Book Publishing Accounting: Some Basic Concepts

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1. The Cheerful Skeptic columns in Publishers Weekly often talk about the business side of publishing. Columns like the one on returns, and the one on overheads, prompt an immense amount of e-mail that conveys an avid craving -- and need -- for information about some of the most basic concepts and procedures in book publishing. No textbook or business school teaches these things because they are so specific to the book world. For example, in what other industry can we find companies that regularly launch a thousand "new products" every year? I have tried in this piece to address some of the most frequent queries and concerns that readers have expressed. In giving answers, I’ve found it necessary to explain and clarify certain fundamental notions and practices that shape the book business as we know it. This is very far from a complete textbook; there are large areas of the business I won’t even touch on, and I don’t know all the answers anyway. I’ll be content if this piece gives some of the answers, and stimulates a healthy skepticism in anyone seeking more of them.

Be warned, however: I will struggle to be clear, but I’m aware that "clear" and "simple" are not always the same thing, and if all these numbers are new to you, you may go into oxygen-debt halfway through this piece. But, as with any complex discipline, concepts that that seem bewilderingly complicated in week-one will seem elementary after you’re six weeks into the semester -- if you do your homework. If you’re looking at this on-screen, you may want to print it out. Publishing is not sub-atomic physics, but it does have its complexities. But then, I know few things that are interesting and valuable -- as book publishing is -- and utterly simple too.

2. We can start our attempt to understand and critique the thinking of some execs and accountants in book publishing with this query from a chief financial officer:

"You took to task those of us who are bean counters and make up formulas for applying costs to projects/books in order for a business to project a balance in its expenses and revenues...most of us do something like taking the budgeted overhead expenses for the year and dividing them by the number of books and using that figure or ratio to guide pricing and list planning. I believe you think there is something wrong about assigning to books/projects the fixed part of overhead -- that is, the rent, the executive salaries, the insurance, etc. How would you have these costs covered? Would you not assign them to each book in some proportionate way? How would you know when the benefits of a project might be outweighed by the costs?"

3. The "assigning" of overheads is a delicate problem for execs during at least three important tasks. All three have an impact on everyone from editors to owners:

(a) Projecting the forthcoming year’s company results, and doing the "planning" those results indicate is needed.

(b) Deciding whether or not to okay proposed new titles.

(c) Pricing those titles.

The query above stems, I believe, from a failure to realize that the "applying" of fixed overhead must be done differently for each of the three tasks. The overheads column the CFO was responding to criticized execs for only one thing: their failure at assignment (b) above. They fail because -- when they contruct a "projected p&l" on a proposed new title -- they insist on deducting from the title’s "profit" a fixed percentage of sales, which they attribute to "corporate overhead" costs. By conveying that if they publish this new book there will be this mythical title-specific "cost" they do three things. (1) They obliterate the actual dollar-value of the new title; (2) they commit themselves to an unjustified formula that will repeatedly result in their rejecting books they should accept; and (3) they muddle the thinking of the very people they most need to be perspicacious -- those who go hunting for new books, and those who judge the potential financial worthiness of those books. In what follows I’ll be saying, among other things, this: You should demand a certain percentage-contribution to fixed overhead when pricing books; but when deciding to buy a book, you should not use a percentage -- you should look at absolute dollars; if fixed overheads are truly fixed, they are utterly irrelevant in judging if a project’s benefits outweigh its costs.

4. Discussion in our industry is often confused because different people have different things in mind when they’re using the same words. I’ll try to make clear what I mean by each of the special terms I use, and I’ll spell out important distinctions between those meanings. I’ll begin with "overhead". There are three kinds of OH (I will, more often than not, use the plural -- "overheads" -- as part of my effort to keep distinct things that are distinct):

Fixed overheads: (FOH): everything that recurs on a steady basis whether you ship no books or a million books -- i.e. the salaries, rent, insurance, etc

Direct Variable overheads: the portion comprising those costs that rise almost linearly with sales -- e.g. shipping, commissions, and more.

Indirect variable overheads: The quintessential indirect variable is promo -- i.e. it tends to rise with sales, but isn’t locked in linearly; you elect to spend it or not, but tend to spend it if you think you see sales there.

Of course, in real life "fixed" isn’t fixed (you can hire or fire mid-year); "direct" is only roughly linear (often, the more books you ship,the lower the cost per unit shipped); and "indirect variable" can vary mightily (Jane Fonda’s famous workout book became the #1 bestseller without a cent spent on advertising.) Still, the trichotomy is useful. Two of those three types of overhead are title-specific-costs (TSC).

5. We need to define TSC. They include all and only those costs that occur solely because you’re publishing this particular title. They specifically exclude any expenses such as rent and salaries that would be paid whether or not you do this book. They include:

5a. Production. This does not mean salaries of people in the production department; it means disbursements for plant and pp&b of each title. "Plant" refers to the one-time-only costs of a title -- typesetting, artwork, freelance costs that wouldn’t have occurred except for this particular title. "Pp&b" means paper-printing-and-binding (which isn’t one-time-only because it recurs every time you print a title). Plant and pp&b are clearly "title specific" costs -- you incur them only because you publish given titles.

5b. Royalty. Obviously the same here -- you have royalty only because you have specific titles. In a given month, if you sell no books at all you will still have rent and salary costs -- but no royalty expense.

Note: On company financial statements you "expense" the pp&b-and-royalty only on books sold. But when preparing an individual title’s p&l, you charge the cost of all the books printed, and either the earned-royalty or the author-advance, which is higher. See the appendix for further explanation of this point.

