I have already written, in another context, about the interaction between physical assets and lost profits. I want to explore the issue from a couple of additional angles.
In the 1989 film Field of Dreams, Kevin Costner’s character hears a voice telling him “build it and he will come”. Costner acts on the voice – why not, wouldn’t you? – and builds a baseball diamond in his Iowa cornfield; sure enough, the ghosts of the 1918 Chicago White Sox, and eventually Costner’s father, appear on the diamond. And James Earl Jones sounded great.
In real life, this is not the way business works. Sales do not necessarily grow or contract in direct proportion to a firm’s capacity. You can build it, but they may not come. (Just ask Target Canada).***
***For anyone reading this in the year 2020, Target Canada was the Canadian subsidiary of a US department store that made a grand entrance into Canada in 2013, and a rather less grand exit less than two years later.
Consider the following examples:
- A hotel suffers a fire on one of its 10 floors, which cannot be used for 1 year. The hotel had an average of 75% occupancy in the year prior to the fire. If the hotel’s normal annual revenue is $1M (or $100,000 per floor per year), is the revenue loss equal to 75% of $100,000?
- A commercial helicopter operator planned to expand his fleet from 3 to 4 helicopters, but as a result of a bodily injury sustained in a car crash he was forced to cease operations. If he had historically generated annual revenue of $600,000 per year, is it reasonable to assume that his annual revenue would have been $800,000 per year with the addition of a fourth chopper (assuming he can prove that he would have gone ahead with the fleet expansion)?
- A manufacturing plant with 8 identical production lines suffers damage to 2 of its lines. Is it appropriate to assume that it will suffer a 25% decline in revenue?
The answer in all three cases is: maybe, but likely not. If a hotel is normally at 75% capacity, that means that it normally has unused capacity of 25%, or 2.5 floors out of a 10 floor hotel; theoretically, the loss of only 10% of the hotel’s normal capacity (i.e. one floor) may not have anyimpact on revenue.
Similarly, the addition of a fourth helicopter may lead to a proportionate increase in revenue, but only if there is sufficient demand willing to pay for and make use of the additional capacity.
This is not to say that there is no impact from the loss of capacity. The hotel that averages 75% occupancy may have 100% occupancy for half the year and 50% occupancy for the other half; clearly, in that case the loss of an entire floor would be quite impactful during the half year in which the hotel is normally full.
Moreover, even if the historic demand had been consistently 75%, night after night, that does not mean that this would have continued indefinitely into the future. It is important to consider any changes to the demand for the claimant’s planned capacity. A review of pertinent industry statistics, where available, may prove helpful in this regard (e.g. published tourism statistics for the region in which the hotel was located).
There is a flip side to the assertion that an increase in capacity does not necessarily drive a corresponding increase in revenue, and that is that a large increase in revenue (premised on anticipated demand for a product or service) can rarely ever be accomplished without a corresponding capital investment. An increase in capacity is necessary, but not sufficient, for an increase in revenue to occur. In a coming post, I will provide an illustration of this and show how it can have a significant impact on lost profit calculations.