The courts of Missouri have recognized that a lost profits damages award may be an appropriate remedy in a variety of breach of contract, tort and business interruption cases.² When lost profits damages are appropriate, the courts agree that net lost profits are recoverable; that is, lost revenue is estimated and expenses attributable to the production of that income are deducted from estimated lost revenue.³ This article examines the treatment of fixed overhead expenses in calculating lost profits damages.

In general, overhead expenses include the continuous expenses of the business, regardless of the expenditures on a particular contract or portion of business.⁴ Thus, overhead expenses may include general office expenses, general supervision, depreciation, management, rent, insurance, taxes, furniture, general utilities, communication equipment, or other expenditures that are not directly related to the performance of a particular contract or segment of business.

Fixed overhead expenses are those expenses incurred regardless of the volume of output. They do not vary with the volume of business.⁵ At times, expenses which are generally considered to be overhead may fluctuate as the volume of business increases or decreases. These variable overhead expenses, also referred to as direct or variable expenses, consist of those overhead type of expenses directly linked to, or which fluctuate with, the volume of output.⁶ Other direct expenses include such items as labor, materials, shipping costs and sales costs, which fluctuate with the volume of output.⁷ In this article, direct or variable overhead expenses and all other direct or variable expenditures costs will be referred to as variable costs.

In lost profits damages cases, the districts of the Courts of Appeals in Missouri are split on the issue of whether fixed overhead must be deducted from lost revenues in calculating lost profits.⁸ The Supreme Court, when presented with the opportunity to clarify the split of authority, did not resolve the issue.⁹ Likewise, there is a split of authority in other jurisdictions on the issue of whether a claimant for lost profits damages must deduct the fixed overhead expenses in a lost profits damages calculation.¹⁰ Commentators express differing views.¹¹

The rule which the courts of Missouri should adopt and follow (the preferred rule) is that fixed overhead should not be deducted from lost revenue when making lost profits damages calculations.

Split Of Authority In Missouri Cases

Eastern District Of Missouri

The approach of the Eastern District of the Missouri Court of Appeals is exemplified by the court's opinion in Meridian Enters. Corp. v. KCBS, Inc.¹² In Meridian, the plaintiff, a travel agency, alleged that the defendant wrongfully deprived plaintiff of the business of handling a 1990 trip to Hawaii, including arrangements for numerous employees of Pier I. Meridian claimed lost profits damages.

At trial, Meridian presented evidence of its expected revenues from the lost business. It presented evidence of expenses directly attributable to the business, such as cost of air travel, hotel, meals, gratuities and other variable costs that would have been incurred had Meridian performed the services encompassed by the lost business. Meridian did not present any evidence of "any overhead expenses" or expenses for its overall program director. According to Meridian's evidence, overhead expenses attributable to the lost business and the cost for the program director were zero because the "overhead was ongoing" and would not have changed had it performed the lost Pier I business. Therefore, Meridian did not deduct any overhead expenses in its lost profits damages calculation.

At the conclusion of Meridian's evidence, the trial court granted a motion for directed verdict ruling that Meridian had not proven its damages. On appeal, the Eastern District of the Court of Appeals affirmed. With respect to overhead expenses, the court stated:

Meridian's evidence failed to establish the overhead expenses which would have been attributable to Meridian's work for the 1990 trip. . . . The fact Meridian's overhead costs would have been expended when Pier I took the 1990 trip or was "ongoing" does not negate the requirement Meridian present evidence of the overhead costs attributable to the 1990 trip. Although not classified as overhead, Meridian further failed to introduce evidence of costs for its program administrator.¹³

The court made no specific damage or accounting analysis. Rather it justified its decision by merely stating, "The cost and expense of operation [overhead] is a considerable item and in an action for loss of profits is an essential item in the proof of damages."¹⁴ In making this statement, the court in Meridian relied on general statements from the Supreme Court of Missouri in Coonis v. Rogers¹⁵ concerning the need to present evidence on, and take into consideration, various factors such as depreciation, cost and expenses of operating the business.