More arcane note: Occasionally -- as in reference book publishing, a huge project requires hiring new people to work solely on this project. This is a case where a salary is a TSC. For tax purposes, the exec may try to expense this as a fixed overhead, but the IRS may step in and say, "No, this is a plant cost and can’t be expensed until the work is published."

5c.Direct variables. The title-specific costs here are those that rise only as you sell books. You pay a shipping cost on a copy-by-copy basis -- but the salaries of the personnel in fulfillment are fixed, and in doing the title p&l you shouldn’t include salaries as a charge because the shipping of this particular copy doesn’t increase anyone’s salary. The "selling" cost that should be charged to an individual title should be restricted solely to commissions or bonuses that rise as sales rise. Sales reps’ salaries are fixed, as are the salaries of sales-management in the home office.In practice -- for both company and title projections -- almost everyone uses a percentage for direct variables -- e.g. 4% or 5% of sales for fulfillment -- because the variations from linear tend to be so negligible and numerous. There are exceptions; for example, when you’re doing a title projection on a book with so large an advance-sale you arrange, say, a bindery shipment that eliminates such costs as freight-to-warehouse and certain warehouse handling-costs. Then, often, a cents-per-book cost is projected instead of 4% or 5% of sales.

5d. Indirect variables. Again the truth is that in practice most execs take an assumed percentage of sales rather than a dollar amount. That is, they do this in projections, not in actuals. They’ll say, "We will spend 7% of sales on promotion." In doing the post-mortem "actual" p&l’s on individual titles, they must use the actual dollar amount spent on promo. For these post-mortem purposes every bill coming into the house for plant, pp&b, and variable overheads likes ads and tours should be title-coded -- so the computer can in the end produce the TSC on each title. A trade house that knows well ahead of time they’ll be doing a huge promo campaign of, say, $500,000 for a particular title will enter that dollar amount when doing the projection.

One other stipulative definition: Within TSC, I’ll make a distinction between "sunk costs" and non-sunk by saying: "Direct TSC" include only pp&b, royalty and direct variables. This distinction will be useful later in the piece where we talk about the theoretically best way to price a book.

6. Thus, here’s what execs usually do with TSC in practice when they’re doing annual company forecasts (as distinguished from actuals, which they can’t do until year-end): They take the total sales projected and say, "50% of these revenues will have to be used to pay for "cost of sales" -- i.e the production and royalty costs. The remaining 50% -- what’s left after deducting cost-of-sales from revenues -- is usually called "gross profit" or "gross margin". Execs will often break down gross profit this way: they assume 10% will go to pay the two kinds of variable overheads, and the remaining 40% will be available as "contribution to FOH". To the extent that FOH is less than (in this example) 40%, the remainder will be a contribution to "profit". (That is, "operating profit". Such things as interest and amortization are then deducted to reach "pre-tax profit" -- the company "bottom line".) They’ll break down gross profit this way whether they’re forecasting annual company results, or a single title’s p&l.

Note: I use these percentages -- 50%, 40% and 10% -- because they approximate norms in trade publishing, but in practice they vary from house to house. University presses, for example, often have a FOH percent that’s much higher.

7. That’s what they do in their first pass annual projected operating statements. (For new books; backlist and returns and remainders and special sales are another calculation to be done differently.).

I say "first pass" because at this early budget/forecast stage they’ve actually, in one room, been estimating the dollars of sales and cost-of-sales, while in another room estimating the anticipated dollars of FOH. They usually get that FOH number by looking at the past year’s FOH and adjusting for raises, rent increases, new hires and departures, etc. They don’t get it by looking at sales. They know it’s an absolute number determined by adding up specific costs like rent and salaries. You can’t project those by taking a percentage of sales.

8. It’s when they compare the projected "contribution" -- e.g. the (hoped for) 40% of revenues left after, in effect, deducting TSC -- to the projected FOH that "planning" often begins, with a consequent second pass -- their official projected company-wide financial results for the year.

9. There is in all of this a vexing chicken-and-egg element, admittedly. For example, where did that "sales" projection come from? From estimated unit-sales times list-prices less discount-to-customers. But where did the list prices come from? Usually from a management fiat. Management has told the editor that when he proposes a new title he must project his list price this way: Calculate your "unit cost of sales" -- i.e. take all your projected production cost (i,e, including plant and all the books printed) plus all royalty/advance cost and divide the sum by the projected number of copies sold. If cost-of-sales is to be no more than 50% of received, then the received on each book sold must be at least double that unit-cost-of-sales. So double the unit cost and that’s what you have to receive after discount. Price your book accordingly.

10. Example: There are several ways of doing this, and I lay out this method only for its benefit of clarity (which, I repeat, does not mean it will be altogether simple to follow). Let’s say the royalty rate is a straight 10% of list, and received-after-discount is 53% of list. So you will be paying 19% of what you receive -- ten-fifty-thirds -- to the author. (If the royalty-rate reaches 15%, you pay 27 1/2% of what you receive to the author.) Let’s say a given title has a plant cost of $12,000, and a pp&b cost of $20,000 to print 10,000 copies. You expect to sell 8,000 (at the projected list price). That yields a unit-production-cost of $4.00 (i.e. $32,000 divided by the 8,000 sold). This implies that, if you’re going to spend no more than 50% of received on cost-of-sales, $4.00 must be (no more than) 31% of the price received (because you’re giving 19% of received to the author). What is $4.00 31% of? Answer: $12.90. If $12.90 is thus 53% of list, list is $24.34. (You round up to, say, $25.)

