The Additional Cost of Discounting
The most important commercial term in your license agreement is the base royalty rate. Obviously.
It’s what you use to calculate the royalties incurred and the contribution of each product.
But is it?
Not always.
There are clauses, rates, and considerations in the agreement that in some circumstances can have far more impact on the bottom line and they are rarely as visible and obvious to the licensee.
But they are to the auditor. Because that’s were the money is. A lot of it anyway.
It’s not always possible to negotiate each and every clause, and often they are set in stone as far as the licensor is concerned. But it pays dividends to understand all of them in detail, especially how they may affect your bottom line.
Below is a simplistic example of the application of a limit to the discount permitted on sales for the calculation of royalties.
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The calculations are based on the following:
- Gross sales $1m
- Royalty rate 10%
- Discount limit 3%
- Notional audit cost $20,000
- Audit findings threshold 5%
So, the effect of discounting sales at 10% and declaring at the prevailing royalty rate based on net sales equates to an effective royalty rate of 13% (assuming this is the only finding in the audit).
Obviously, this analysis of the discounting process is simplistic to illustrate the impact of discounting and there are many more considerations to take into account. Standard trade discounts are likely to be one element of a wider customer agreement and it may be necessary to discount slow-moving lines to sell through at times, but these justifications will be wholly irrelevant in the context of an audit. Unless of course you have an agreement in advance or have negotiated the discount clause to cover these eventualities. This is rarely the case.
It may still be advantageous to discount even with this additional cost but at least with the benefit of foresight the cost is recognised and can be accounted for. And in this scenario, (designed to illustrate a point of course) the actual cost of discounting $1m sales at 10% is $127,000.
And, of course there is interest on the findings which pushes this up even more…