The statements in Coonis were appropriate for the facts in that case because the plaintiff failed to present evidence of variable or fixed expenses. However, the court in Meridian relied upon Coonis for the express proposition that fixed overhead expenses must be deducted from revenues as part of a net profits calculation. Moreover, the court in Meridian is not alone in its suggestion that all expenses, including fixed overhead, must be deducted. Thus, for example, in Brown v. McIBS, Inc.,¹⁶ the court stated that "overhead, rents and other expenses must all be deducted from sales before net profits can be determined." In Morrow v. Missouri Pacific Ry. Co.,¹⁷ the court held that profits consist of the advantage or benefit "remaining after all costs, charges, and expenses have been deducted from the income. . . ." Likewise, in Rich v. Eastman Kodak Company¹⁸ (applying Missouri law), the court made a blanket statement that "it was necessary to include all salaries as expenses in determining net profit of the company."¹⁹ Additional broad statements to the effect that fixed salaries, insurance and depreciation on equipment are expenses that must be deducted from revenue in lost profits damages calculations are contained in All Star Amusement, Inc. v. Jones.²⁰

Furthermore, the Eastern District Court of Appeals, in the case of Skinner v. Thomas,²¹ recently held that "a plaintiff fails to make a submissible case of damages if plaintiff does not introduce evidence of overhead expenses such as mortgage or rent, utilities, and salaries attributable to the business producing the income . . . [P]laintiff's failure to produce evidence of overhead expenses prevents them from making a submissible case." While this case should be viewed as a failure to meet the burden of proof case, the dicta in the case will no doubt be used by litigants to argue that all overhead costs, fixed or variable, must be deducted in a lost profits case.

Other Courts of Appeals In Missouri

Contrary to the proposition expressed in the Eastern District cases that fixed overhead must be deducted in making a lost profits damages calculation are Missouri cases holding that fixed overhead is not deducted from lost revenues in making a lost profits damages calculation. E.g., MFA Coop. Ass'n No. 86 v. Stone, et. al;²² All Star Amusement, Inc. v. Jones²³ (holding that where the business operated in multiple locations, it was not necessary to show expenses except as attributable to that portion of the business which was lost); Orr v. Williams²⁴ (holding that income and expenses attributable to a segment of business lost, not as to the entire business, must be shown).

In MFA, a farm supply dealer sued to collect monies due for cattle feed, fertilizer and other farm supplies furnished to milk producers. The defendant milk producers counterclaimed, alleging that certain ingredients (ASCDP) found in the feed they purchased from MFA caused their cattle to produce less milk. They presented evidence of the amount of revenue they lost as a result of decreased milk sales. The milk producers' testimony was that, except for certain variable expenses relating to the lost amount of milk, their costs would not have changed.

The Southern District affirmed a jury verdict that was reached without any evidence of the deduction of overhead expenses. In attempting to distinguish the case from Meridian and Coonis, the Southern District stated:

Here, the hypothesis of Defendants' claim against MFA was that the milk produced by Defendants' herd diminished because of the ASDCP. Nothing in the record suggests Defendants' operating costs during the period in dispute would have been higher had the herd produced the customary amount of milk. Said another way, there was no evidence that it would have cost Defendants any more to produce the "lost milk" plus the actual milk than it did to produce the actual milk alone.

Consequently, the jurors could have reasonably concluded that the profits Defendants lost could be readily ascertained from the evidence adduced at trial.²⁵

The issues in MFA and Meridian were the same: Should fixed overhead be deducted from lost revenue in calculating lost profits damages? Both of the claimants in Meridian and MFA presented evidence that their operating costs would not have changed. In Meridian, the Eastern District held that failure to deduct overhead expenses was fatal to the plaintiff travel agency's damage calculation. In MFA, the Southern District held, without citation of specific authority, that it was not necessary to deduct overhead expenses in the claimant milk producers' lost profits calculation.