11. Test the example (as if you had priced at $24.34): You do sell 8,000. You receive 8,000 times $12.90 = $103,200. Your production costs were $32,000. Your royalty at 10% of list was $2.434 per book 8,000 times = $19,472. Total cost of sales: $51,472. That’s 50% of your revenues of $103,200 -- leaving 50% of revenues for all overheads (fixed and variable) and for profit.

12. The management fiat saying that, in setting the price of the book, there should be a 50% gross profit -- or some variation thereon -- comes, as we shall see, largely from little more than looking at company history. In fact, a house will sometimes ignore unit cost and "price the book to market" -- about which more later. But, though you may grumble about the percent demanded, every house, when pricing a book, needs some gross profit. If they price all their books so the received equals only production-and-royalty (and variables), then they’ll have nothing left from revenues to pay rent and salaries. Now we’re getting closer to the question of when and when not to use an "allocated" FOH, and how much it should be.

13. Later in this piece, I’ll be saying that in setting the price of a book, you should use an allocation. I’ll get back to why and how much -- and I’ll even explain why theoretically using an allocation is irrelevant and therefore wrong -- but only theoretically. In this paragraph, however, I’ll merely urge it not be called an "allocation". Call it "contribution" -- for two reasons. The primary danger of saying the likes of "allocated cost" is that, if we say it enough, we come to be mesmerized by the words -- to the point where we believe that a new title actually does cost new fixed overhead when it emphatically does not. This may not hurt us when we’re pricing the book, but it can kill us when we’re deciding whether or not to publish a book. Second reason: I guarantee your editors will understand and live with the word "contribution" better.

14. I said there were three places where the notion of FOH comes into play. Notice this difference among the three: You feel an urge to "apply" FOH when you’re pricing a book, and when you’re deciding whether or not to publish a book -- thus insidiously suggesting that FOH somehow varies with sales: this book with much bigger sales "costs" lots more in FOH. But when you do your projected annual operating statement, there’s no such temptation to think of FOH’s being in any way contingent on sales. Your lump-sum FOH is what it is -- you do it in "another room" from where they’re projecting sales and TSC. (Reminder: "FOH" means "fixed overhead"; TSC means "title-specific-costs"; "contribution" means what’s left after you deduct all TSC from sales revenues.)

15. I’ll dwell a bit longer on the exec’s assignment in #3a above -- doing his company-wide projections and planning -- before getting back to the jobs of approving new titles and pricing them. Having completed his "first pass" projections, the exec then compares the projected total annual contribution to the total annual FOH -- and if the FOH is larger, he says, Oh-oh, I’m going to have a red-ink year unless I do something.

16. Now, if you’re the exec there are many things you might consider in your "planning", but, momentarily, I want to focus on only one: You should look to see if you’re using your FOH up to capacity. I have not, with this remark, gone off on a management training tangent. I make it because it will help us understand how and when to "apply" FOH. Obviously you don’t "apply" FOH when you do the company projections; you simply add up rent, payroll, etc. The only places -- from #3 above -- where you’re tempted to apply FOH are in pricing and acquiring titles. Examining the capacity of your fixed apparatus -- staff, space, etc -- may prompt you to ask a fruitful panning question like this: Could you, with the same fixed apparatus you have now, publish more books this year?

17. To prepare for this next segment in the argument, I need to establish four premises.

17a. Publishing additional books usually entails no ncrease in FOH. In the house where I worked, the trade division went from 42 titles a year to 151 before we had to hire a single extra employee. Eventually the company was doing 300 times as many titles, with only 18 times as many employees. Often during the year we’d be offered titles which we signed up and then published within a matter of months -- with no increase in payroll, rent, or any other fixed cost. In the original Cheerful Skeptic column in which I talked about allocated overhead, I cited a big book that eventually contributed $1,500,000 to FOH; if the house had not published that book, they would have had the same FOH -- and $1,500,000 less to pay it. Granted: eventually you’ll be publishing up to capacity, and to take on any more books you will indeed have to hire more people -- but chances are you’re far from there yet.(And when you do get there you’ll see that FOH does not slope up; it steps up -- and stays there on a plateau, unmoved by an extra title here and there. Then, twenty or thirty titles later, another step up may be required.)

17b. "Displacement effect" is seldom a factor. Though it can happen, it’s a rare occasion when the late appearance of book "A" on a list reduces the sales of "B" on that list. Even rarer is it that by publishing "A" we make it impossible to publish "B". In the old days of mass market, when each imprint was allotted a fixed number of pockets by the wholesalers, displacement was a constant preoccupation because if you shipped one title it meant you couldn’t ship another. But in trade publishing the elasticity in size-of-list is far greater than most people think. At the house where I worked, we expanded the number of titles in every genre year after year; contrary to conventional expectation the number of copies sold per title went up.

I’m also aware that in talking about the elastic market, I have to be wary about large lead titles. Again, paperback publishers saw this clearly. Each month could have only one lead title. If title B was to be your lead, and you moved title A onto the list ahead of it, B’s potential sales would be reduced. (Which is one reason why mass market houses started creating additional lines with entirely different imprint-names. Each imprint could have a "lead" title.) But this displacement effect takes place much less in hardcover publishing. The $1,500,000 windfall-title above was, despite its lead-title size, essentially an add-on to the publisher’s list that year. And -- by adding it on -- they dropped an additional $1,500,000 to the bottom line. At the house where I worked, late-appearing titles often came to our door after the coming season’s list was "closed". Once, a controversial secret book was offered to me on August 10. Six weeks later, we had published it and it was #1 on the non-fiction hardcover bestseller list in The New York Times. And: no diminution was seen in the anticipated sales of any other book on that season’s list. (Again, I concede there’s a limit to this flexibility. If you’re asking for a 50,000-copy advance on ten titles, you’re more likely to meet target than if you’re pushing for 50,000 on twenty-five titles. But in the every-year world, we’re seldom considering a 150% increase in the number of titles.)

