Whether it is in the context of determining lost profits in a breach of contract, patent infringement, or other litigious dispute, or when conducting an accounting of profits in an infringement matter, the concept of "incremental cost" can be a contentious one. Over the years, I have been asked a lot of questions by litigation lawyers about what various "cost" concepts mean. Set out below are some of the more common questions that I am asked as well as an explanation of various accounting concepts that are relevant in calculating damages and losses for purposes of litigation.
A good starting point is the following quote from Teledyne v. Lido, where Addy J stated:
"...the infringer is entitled to deduct only those expenses, both variable and fixed, which actually contributed to the sums received and for which he is liable to account. It follows that no part or proportion of any expenditure which would have been incurred had the infringing operation not taken place, is to be considered as deductible."
This quote is in the context of an accounting of profits. The concept of deducting only those costs that would not have otherwise been incurred had the infringing operation not taken place is generally referred to as "incremental" or differential cost. The incremental cost concept is applicable in both an accounting of profits and a lost profits/damages calculation, with one significant difference: it is the Plaintiff's incremental costs that are deducted in a lost profits/damages calculation and the Defendant's incremental costs that are deducted in an accounting of profits.
The financial information required to assess incremental costs is generally included in the Plaintiff's or Defendant's accounting records. It is important to note that not all costs (i.e. expenses) that are deducted for accounting purposes are incremental costs or otherwise deductible for purposes of calculating losses for purposes of litigation.
With that backdrop, here are some oft-asked questions relating to accounting concepts in the context of calculating losses:
How does an income statement assist in identifying and quantifying incremental costs?
An income statement summarizes a company's revenues and expenses for a certain period, generally monthly or annually. The annual or fiscal year-end income statement may be audited or reviewed by the company's external accountant/auditor. The format and level of detail varies from company to company, but are most often presented:
- By expense type or category (eg. wages, professional expenses, rent); and/or
- By department (eg. Manufacturing cost of sales, General & Administrative, Selling and Marketing)
If the information disclosed in the company's income statement is summarized in broad categories, more detailed information is often sought from other financial documents, such as:
- Trial balance
- General ledger
- Budget to actual variance analysis prepared for management
Do all companies include the same kinds of expenses in cost of sales?
Cost of sales (or cost of goods sold) refers to the cost of those goods a business has sold during a particular period. The types of expenses included in cost of sales vary based on the costing methodology adopted by each company. Cost of sales may include:
- Raw materials
The degree to which overhead costs are included in cost of sales depends on the costing methodology employed.
Does incremental cost always include at least "cost of sales" on the company's income statement?
Not necessarily. The answer will depend on factors such as: the costing methodology adopted and the types of expenses included in cost of sales; the magnitude of infringing product sales volumes relative to non-infringing sales volumes of the infringer (for accounting of profits) or the plaintiff (if lost profits/damages), the nature of the infringing product (e.g. whether it is a standalone product or part of another non-infringing product).
What types of costing methods are there?
There are two primary costing methods a company can adopt: Full absorption and Direct costing. Full Absorption costing (also referred to as absorption costing or full costing) means that all of the manufacturing costs are absorbed by the units produced. In other words, the cost of a finished unit will include direct materials, direct labor, and both variable and fixed manufacturing overhead. Under direct costing (also called variable costing), the fixed manufacturing overhead costs are not allocated or assigned to the products manufactured.
What do the following cost terms mean?
i) Variable Costs - costs that change in proportion to the level or volume of goods or services produced. Variable costs may be direct (e.g. labour, materials) or indirect (e.g. overhead).
ii) Direct Costs - costs that can easily be associated with the production of a particular product. For example, the salaries and benefits of employees that work on the production line are generally categorized as a direct labour cost.
iii) Indirect Costs - are not directly associated with the production of a product and can be fixed or variable in nature. For example, the salaries and benefits of production line supervisors may be considered an indirect cost.
iv) Fixed Costs - costs that are not dependent on, or don't vary with, the level of goods or services produced by the business. They tend to be time-related, such as administrative staff salaries or monthly rental expense. Fixed costs may be referred to as overhead costs.
v) Semi-variable Expenses - costs that have a component that varies with volumes or other production activity, and a component that is fixed. For example, sales people may be compensated by way of a fixed salary plus a commission based on sales or rent expense may be comprised of base rent plus a variable portion that is contingent on sales levels.
vi) Step-Variable Costs - Costs that are fixed over smaller volumes but vary once a certain threshold of volume is reached. For example, production line supervisors – a supervisor's salary is generally fixed. However, as volumes increase and additional production lines are added, more line supervisors are needed, and the total salary expense increases.
Does Incremental Expense Mean Variable Expenses Only?
It depends on the specific facts of each case. Incremental costs can include some or all of the following: variable costs, fixed costs, semi-variable costs, and step-variable costs.
The accounting profession has numerous terms that are used to categorize different kinds of costs, including those set out above. Lawyers have the challenge of not only understanding what these concepts mean, but how they apply to a determination of financial loss.
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.