Perhaps the difference between the two cases can be explained in terms of the allocation of the burden of proof, a matter of procedural law. In Meridian, the Eastern District stated that plaintiff's evidence that the overhead costs were ongoing did not negate Meridian's need to present evidence of overhead costs attributable to the lost business. If the issue is burden of proof, the Southern District in MFA changed the burden for its claimants. In MFA, the court appears to place the burden on the party defending the claim for damages to show that operating costs with respect to the lost milk production would have been higher had the milk cows produced the customary amount of milk.²⁶ Whether the cases are analyzed in terms of substantive law (whether fixed overhead must be deducted in a lost profits damage calculation) or in terms of burden of proof (whether the claimant must positively show that overhead expenses would not vary if the lost business had been performed), Meridian and MFA present conflicting case law.

The Supreme Court of Missouri

Amid these differing views and approaches, the question of deducting fixed overhead was squarely presented to the Supreme Court of Missouri in High Life Sales Co. v. Brown-Forman Corp.²⁷ High Life Sales, a liquor distributor, sued Brown-Forman, a supplier of liquors and wines, for wrongfully terminating High Life Sales' franchise to sell California Cooler wine. With respect to damages, the uncontradicted testimony of High Life Sales' expert was that California Cooler was an "'add-on' product" in High Life Sales' extensive line of liquor and wine products. High Life Sales' damage expert witness testified that the revenue from California Cooler constituted a very small percentage of gross sales of High Life Sales and that High Life Sales' operating expenses (overhead) were not increased when California Cooler was added as a product, nor were they decreased when the product was removed. In calculating lost profits, the damage expert did not reduce projected gross profits by those overhead expenses that remained unchanged from the loss or addition of the California Cooler product. He reduced projected gross profits by the "direct expenses," such as sales commission, advertising and inventory financing costs, which were directly attributable to the California Cooler product.

Brown-Forman contended that plaintiff's calculation was improper. It asserted that the proper measure of damages required the deduction from projected revenues of a pro rata share of all overhead expenses in making a lost profits calculation. Brown-Forman moved to strike the damage calculation testimony of High Life Sales' expert damage witness because his calculations did not include a deduction for overhead expenses. The trial court denied the motion to strike the damage calculation testimony.

On appeal, the Supreme Court addressed the precise issue about which Meridian and MFA differed -- whether fixed overhead should be deducted from lost revenue in calculating lost profits. The Court recognized that it had before it an issue concerning the substantive law of damages. Nonetheless, it did not resolve the issue. While rejecting Brown-Forman's position that a lost profits damages calculation that did not deduct overhead expenses should be stricken, the Court stated that "it was proper for the jury to determine under all the evidence whether High Life was damaged and, if so, to what extent."²⁸

Thus, instead of clarifying the law and articulating the proper measure of damages in a lost profits case, the Supreme Court left to the jury the determination of whether fixed overhead costs should be deducted. Perhaps the Court was concerned about the potential impact of the case on the use of general M.A.I. damage instructions. Likewise, based upon the Supreme Court's lengthy discussion of the evidence, the Court may have concluded that the jury made a just disposition of the case.

Nevertheless, the Court's decision to allow the jury to determine whether fixed overhead costs should or should not be deducted is difficult to justify. High Life Sales was not a case where there was an issue of fact as to whether the overhead expenses were fixed or variable. It was uncontroverted that the overhead expenses in question were fixed. Either fixed overhead, as a matter of law, should be deducted or should not be deducted from lost revenues in a lost profits calculation. Pursuant to the holding and teaching of High Life Sales, will juries determine the issue of damages without adequate direction on the proper measure of damages? Without a doubt, parties will continue to argue that fixed overhead expenses should or should not be deducted as it serves their own interests, unless the courts of Missouri focus on this issue and clarify the law.

What Should Be the Law of Missouri?

A claimant has the right to recover damages for the detriment suffered or the benefit lost caused by a breach of duty owed to claimant or by a wrongful act. More specifically:

The stated goal of the damages remedy is compensation of the plaintiff for legally recognized losses. This means that the plaintiff should be fully indemnified for his loss, but that he should not recover any windfall. Stated in this way, damages is an instrument of corrective justice, an effort to put the plaintiff in his or her rightful position.²⁹

Obviously, a claimant should recover in damages no more and no less than what the lost opportunity would have yielded. For example, contract damages should "put the injured party in as good a position as that in which he would have been put by full performance."³⁰ If the business had not been lost, what amount, if any, would have been added to the bottom line of the claimant's financial statement?