17c. I’m assuming for this discussion that cash-squeeze is not a factor. We’re talking about what to do this year -- meaning the time-gap between cash-out and cash-in is small. (Which implies that what I’ve said applies most usefully to, say, fiction and hot-topic non-fiction. For scholarly and reference books, cash tied up in long-gestation projects can certainly be a factor.)17d. Similarly I assume that cost-of-money for so short a time is not an issue. (A small en passant observation that can’t be explored here: I know of no publisher who ever tries to recognize the positive-interest-in-perpetuity that profitable titles produce. An even more arcane point: A division in a large company is often charged with interest for "funds employed" -- money tied up in inventory, author advances, and even accounts receivable. But when do you ever see that division credited with positive interest on last year’s after-taxes profit?)

18. Having said this much we can now say that, when confronted in first-pass with a potential red-ink year, your first step in "planning" should not be to run through the list cancelling all the titles with low contribution percentages. A low contribution-percentage to FOH should NOT be the reigning factor in deciding whether or not to publish a book. Absolute dollars of contribution should. Rephrased: In deciding whether or not to publish a book, if you reject books automatically when they fail to meet your demanded "allocated overhead" percent, you will consistently burn money.

19. Rephrased again: If the four premises named in #17 above are valid, and a quick new book is proposed that has a contribution of an interesting size in absolute dollars -- even though as a percentage of received it’s below the pricing formula standard -- you should do it. Any exec who declines such a title because its contribution percentage is less than "formula" -- or who cancels an already-scheduled similar title -- has almost certainly reduced this year’s potential pre-tax profit. Because there is almost no way he can simultaneously reduce FOH by an amount greater than the aggregate contributions of the cancelled titles. If he cancels ten small books with an aggregate contribution of $80,000, and somehow manages to cut FOH by $30,000, he’s a $50,000 loser. And his move is even sillier if the plant cost is already spent and the author-advance is unrecoverable.

20. We can move closer to a general insight with this example: Suppose an editor comes in and says he’s been offered two books, and he can only do one of them. He wants you to choose. You believe the first book would have $50,000 in sales, and, after TSC, a contribution of $17,500.That’s 35% of sales. The second book would have $300,000 in sales. But high TSC would leave only $60,000 for contribution -- 20%. You can do one and only one of these titles, and it can be fitted in this year. Which book do you choose to do? It’s pretty to think that no one would be so terminally stupid as to choose the first, but I guarantee there are publishing execs who would. When it happens it’s often because, under the crush of a thousand decisions every month, the execs have laid down formula-dictated fiats based on percentages rather than absolute dollars. "Don’t come to me with any proposals that show a contribution of less than 35%!"

21. Seven months into the year an editor rushes in with a book based on a late-breaking hot topic. He says, "It’s from a packager. It’s ready to go, I know I can make catalog. But it’s costly, and the contribution will be only 25% of sales. But that’s still $100,000 and we can have it in ninety days!" The exec who briskly produces his book-proposal form and says, "Can’t you see it says here a book is a loser if it doesn’t have a contribution of 35%?" should be asked in return: "And can’t you see you just said no to $100,000 extra profit this year?"

22. Every title the execs can squeeze out of their apparatus this year -- provided the premises in #17 hold, and provided each title has at least some contribution -- will increase their annual pre-tax profit. This is because the annual FOH is a large, fixed number of absolute dollars -- twelve months of rent, salaries, and the like. Thus, the more absolute dollars of contribution you can accumulate, the faster that year’s FOH bill be covered -- and any additional accumulation of contribution before year-end will go toward the year’s "profit". The publisher who did the $1,500,000 book was fully aware that the book’s contribution as a percentage was under the company formula (which meant that when he came to pricing the book his task was to price it not to formula but to market). But the size of the book’s absolute-dollar contribution was persuasive, and it should have been.

23. Every reasonable publisher occasionally allows a highly profitable editor to smuggle onto the list a personal favorite that has a low contribution. The publisher does this even though he knows that the premises in #17 are not airtight. He suspects, rightly, that every title has direct costs that escape detection because nobody can track every cent of expense back to the title that caused it. A tiny title with a projected 2,000 copy sale will occasion letters, messengers, in-house and catalog postings and the like -- all of which will erode the gross profit.He also suspects dilution of attention, which he can’t quantify. If he could sum all of these concerns, he knows the number would be small -- but, still, it’s some number of dollars, and some percentage of the revenues from the book.

Which is to say you should prepare a projected p&l on every proposed new title, and it’s useful to have that p&l state the percentage of that contribution as well as the dollars. ("Percentage" here means the dollars-of-contribution as a percent of dollars-of-book-sales.) If every title an editor proposes has a small contribution-percentage, then he’d better have a very large number of those titles, and their in-house consumption of time-per-title had better be small. (See #24 below.) In sum, even the most flexible publisher should draw an absolute-dollar line -- the contribution must be at least such and such in absolute dollars, unless there is some ulterior reason for doing this no-contribution title.

The absolute-dollar threshold will vary from house to house. In a very small house a $7,000 contribution might be prized. There have been very large houses that allegedly told editors to bring forth nothing but books that would sell 50,000 copies or more. If that takes your breath away, it should: It’s a policy based on a toxic combination of stupidity and laziness.

24. The peril of the analysis I’ve given here is that editors may use it to justify one small-contribution title after another, to the detriment of acquiring and publishing more profitable books. "They’re all contributing absolute dollars, aren’t they?"

