and the nature of the expense.

Typically each line item or type of cost in the detailed profit and loss statement should be considered to assess whether it is fixed, variable or step variable or has some other relationship to revenue, and instructions may be required as to the appropriate legal frameworks to be used for the allocation of these costs. The forensic accountant will need to consider the exact nature of the cost, and whether that cost would have changed during the specific loss period if either no other product had been produced or an alternative product had been produced to determine whether it should be taken into account. This will, in part, depend on the scale and time period of events being considered.

The treatment of those costs that are truly 'fixed' over the scale of change and time period of the dispute will depend on the relevant 'counter factual' or 'but for' scenario(s). It is essential these are clearly understood and agreed with the legal team. This is a key area where it is important for the instructing solicitor and forensic accounting expert to actively discuss and agree on the potential scenarios that need to be considered to reflect potentially different legal and accounting assumptions on 'overheads'.

Endnotes

¹ Robinson v Harman (1848) 1 Exch 850 at 855. See also Western Web Offset Printers Ltd v Independent Media Ltd [1996] CLC 77 at [79] and The Commonwealth of Australia v Amann Aviation Pty Ltd [1991] HCA 54; 174 CLR 64 at 81.
² Often profit is used as a surrogate for cash flows, but it is important to assess whether this is appropriate, as ultimately it is the lost cash flows that need to be measured as the wronged party will be given a sum of cash as compensation.
³ Cost Accounting, Horngren.
⁴ Management Accounting 5E, Information for Creating and Managing Value, Langfield et al (2009).
⁵ Management Accounting 5E, Information for Creating and Managing Value, Langfield et al (2009).
⁶ Dart Industries Inc v Décor Corporation Pty Ltd ('Lettuce Crisper Case') [1993] HCA 54.
⁷ Kettle Chip Co Pty Ltd (now known as ACN 003 655 132 Pty Ltd) v Apand Pty Ltd (formerly CCA Snack Foods Pty Ltd) & Anor [1998] FCA 586 (2 June 1998).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.