John Krog is president, chairman of the board, production supervisor and majority

shareholder of Krog’s Metalfab, Inc. 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, Illinols. 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. 2013, 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 2013, Krog felt that the worst was over. A new plant had
been leased in Chicago and the company was almost back to normal.

Finally, Krog could turn his attention to a matter of considerable importance:

settlement with the insurance company. The company’s policy stipulated that the
building and equipment loss be calculated at replacement cost. This settlement had
been fairly straightforward and the proceeds had aided the rapid rebuilding of the
company. A valued feature of the insurance policy was ‘lost profit” coverage. This
coverage was to ‘compensate the company for profits lost due to reduced operating
capacity related to fire or flood damage. The period of ‘lost profit” was limited to
12 months. Interpreting the exact nature of this coverage proved to be difficult. The
insurance company agreed to reimburse Krog for the overtime premium,
transportation, and housing costs related to operating out of the Moline
plant. These expenses obviously minimized the damages related to the 12 months
of lost or reduced profits. But was the company entitled to any additional
compensation?
Krog got out the latest edition of Construction Today. According to this respected
trade journal, sales of products similar to products produced by Krog’s Metalfab
had increased by 7 percent during 2013. Krog felt that were it not for the fire, his
company could also have increased sales by this percentage.
Income statement information is available for 2012 (the year prior to the fire) and
2013 (the year during which the company sustained “lost profit”).The expenses in
2013 include excess operating costs of $250,000. Krog has documentation
supporting these items, which include overtime costs, hotel costs, meals and such
related to operating out of Moline.The insurance company is quite Willing to pay
for these costs since they reduced potential lost profit.
The chief accountant at Krog, Peter Newell, has estimated Iost profit to be only
$34,184.Thus, he does feel that it’s worthwhile spending a lot of company
resources trying to collect more than the $250,000.
Peter at his calculation as follows:
Sales in 2012 $5,091,094
Predicted sales in 2013. assuming a 7% increase $5,447,471
Actual sales in 2013 . $3,857,499
(A) Lost sales $1,589,972
(B) Profit in 2012 as a percentage of 2012 sales
($109,495 / 5,091,094) .0215
Lost profit (A X B) $34,184
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 profits Using the limited
information contained in the financial statements for 2012 and 2013, estimate lost
profits. (Hint: You can proceed as follows.)
STEP 1: Determine the level of fixed and variable costs in 2012 as a function of
sales. You can use account
analysis, the high-low method or regression if you are familiar with that technique.
STEP 2: Predict what sales would have been in 2013 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 2013.
STEP 3: The difference between actual profit in 2013 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?