If you have an editor who year after year wants to do only ten books, all of which are projected to have small dollar-contributions -- chances are you should ask him to find another job. There are available editors out there who can do better than that. (And there are also editors who can produce for you a lump-contribution that is literally negative, if you’re not careful.) You can try to educate such an editor this way: Sum this year’s aggregate contribution from all his new titles. Take his annual salary and that of his assistant, multiply by 125% to take into account such out-of-pocket costs as fringes; add his t&e. Subtract all that from the contribution. Call the result "net contribution". Then you can show him what he’s really contributed this year to the rent and to the salaries of all the support people in production, sales, etc. If you wanted, you could sum all FOH except editorial; if, say, the editor in question is one of ten editors in the company, you could multiply his total contribution by ten and say, "If all the editors did as you do, this is what the total contribution would be towards all these other FOH for the year. I.e. we’d go bust."

In the long run it’s not a distortion to say that if that ten-editor house does 100 titles a year, and each title has a lifetime-contribution of only $10,000, and the FOH is $2,000,000, the house will suffer an annual loss of $1,000,000. However, if each editor managed to do 25 books a year, each with the same $10,000 contribution -- and the FOH could remain fixed -- the "profit" would be $500,000. The point is, so long as the FOH stays fixed, you want as many dollars of contribution as you can get. All other things equal, I’d rather have an editor who regularly does 25 titles with a total contribution of $500,000 -- even if his contribution percentage is a lowly 20% of sales volume -- than an editor who regularly does 10 books a year with a contribution percentage of 35% -- and a total contribution of only $250,000.

One implication of all this is: The larger the title, the less relevant the percent of contribution. Embrace $1,500,000 in contribution even if it’s a mere 20% of sales. The smaller the title, the more important it is to be aware of the contribution percent. To use cartoon numbers to make the point: If those "undetectable" TSC referred to in #23 amount to 3% of sales, then a title with an ostensible 10% contribution is actually contributing only 7%. (Still, if the 7% is $1,000,000, and it’s effectively a guaranteed instant profit -- as certain special sales are -- think three times before walking away.)

Exam question: A respectable packager comes in with an series-idea he calls, "The Year in Sports". It’s five titles, "The Year in Sports: Football", "The Year in Sports: Baseball", etc. He’ll deliver finished books, year after year. The books are solid, you check the market, which convinces you the series will do $4,000,000 a year, but with a price-ceiling that means the contribution to FOH and profit will be only 25% of sales. The added in-house burden will be minimal with no increase in FOH, and the sales department says it won’t cut into the success of other titles. What do you say?

25. Which, in a roundabout way, gets us back to why you should use a required contribution when pricing books. And why, except for the biggest books (and the editor’s small personal favorite), using a percentage-of-sales number is okay. Few things bother responsible financial officers more than foolish editors who always want to price their books real low so they’ll sell a lot of copies. Hey, the editor says, I know what my title-specific costs are, and I know my book’s revenues are covering them -- so I know I’m not losing money. We’ve just seen why if such editors were allowed to have their way the house would soon be out of business. So: We usually should use a contribution-percentage requirement in pricing for the glum reason that no one has figured out a better way to do it.

26. What’s the best price to put on a book? Here is the entirely correct, semi-useless answer: The optimal list price for a book is the one that maximizes the contribution in absolute dollars. (This is what "pricing to market" should mean, but too often it’s used to mean something vaguely like: "Price it so low that making it any lower wouldn’t sell any more copies.")

The calculation of this dollar-contribution involves the concept of "direct TSC" that I introduced in the last paragraph of #5. You estimate the "contribution" of a title at a given price by taking the estimated number of copies you will sell at that price, and multiplying it times what we might call the "direct margin" -- which is what’s left from received-per-copy, minus the per-copy pp&b and the royalty and the direct variables like shipping and commission. It ignores plant and promo. So it can look like this: "At $15 list, I receive $7.50; pp&b is $2.50, shipping $.50, and royalty is $1.50. This leaves a direct margin of $3.00. I think I’ll sell 10,000 at $15, so absolute dollars of contribution -- to plant, indirect variables, FOH and profit -- is $30,000.

27. Notice that the examples in #20 and #21 both assume that you can’t always solve a contribution-percentage problem merely by raising the price -- because at some point raising the list price further will so reduce the number of copies as to make the move counterproductive. And reducing the price so you can sell more copies carries the peril of damagingly reducing the direct margin per book.Suppose you price a book so low it sells 50,000 copies -- but with a contribution of only $1 per copy. Or suppose you price it so high it has a contribution of $10 per copy, but sells only 5,000 copies. Then suppose you price it so it has a contribution of $4 per copy -- and it sells 25,000 copies. It’s obvious the best price is not the one that sells the most copies, or the one that has the highest contribution per copy. The first two prices produce title-contributions of $50,000 each. The last -- $100,000.

28. This is all entirely correct, but the semi-useless element lies in this: The optimal price is the one such that when you multiply the number of copies sold times the direct margin, you get the highest product, the highest total contribution to sunk costs and FOH -- and no one -- absolutely no one -- has a sure-thing way of knowing what that price is.

29. There is no generic question more important to a company’s profitability than this: What will be the impact on the consumer of this price for this book? (Realize, we’re talking about hundreds of pricing decisions a year, on products with total expected revenues as low as $35,000. You can’t do consumer research on products like that.)