Not requiring the deduction of fixed overhead from lost revenues in a lost profits case best achieves the ends of the basic theory of damages. In a case such as High Life Sales, where it is uncontradicted that the lost business opportunity would not increase overhead expenses for the claimant, such expenses should not be deducted. Simply stated, "The only matter of concern is the detriment suffered or the benefit lost as a result of the breach. . . . If the fixed expenses neither increased nor decreased as a consequence of the nonperformance of the contract, there would be no loss or benefit arising from that factor."³¹

When overhead is fixed and the lost business produces no savings in overhead expenses, the lost business only costs plaintiff its direct expenses associated with such business, and no deduction from profits for fixed overhead should result.³² Therefore, the law should be that fixed overhead not be deducted in a lost profits damages calculation.

Defendants in lost profits cases will frequently argue that this preferred rule ignores modern accounting practices. They contend that businesses routinely use cost accounting models that allocate all expenses, including fixed overhead, to units of production. To do otherwise, it is claimed, violates generally accepted accounting practices.

It is true that many businesses and successful businessmen use cost accounting techniques to ensure that the prices charged for their products or services cover all of their expenses. "However, because it is useful for planning purposes to allocate a portion of overhead to each transaction, it does not follow that this allocate share of fixed overhead should be considered a cost factor in the computation of lost profits on individual transactions."³³ Cost accounting is a business management tool. It allocates variable costs and fixed overhead to all aspects of the business, rather than to individual transactions. Cost accounting, however, does not provide a view of the actual change on the financial statement's bottom line resulting from lost opportunity. It only provides an analysis of cost allocation per unit of production.³⁴ Cost accounting is not the same as accounting for damages.

The fallacy of the cost accounting argument can easily be demonstrated. In a case where a company has fixed overhead of $10,000 and performs five similar contracts, the allocated overhead cost is $2,000 per contract. However, if one contract is breached, the allocated overhead cost rises to $2,500 per contract, reducing the profitability of each of the four remaining contracts and the overall profitability of the company. Whether viewed on a contract by contract profit basis or on a company-wide "clear" profit basis, a claimant's overall profitability will be reduced by the loss of a contract since each unit of production must bear a greater portion of the overhead if fixed overhead is deducted.³⁵ The end result of the analysis is that the company's true measure of loss of profit when overhead is fixed is the lost revenue less the direct expenses.³⁶

For example, as it was shown in MFA, the milk producers had already paid for the fixed overhead cost out of the revenues generated from the milk that was produced. Thus, if the court requires the milk producers to again deduct a pro rata share of fixed overhead costs in connection with the lost profits damages calculation, the milk producers pay for those fixed overhead costs more than once. Because the fixed overhead is paid from revenues from the milk produced, the impact of the lost milk production on the financial status of the mild producers is merely the loss of revenue less variable costs, if any, the milk producers saved.

Likewise, in High Life Sales, if the Court requires an allocation and deduction of fixed overhead from the lost California Cooler sales revenue, High Life Sales' financial bottom line is affected twice by the fixed overhead costs -- initially when the costs were actually paid and, finally, when the court deducts a pro rata portion of those same costs from the estimated lost California Cooler revenue. By any analysis, if fixed overhead must be deducted in the lost profits calculation, the injured party is in a worse overall financial position than if the contract had been performed.

The Uniform Commercial Code Incorporates the Preferred Rule

The Uniform Commercial Code adopted in Missouri mandates that "reasonable overhead" (interpreted in Missouri as fixed overhead)³⁷ should not be deducted in lost profits damage cases governed by the UCC.³⁸ Therefore, by statute, the preferred rule in Missouri has been established in UCC cases.

