He formed the company in 1991 to manufacture custom built aluminum storm windows for sale to contractors in the greater Chicago area. Since that time the company has experienced tremendous growth and currently operates two plants: one in Chicago, the main production facility, and a smaller plant in Moline, Illinois. The company now produces a wide variety of metal windows, framing materials, ladders, and other products related to the construction industry. Recently the company developed a new line of bronze finished storm windows, and initial buyer reaction has been quite favorable. The company's future seemed bright, but on January 3, 2010, a light fixture overheated causing a fire that virtually destroyed the entire Chicago plant. Three days later, Krog had moved 50 percent of his Chicago workforce to the Moline plant. Workers were housed in hotels, paid overtime wages, and provided with bus transportation home on weekends. Still, the company could not meet delivery schedules because of reduced operating capacity, and total business began to decline. At the end of 2010, Krog felt that the worst was over. A new plant had been leased in Chicago, and the company was almost back to normal.
Required:
a. Mr. Krog is not convinced by Peter's analysis and has turned to you, an outside consultant, to provide a preliminary estimate of lost profit. Using the limited information contained in the financial statements for 2009 and 2010, estimate lost profit.
STEP1. Determine the level of fixed and variable costs in 2009 as a function of sales. You can use account analysis, the high low method, or regression if you are familiar with that technique.
STEP2. Predict what sales would have been in 2010 if there was no fire. Using this level of sales and the fixed and variable cost information from step 1, estimate what profit would have been in 2010.
STEP3. The difference between actual profit in 2010 and the amount estimated in step 2 is lost profit.
b. Based on your preliminary analysis, do you recommend that Mr. Krog aggressively pursue a substantial claim for lost profit?
c. What is the fundamental flaw in Peter Newell's analysis?