30. If you don’t impose a required contribution-percentage when pricing, you have to rely on your fallible "gut". You ask yourself (or yourself and your most reliable people): Suppose we price this book at $25. What percent fewer units would it sell at $26? At $27? What percent more at $24? At $23? And so on up and down. Make sure all your guesses are right. Oh? And how do I do that? Once I told the sales department I wanted to price a book at $25, and sell 15,000. No protest. It sold 200,000. There’s zero doubt if 200,000 were the announced target, sales would have pleaded for a $20 list. Their gut would have told them to.

31. If the gut guesses in #30 about relative unit-sales at different prices were correct, you obviously could calculate what the total dollar-contribution of the title would be at those various possible prices. You’d then pick the price that has the highest contribution in total dollars (again -- not the one with the highest dollar-contribution per copy, and not the one with the highest percentage contribution -- either per copy or as a percent of the total sales.)

32. (En passant: If there are times when you feel you must rely on gut, the reason to ask -- as in #30 -- what percent fewer copies rather than how many fewer copies is two fold. If you’re taking a percentage, it’s easier to do the math; consider the confusion if they all start with a different unit-sales number at the $25 price. More important, experience has shown there is less capricious irrationality if the guessers work with percents. I owe this insight-- and others -- to the most perceptive creative thinker American publishing has ever seen -- Leonard Shatzkin.)

33. There is less caprice, but still lots of it. The guts of many salesmen and editors (not all) tend to be influenced by a passion to sell lots of copies. That, as the phrase goes, is how they get off. So their first impulse is to go for a low price. They can be trained to focus on total contribution instead of total copies. I’ve watched it happen. The best training tool for editors is the one I sketched out in #24 above: Produce for each editor his annual p&l that sums the results of all his books that year -- and the big bold-faced bottom line is total annual contribution. I’ve seen editors turn around to the point where they are the ones pushing for a higher list price.

Authors: Yes, there is a potential conflict here between the publisher’s interests and the author’s. But since there’s often no conflict at all, and because it would take another thousand words to explicate the matter, I can’t treat it here.

34. Now you know why I say no one has figured out a better way to enhance chances for a useful contribution per title than to impose a required contribution expressed as a percentage of sales. In sum, though everyone knows there’s a counterproductively high and a counterproductively low price -- no one knows for sure what they are. So if, in our ignorance of how to price to market, we should price to a formula with a required contribution percentage, the question remains: What should that percentage be? I’ve cited a common decision-procedure -- demand 50% gross margin, or 40% after TSC -- but is that the right way to go?

35. You can’t get your answer from history. One of the great vexations of book publishing is the inability to verify what effect a price has had. Titles regularly sell more or fewer copies than expected. Neither those who favor lower prices nor those who favor higher can be refuted by the results. Let’s say "formula" dictated a $25 price, but the Low Guys prevailed and it was priced at $24. And it sells more copies than projected. They’ll say, "See!" If it sells fewer, they’ll say, "It would have sold a ton fewer yet at $25." The High Guys meantime will be saying, "It would have sold the same at $25 and we’d have made a lot more money!" Whose gut is right?

36. Thus, in the end, the boss has to impose some rules, and they’re bound to be somewhat arbitrary. Suppose the boss has been hoping for a profit of 10% of sales. He got it last year and the year before, and both years his actual FOH was 30% of sales. Let’s say he knows he’s doing better than other publishers, and, not wanting to fix something that ain’t broke, he requires the same 40% contribution this year in the "pricing formula" as he has for the last few years.

Let’s say further that suddenly, when they’re almost through the budgeting process, it becomes evident that a certain title -- expected to be relatively modest -- will obviously be a blockbuster. Not only will its sales be hugely larger than projected in first pass projected financials, it will raise the total company sales by 50%. Quick arithmetic reveals that FOH this coming year will be only 20% of sales, not 30%. What should he do? Specifically: Should he revise his formula?

37. Answer -- yes, if he wants to ensure that he never makes more than 10% profit. In other words the answer is no. By using his formula in the past, he seems to have done well enough -- that is, he seems to have escaped pricing his books too high for the market, or too low to produce an acceptable contribution. He should retain his formula, and, if the projections are right, break his company profit record.

(The guy who prices the books has a cruel assignment if he’s interested in his public image. If he prices a title high and it sells far more copies than expected, no one will give him the credit. But if it sells far fewer, lots of people will give him the blame.)

38. I said he "seems" to have escaped. But, as #35 implied, he doesn’t know if he could have been doing even better all along. And he never will know, for sure. But here’s a rule of thumb: If you’re going to change the contribution percentage required in your pricing formula, chances are it will be better to move it up rather than down.

Historically, the prices of books have gone up -- not because the required contribution percentage has been raised, but because -- with rising paper costs, etc -- the unit cost has risen. Eventually, some publisher breaks a "price barrier". In hardcover, the first publisher to price a novel above $19.95 was considered foolhardy or foresighted, depending on whether the name-calling was before or after the book’s success. In mass paperback, $3.95 was once considered the highest acceptable price no matter how long (and unit-costly) the book. Then $4.95, then $5.95...One barrier after another was broken, and if it was broken with a title that had strong author-and/or-subject appeal, I can’t off-hand think of single case where the higher price is thought to have killed the book.

Thus the generalization: Tolerance for higher prices tends to be greater than, say, our sales execs and certain customers will tell us it is. (Don’t try to break barriers with ho-hum books; everybody out there who doesn’t need the book will seize the occasion to "teach you a lesson". Most people outside the highest exec offices like lower prices, including bookstores and libraries.)

39. When we think we’re "pricing to market", often enough we’re simply "pricing to competition". This misconception is not so feckless-making as it may sound, because again and again what the customers will tolerate paying depends not on what they can actually afford but on what they’ve been conditioned to feel is a reasonable price. All of us have passed up purchases that we can easily afford, but the notion of being "gouged" or "ripped off" stops us.

