Royalties, the Net v. Gross Profit Distinction, and Dolly Parton.
Part 3
In last week’s installment we defined both net and gross profits and established that both measurements are interconnected. Determining the gross profit is an essential steppingstone in finding the net profit. This final installment will have a startingly lack of Dolly Parton fun facts, and a surplus of business language but I’m sure Dolly would agree that understanding business basics is absolute necessity in this 9-5 world we live in. This post is dedicated to explaining how gross profit – on its own – can provide incomplete and potentially hazardous misinformation when removed from the context of net profit.
A gross profit assessment shows whether a company is able to earn a profit while paying its variable production and labor costs. It’s a helpful tool when analyzing sales, effective labor usage and productivity levels. However, using only gross profits to assess profitability provides an incomplete picture of a company’s financial standing because it does not include the fixed costs that are often essential and unavoidable that only appear in a net profit assessment.
A net profits assessment shows the profit earned while accounting for all aspects of the company’s business operations. Net profits provide a more inclusive, fuller picture than gross profit and can be used to assess management in addition to lower-level labor workers. For example, while a company’s gross profits might have increased that does not necessarily mean that the net profit has increased. If a company is taking on debt, a fixed cost, to increase production then the gross profits will increase but the net profits will decrease as the debt interest builds. This debt can often be substantial since many essential expenditures like pitching, marketing, and research and development are fixed costs that are frequently incurred as debt.
Putting it all Together: The Consequences of Gross Profits and Net Profits on Royalty Agreements
The gross versus net profit interaction is an essential part of royalty agreements because royalties can be taken from either the gross or net profit of the intellectual property that is being licensed out. For many royalty agreements, especially with lesser-known artists and musicians, net profit is the preferable option. Net profits provide a more accurate representation of the true revenue being earned from the project. It allows up and coming creatives to spend money to make more money. Additionally, net profits protect against potential funding issues in a way that gross profits cannot. When royalties are based off of gross profits, as explain above, many of the companies most valuable and reoccurring costs are not represented, potentially putting a company or an individual in a position where they are forced to pay royalties using money that does not exist after the fixed costs are accounted for. Consequently, unless you’re out here creating Grammy Hall of Fame level songs all by yourself like Dolly Parton consider using net profits in your next royalties’ agreement.