|  |
 |
 |
 |
|
|
|
Printable Version
E-mail to a Friend
APA | MLA | |
Alison Brown and Garry West launched Compass Records Label (“the company”) in 1995 when the music industry was at the peak of its glory, having grown from $2 billion in 1969 to $40 billion in 1995. Although the market was dominated by four big players, there were still opportunities in niche segments and the company started to carve its niche in the folk and roots musical genres. Since inception, it grew at a Compounded Annual Growth Rate (CAGR) of 18.84%. Notably, in the years after 2003 when the music industry was declining at a CAGR of 5%, the company grew at a CAGR of 74.10%. In 2005, the company saw 80% of its titles turn in profits as compared to a 10% for the big four.
In June 2005, the company was contemplating on offering a recording contract (“the contract”) to a talented but new folk musician, Adair Roscommon (“the artist”). The artist, both a songwriter and a recording artist, had released an album in 2003 which sold 2,500 copies. Given a limited budget, the company needed to decide on the type of contract to offer: license for a limited period or produce and own. The company had historically preferred to license rather than produce and own. But with new distribution agents in Europe and Asia creating opportunities to sell CDs in new markets around the world, and the recently built studio making album production easier and cheaper, the company needed to re-evaluate their historical strategy.
Expenses
The expenses incurred by the company upon offering a contract are classified under these categories:
1) Royalties: Mechanical royalties are fixed to a statutory rate of $0.085 per song per CD sold. For artists who are both songwriters and recording artists, the company includes a controlled composition clause or negotiates a co-publishing agreement allowing the company to limit its mechanical royalty expenses. Recording artist royalties are negotiated between the company and the artist. Depending on the stature of the artist, recording artist royalties ranges between 8% - 25% of the retail price of the album. The retail price of an album is $17.98 per CD.
2) Production and Manufacturing: The company spends between $15,000 and $25,000 to produce an album. With the recently built recording studio, production costs would be reduced by $500 a day for a project. The manufacturing expenses are about $0.70 per CD in addition to the $0.20 per CD for printing the booklet and other materials inside the case. The company manufactures 30% more units than its estimated sales. It recoups 100% of this total cost from the recording artist royalties particularly if the album sells.
3) Marketing and Distribution: The company has a highly specialized and targeted promotion strategy, including a mail out volume of 2,000 CDs. The company negotiates a manufacturing cost of $0.50 per CD with an additional $2 per CD for postal and other expenses. Live concert promotions cost the company $3,000 for print-advertising campaigns, $500 for posters and press, $1,000 for e-card mailings and $2,500 for an independent radio promoter. CD distribution is critical; local distributors charge 21% of the wholesale CD price of $11.45 per unit for distribution, while foreign distributors do not charge a distribution fee. The company also spends around $5,000 on in-store listening stations and other retail programs to market a new artist. Unsold units are writen off after two years. The company recoups 50% of this expense from the recording artist royalties.
Licensing Contracts
When the company licenses the artist’s album for a limited period, it will certainly be more cost-efficient in the short term. The artist bears the production cost and the company bears the manufacturing, marketing and distribution costs. The company then pays the artist a fee, usually between $3,000 and $5,000 depending on his or her popularity, to cover part of the production cost.
However, upon signing the licensing agreement, the company is entitled to exploit the recording for only a predetermined period of time, usually five to seven years. This will limit the company’s potential profits, especially if the artist goes on to become very popular and the album hits record sales. The upside of a license contract is the earlier revenue realization of marketing costs since the company does not need to realize the production costs.
Product and Own Contracts
Under the produce and own contract the company incurs the production costs but these costs are completely recovered from the recording artist royalties. The artist receives no upfront fee. Under such a contract, the risks and rewards of owning the recordings are typically passed on to the company. It is entitled to exploit the music through the sales of albums and electronic downloads, which was increasingly popular, as well as through licensing the music to other record companies and entities that wish to use the music in commercials, television programs and films. This results in almost unlimited upside gain for the company. However, if the artist or album flops, the company would risk owning an impaired asset. The downside of a produce and own contract is delayed revenue realization or non realization of marketing costs.
A Decision to Make
The company will have to analyze and decide which contract type earns maximum profits while minimizing costs. If the company produces and owns the artist’s album, the initial costs will be approximately $20,000. Since the company is confident about the artist’s ability, this option could potentially generate infinite revenues. If the company licenses the artist’s album, the initial costs will be minimal - approximately $3,000. However, tangible returns may take time and more than one album, and it is possible that a larger recording company will come in and sign the artist once she attains a respectable level of popularity, bearing any clause in the licensing contract that addresses this issue.
There are a few tools the company can use to analyze these two mutually exclusive contract types. The first is the Net Present Value (NPV) method which technically calculates the present value of all future cash flows, discounted at the company’s cost of capital. A positive NPV indicates that a particular contract type is profitable and therefore worth considering.
Alternatively, the company can also calculate the Internal Rate of Return (IRR) of each contract type. However, since these two contract types are mutually exclusive, and given differences in the timing and size of the cash flows involved, the NPV method is more reliable. This is largely because the NPV method, which uses the company’s cost of capital as the discount rate, assumes that differential cash flows, occurring from timing and size differences of the two contract types, can be reinvested at the cost of capital. This is more realistic than assuming that the differential cash flows will be reinvested at the IRR because most firms do have access to the debt and equity markets.
The third method the company can consider is Discounted Payback, where future cash flows are discounted using the company’s cost of capital and then used to find the year the contract breaks even.
These methods expect the company to make assumptions on the expected sales which it can project using past sales figures. For a decision with a higher confidence level, the company needs to do a sensitivity analysis for varying sales projections.
In conclusion, given the different natures of the two contract types, Compass Records should use the NPV method as a primary tool of evaluation and supplement it with the Discounted Payback method to help the company make a better decision. The contract with the highest NPV, and preferably the shortest breakeven period, should then be accepted.
|
|
 |
 |
 |
|
|
|