The most powerful conditioning factor here is the range of prices that customers regularly encounter in the marketplace. Thus, somewhat willy-nilly, by using the same general pricing formula as all your fellow publishers, you are pricing to competition -- but pricing to competition, it turns out, usually is pricing to market.

40. But suppose your FOH year after year runs at seventy or eighty percent of sales -- or even ninety, a number put to me by a university press exec? In pricing books, can you possibly use a required contribution-percent equal to that? Probably not. And you can’t just say, "Well why don’t we just do books that sell more?" You can do such standard things as checking for extravagances in FOH and production costs or author-advances, and you can undertake the difficult task of reevaluating the ability of your editors and sales operation. There are two other things you can do: You can make yourself test the upper limits of price-tolerance in the marketplace. As I’ve said, it’s often higher than we think. And you can publish more books (provided they all have revenues higher than their TSC.) It’s extraordinary how often execs go the exact wrong way: Given a couple of years of red ink while publishing 240 titles, their solution is to "cut back" to 180 -- with nothing like a 25% reduction in FOH. The "strategy’ is to "publish fewer books but better books" -- as though they’ve known all along which titles would lose money. They consistently find that their percentage of losers remains constant -- but now they lack the aggregate contribution of the sixty cancelled titles a year. Within two years they’re out of a job.

Certainly if every title on the list is a sure-thing red-ink loser, then you cut your company’s annual loss by cutting the number of titles. But if they all make some small contribution, and if when you cancel titles you do not make a cut in FOH equal to the aggregate lost-contribution, you have increased the company red ink for the year.

Meantime a word about university presses. Much of what I seem to advise here will not apply to them, because a university press’s first brief is often not profit but the spreading of information. This piece is not intended to tell them what to do; it’s meant only to help them understand what they are doing.

41. Strategic tip for the small publisher who asked me what percentage to use to satisfy his investors. They wanted to see the projected p&l’s on all proposed new titles -- and the p&l’s should show a contribution percentage. Here’s what to do. (1) Sum projected annual sales. (2) Sum your annual FOH and a little bit for profit. (3) Take the second number as a percent of the first. (4) Use that percent as the required contribution percent on each title p&l. Adjust projected unit-sales and prices accordingly. (5) Pray. Pray they’re not canny enough to match up each print-and-price sheet with each projection sheet; pray happy lightning strikes early in the year, stunning them into inattention thereafter; pray you have in fact picked good titles and and the projected units and prices are reasonable. Failing those prayers, pray you remember how to prepare a resume.

42. Recent buzz-notions among financial planners have names like "Activity Based Costing" and "Uniform Capitalization". These forms of accounting -- which amount basically to an effort to make all costs TSC -- are diametrically wrong for the kind of book publishing we’re discussing. Such accounting methods are prompted by several motives. The first is a sincere, well-intended but misplaced -- in book publishing -- effort to tie essentially all costs in a company to the product that company produces. This way, they believe, when they look at the sales the product generates, they can better judge if the product was worth it. But, this piece has been arguing, there is in book publishing a disjuncture between FOH and actual product cost -- TSC. It’s thus a delusive fiction -- with potential damaging consequences -- to say that all FOH can be traced to individual titles causing it.

Which is to say these accounting methods may work just right for a services company, or a few-new-products-a-year company like General Motors. If General Motors decides to launch a new model, chances are they will have to increase their payroll and rent new space. If you embark on a new ten-volume reference work with an eight-year gestation, that’s not a new book, it’s a start-up subsidiary that requires its own special accounting. But the book publisher who decides to do an extra novel or biography won’t have to raise the President’s salary or hire another body and office to do the book. By making all costs TSC you ignore totally the indisputable fact of how infrequently new products and higher sales create any new FOH. When my company sold 5,000,000 copies of the paper edition of The Silence of the Lambs, I guarantee our rent stayed the same. The only way to compare project A to project B is by comparing their dollar-contributions -- which, by the definitions given above, requires charging the book with solely the disbursements it caused, and not with any FOH which, since it would have occurred anyway, logically could not have been caused by the title in question.

The second motive behind such methods is often suspect. Example: A company may "capitalize" a large percentage of its editorial costs in its financial statements by categorizing that cost as part of plant. They then expense this year’s total plant cost over, say, the next five years. Their argument is that the editorial work went into a product that was expected to sell for five years -- so this is just matching costs to revenues. But the effect is to make this year look good at the expense of later years. As long as the company’s sales continue to slope up, the day of reckoning will be delayed. But once the sales plateau, the "plant" that has to be expensed will be a larger and larger percent of sales -- with consequent impact on the profit line. (Livent, the theater producers who created the musical Ragtime, even capitalized the huge initial promotion on each production, expensing it over five years. Consider what a boon that could be to a publisher desperate to look good this fiscal year. He puts a million dollars into launching a new title for this Christmas, picks up all those initial sales with their alleged contribution, and, by capitalizing the promo cost and spreading it over five years, only has to expense $200,000 in promo. Of course, four and five years from now, when the title is as dead as Gorboduc, they’ll then still be expensing $200,000 a year for the deceased.)

It’s a method that start-up organizations who want to look good from day-one might be eager to adopt. Or it could be used by a company that anticipates selling itself three years from now. It makes these next few years look nifty -- with the new owner unwittingly picking up costs that were incurred years ago to produce sales years ago. Ideally, the auditors a buyer chooses to do its due diligence before an acquisition will be very familiar with the accounting twists and loppholes that are special to publishing.

Another incidental by-product of such accounting is the difficulty in doing any realistic post-mortem p&ls on given individual titles.