Under UCC § 2-708(2), the analysis of Missouri courts is consistent with general damage principles expressed above in this article. Thus, in American Laminates, Inc. v. J.S. Latta Co.³⁹ the plaintiff sued for lost profits damages resulting from the defendant's wrongful cancellation of purchase orders. The court awarded lost profits damages under UCC § 2-708(2). In responding to arguments commonly made to require the deduction of fixed overhead, the court rejected the defendant's argument that, by not deducting fixed overhead, the plaintiff received a windfall. It correctly pointed out that, in fact, the opposite is true. Total profits would be reduced unjustly if courts require fixed overhead, already paid once, to be deducted from lost revenues in the lost profits damages calculation. Following the preferred rule, according to the court in American Laminates, Inc., puts the plaintiff in "as good a position as it would have enjoyed had [defendant] performed this agreement."⁴⁰

The considered view of the drafters of the UCC lends considerable support to the proposition that the approach advocated in this article should be applicable to all lost profits cases tried under Missouri law. With the preferred rule now being mandated in all UCC cases, courts will be less likely to automatically rely on language from old cases that may not be on point or that are not well considered. Courts will have the opportunity to refocus on underlying principles of compensation for damages and less on inapplicable accounting techniques. The time is ripe for Missouri courts to establish the preferred rule as a uniform rule in all lost profits cases.

Conclusion

The confused state of the law in Missouri concerning fixed overhead costs in lost profits cases begs for clarification. The law should require a claimant seeking lost profits damages to calculate those damages by presenting admissible evidence of estimated lost revenue and admissible evidence of all variable costs that are deducted from these estimated lost revenues to determine claimant's lost profits. In this regard, a claimant should bear the burden of proving that overhead-type costs are fixed costs; otherwise, the overhead costs will become part of the variable costs required to be deducted from the estimated revenues in the lost profits calculation. When the evidence is uncontradicted that certain overhead-type costs are fixed, as in MFA and Meridian, the court, by instruction or other limiting action, should preclude the factfinder from deducting fixed overhead costs from estimated lost revenue. However, when the claimant's and defendant's evidence present a true issue of fact as to whether overhead expenses are fixed or variable, the court should instruct the factfinder, in determining a lost profits damage award, to deduct or not deduct from estimated lost revenues overhead costs depending upon the factfinder's determination of those costs' fixed or variable nature.

© 2000, H. Kent Munson

Endnotes

¹ Mr. Munson is a partner in the law firm of The Stolar Partnership, where he practices in the areas of commercial litigation and employment law. He received his J.D., 1973, from Duke University Law School. He is a past president of the Bar Association of Metropolitan St. Louis.

² See, e.g., Refrigeration Indus., Inc. v. Nemmers, 880 S.W.2d 912, 920 (Mo. App. W.D. 1994) (breach of covenant not to compete); Meridian Enterprises Corporation v. KCBS, Inc., 910 S.W.2d 329, 331 (Mo. App. E.D. 1995) (tortious interference with business relationship); Scullin Steel Co. v. Paccar, Inc., 708 S.W.2d 756 (Mo. App. E.D. 1986) (breach of sales contract); Coonis v. Rogers, 429 S.W.2d 709 (Mo. 1968) (business interruption resulting from interference with contractual relationship).

³ Coonis v. Rogers, 429 S.W.2d at 714; Meridian Enterprises, Corporation v. KCBS, Inc., 910 S.W.2d at 332; MFA Coop. Ass'n No. 86 v. Stone, 971 S.W.2d 885, 890 (Mo. App. S.D. 1998).

⁴ Alvey Conveyor Mfg. Co. v. Kansas City Terminal Ry. Co., 203 S.W.2d 606, 609 (Mo. 1947).

⁵ Universal Power Systems v. Godfather's Pizza, 818 F.2d 667, 673 (8th Cir. 1987) (applying Missouri law); Scullin Steel Co. v. Paccar, Inc., 708 S.W.2d at 763.

⁶ Universal Power Systems v. Godfather's Pizza, 818 F.2d at 673.

⁷ Id.

⁸ Meridian Enterprises Corporation v. KCBS, Inc., 910 S.W.2d 329 (Mo. App. E.D. 1995); MFA Coop. Ass'n No. 86 v. Stone, 971 S.W.2d 885 (Mo. App. S.D. 1998).