43. There is, of course, much more that could be said about "pricing to market", and about "planning the list", and -- following from #39 -- about which markets for which products are elastic or inelastic, and much, much more -- but I’d better stop here or the core points I’ve been trying to make will be obscured even more by the surfeit of detail.

44. To summarize the answer to the question put in #2:

1. When pricing books, do use a pricing formula, and see that the formula demands a contribution-percentage.

2. When deciding whether or not to do a book at all -- i.e. when you’re making a publishing decision as distinguished from a pricing decision -- focus not on the contribution’s percentage but on the amount of absolute dollars.

3. At the beginning of the year, when you’re doing the annual forecasts, if you see that your FOH is projected to eat up an astronomical percentage of your revenues, do not think you are remedying the problem by cutting titles with low contributions. This is an effective treatment only if you can replace a deleted title with another title that has more contribution. If the first title has any contribution at all, and you delete it without a replacement, you have just increased your loss for the year. Here’s a sweeping generalization: Any mature company that has FOH of seventy or eighty percent needs to do one of two things: Find better editors -- i.e. editors who can bring in books that will have higher contributions -- or increase the number of titles being published, because -- say I categorically -- any mature company with so robust a FOH is not using it up to capacity.

Epilogue. I’m aware I haven’t supplied a checklist of hard numeric dicta -- "here’s what your contribution-percentage must be, your profit percentage, your number of books per editor." I haven’t done it because I would be wrong -- not just for your house, but wrong in principle.

I understand those who admire mathematical adroitness, and logic, and consistency and completeness of systems. Departures from any of these makes them uneasy. So, when they have the power, they tend to impose forms, formulas, and formats on the troops. Most of the time most of the troops live easily enough with this, because each time a question comes up who wants to have to reinvent the wheel? And many of the forms make sense, by and large.

But it’s a fundamental truth -- and not just in business -- that the very best of thinkers and leaders have to rise above their passion for formulas. The world is infinitely complex, often indeterminate, and as changeable as the river. We can’t devise complex enough formulas to embrace this infinity, and even if we could it would be infinitely hard to apply them. Thus the ultimately most effective minds learn to live occasionally with loose ends, with ad hoc decisions, with lack of mathematical certainty -- with "gut". If they’re good enough, they don’t go to pieces when confronted with the small daily chaos of life, and they don’t become mad totalitarians commmanding the patternless seas to conform. They will live with the fact that sometimes departure from formula is the right thing, and sometimes a guess, and sometime taking a chance. They may prefer a world of calculation, of deduction, but they know much of it can be mapped only byinduction, by experiment, by feel. History has shown them that permanent concrete bunkers do not serve either to defend or to advance, and they know they must advance. And, if they’re good enough, their imperfect gut will still be adequate when -- and it will -- their calculator goes blind.

Appendix re: One difference between a company p&l and a title p&l:

You "expense" pp&b-and-royalty differently depending on whether you’re doing the company’s annual projections and actuals, or individual title p&ls. As a generalization we can say this: Accepted accounting practice, and the IRS, allows a company to list as a cost only the royalty and pp&b on books sold. But when you’re trying to evaluate a given title’s worth to you, you should charge it with the cost of all the books printed and with the royalty-earned or the author-advance whichever is higher. In the company statements, the unsold books and unearned author-advances are "carried on the balance sheet" as assets -- until they are "written off". If you’re never going to sell those books or earn out those unearned portions of advance, your auditors will require you to expense them as write-offs because their job is to see that your statements -- which include your balance sheet -- give an honest picture of the health of your company. The auditors’ responsibility is not so much to managment as to the owners and to potential buyers of the company. Meantime, the IRS doesn’t want you to write off these "assets" as expenses prematurely -- because you may just be trying to reduce this year’s taxable-income line by expensing everything in sight.

The more heinous sort of quasi-cheating goes the other way, however: Management (and owners looking to sell) will stall write-offs as long as they can. This makes their profit line look better, and their balance sheet will seem to show valuable "assets" that in fact are worthless. That’s why good "due diligence" -- the inspection of the company by a potential purchaser -- requires digging deeply into the entries on the balance sheet. The "inventory" entry on a book publisher’s balance sheet will often be a huge number -- tens of millions of dollars. It’s supposed to express the sum of the value of all the books in the warehouse. A good auditor will go look for those books -- sometimes they don’t exist at all -- and, when he finds them, look at the sales history title-by-title. They’re apt to find, say, 10,000 copies of a title that has sold a total of 100 copies in the last three years. This, they will say, is an "inflated asset" and it should be written down if we’re to arrive at a true picture of the value of this company. It’s even more important to examine on hands-and-knees the items that constitute the "Royalty Advances" entry on the balance sheet. For example, here are three categories to look for: (1) Books already published. These advances can only be justified as "assets" if

There is evidence for believing that future royalty earnings or rights income will exceed the currently unearned portion of the advance. (2) Advances outstanding on very old contracts. Is it probable the manuscript will never be delivered? (3) Large advances for books the value of which has clearly dropped since the book was signed up. (Your imagination can probably supply ten of these in the time it takes to wince thrice.) Still another asset to be inspected closely is the alleged "accounts receivable". We are led to believe that a clerk at Penguin would grant large customers a large discount off their owings if they would pay the lower amount early. She retained the kick-back amount in the accounts receivable balance. She did this, we’re told, for years. But surely the auditors year after year went through the standard practice at year-end of asking each large debtor, "Here’s what our ledgers say you owe us. Is this an accurate figure?" As I said at the beginning, a knowledge of how publishing really works can be interesting and valuable.

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