⁹ High Life Sales Co. v. Brown-Forman Corp., 823 S.W.2d 493 (Mo.banc 1992).

¹⁰ S.R. Shapiro Annotation, Comment Note: Overhead Expense as Recoverable Element of Damages, 3 ALR3d 689 (1965), c.f., 2 Robert T.Dunn, Recovery of Damages for Lost Profits, §6.5 (1998).

¹¹ See, e.g., Richard E. Speidel & Kendall O. Clay, Seller's Recovery of Overhead Under UCC § 2-708(2): Economic Cost Theory and Contract Remedial Policy, 57 Cornell L. Rev. 681 (Fixed overhead should be deducted); c.f., Robert Childress & Robert K. Burgess, Seller's Remedies: The Primacy of UCC 2-708(2), 48 N.Y.U. L. Rev. 833 (Fixed overhead should not be deducted).

¹² 910 S.W.2d 329 (Mo. App. E.D. 1995).

¹³ Id. at 332.

¹⁴ Id. at 332.

¹⁵ 429 S.W.2d 709 (Mo. 1968).

¹⁶ 722 S.W.2d 337, 341 (Mo. App. E.D. 1986).

¹⁷ 123 S.W. 1034, 1039 (Mo. App. S.D. 1909).

¹⁸ 583 F.2d 435 (8th Cir. 1978).

¹⁹ Id., at 437.

²⁰ 727 S.W.2d 930, 932 (Mo. App. W.D. 1987).

²¹ 982 S.W.2d 698, 700 (Mo. App. E.D. 1998).

²² 971 S.W.2d 885 (Mo. App. S.D. 1998).

²³ 727 S.W.2d at 932.

²⁴ 379 S.W.2d 181, 190 (Mo. App. W.D. 1964).

²⁵ 971 S.W.2d at 890.

²⁶ MFA Coop. Ass'n No. 86 v. Stone, 971 S.W.2d at 890. The burden of proving with reasonable certainty lost profits, or any other damage, remains with the claimant. Some courts do not establish a high standard in terms of quantity of evidence to meet its burden. See, Whitman's Candies, Inc. v. Pet, Inc., 974 S.W.2d 519 (Mo. App. W.D. 1998), wherein the court sustained a lost profits calculation based upon the president of plaintiff testifying that the candy making company would make $1.79 net profit per box of candy, leaving it to defendants to dispute the validity of the net profit testimony.

²⁷ 823 S.W.2d 493 (Mo. banc 1992).

²⁸ Id., at 503.

²⁹ 1 Dan D. Dobbs, Law of Remedies, §3.1 (1993).

³⁰ Restatement Of Contracts, §329 (1933).

³¹ Oakland California Towel Co. v. Sivils, 126 P.2d 651 (Cal. Ct. App. 1942).

³² Vitex Manufacturing Corp. v. Caribtex Corp., 377 F.2d 795, 798-99 (3rd Cir. 1967). Vitex is particularly well reasoned and contains a lucid analysis of the issue.

³³ Id.

³⁴ Id.

³⁵ Id.

³⁶ In Speidel & Clay, the authors attempt to discount this legal analysis by introducing an economic model that requires an analysis of the competitive market and how near-capacity claimant's production was functioning. (At pages 695-701). However, in the end, the authors acknowledge the extremely complicated problems of proof and great difficulty in explaining the theory to factfinders. Childress and Burgess find such economic model as flawed and rationally argue that the preferred rule provides a closer approximation of a claimant's true losses.

³⁷ Section 400.2-708(2), RSMo 1994; Scullin Steel Co v. Paccar, 708 S.W.2d 756 (Mo. App. E.D. 1986); Productive Automated Systems Corp. v. CPI Systems, Inc., 61 F.3d 620 (8th Cir. 1995); Universal Power Systems v. Godfather's Pizza; 818 F.2d 667 (8th Cir. 1987).

³⁸ See cases cited in Note 21 for application of this section in Missouri.

³⁹ 980 S.W.2d 12, 24 (Mo. App. W.D. 1998).

⁴⁰ Id. at 24.