Music Advocacy Journal Issue #3: Technical Treatise on Record Piracy – Part 2, Where Does Your CD Money Go?

Introduction

In Part 1 “Yin and Yang”, I laid out the critical questions surrounding music piracy and shared a true story that exhibited a polarized point of view on the topic. We talked about how MYnstrel approached the problem of music retail from a neutral position – concerning ourselves with all of the competing interests of different parties, and digging up the facts.

In Part 2, “Where Does Your CD Money Go?”, I will share some of MYnstrel’s analysis that was generated in our music retail Business Process Engineering activities. The key question in this issue of Music Advocacy Journal is simple:

  • Where does your money go when you purchase a CD?

It’s important to know where the money for a CD goes to understand how piracy impacts the workers responsible for getting the album from the artist’s mind and into your hands. In addition, there have been numerous ideas about music piracy in the past five years that seem to have some validity, but are actually harmful to artists and fans because the ideas don’t consider the full realities of music recording, production, distribution, and manufacturing. For around 100 years, music has been fixed into recorded vehicles of consumption that the public has enjoyed. Over the years and behind the scenes many things have changed, but many of the principles are the same.

Haven’t you always wondered what you’re paying for when you purchase recorded music? I think this is a fascinating article not just for Artists and Music Biz Pros, but also Music Fans. Let’s dive in!

Those evil record companies…

More than a decade ago, before I knew much about the actual business of music, I was an engineer-in-training, learning how to solve complex problems with applied mathematics, computer science, physics, chemistry, biology, and economics.

I heard word on the street that the major record companies were evil corporations, and they ripped off artists and fans. The only justification I heard for this judgment is that “Artists only make a dollar or two from a record sale.”

In my younger more impressionable years, I was more inclined to believe subjective claims. Now, with a plethora of facts at my disposal, I have a different opinion.

My conclusion? It is likely that history is repeating itself. During the Great Depression in the USA, the record industry’s annual revenue declined from $100M to $20M because they blew off the impact of radio, erroneously confident that music fans would always want their own personal record collections.

The music industry didn’t predict the Great Depression, and they didn’t predict the widespread sufficiency of radio as an alternative to personal record collections. Does anyone see a parallel today, in 2009?

In addition, by the time we get through this series of articles, you’ll realize something – the vast majority of the money collected from a music retail sale is not going into the Record Label’s pocket. It is going into an insurance pool that the Record Label manages. This pool was created by everyone who has listened to popular music for the past five decades. It is the effect of narrowcasting, the price we pay for diversity of choice – and the immense financial risk that is created by that uncertainty.

This is easily observable any time you hear a fan say something like, “Yes, I like rock, but not rock style x, y, z, metal, nu-metal, hard rock, soft rock, pop rock, funk rock, emo, screamo, classic rock, punk rock, goth rock, etc. etc.” Although Urban/Hip Hop/Rap is less narrowcasted because of its relatively young age, it’s well on its way too.

Today, musical sounds and bands are so highly specialized, it’s difficult even for the most trained ear to pick the ones that will make their money back – and on the contrary, the albums that will burn up hundreds of thousands of dollars without coming close to making the money back. The albums that succeed largely subsidize the albums that fail. It’s a gamble. Most of your money pays for that gamble, so we get the wide variety of choices and diversity that we create with our highly specialized preferences.

Today, I don’t believe that record labels are evil, although they are definitely unscrupulous at times (like any business). I purport that the record industry has made some crucial miscalculations over the past two decades, and all of the people who depend on them for music – Fans, Artists, and Music Biz Pros – have suffered the consequences of those miscalculations. When you see the economics that underlie a record sale, you might agree with me.

Where does my money go?

When you buy anything in a store, your money is going somewhere. So where exactly does the money from a single record sale go? What are you paying for? Seems like a simple question, right? Buckle your seatbelt for a real treat! MYnstrel dove into over 2,000 pages of textbooks on music business, legal proceedings from major law suits, and dozens of annual reports from music industry publications, so that we could extract the figures that would underlie a normal CD sale. It took over 20 spreadsheets to generate our analytical model of the cash flow from a CD sale.

Now, understand that there are all sorts of variables. In most record contracts, the artists don’t get paid for largely discounted CD sales. Some cuts of the money from the sale are hard and fast amounts, some are percentages, and others depend on the number of songs on the album (and length of the song).

We’ll start by figuring out how much front-end revenue an average CD generates ($16.83), accounting for the retail stores and the government. It’s important to note that all the individual numbers in this analytical model are estimates that might be off by small orders of magnitude, because of how many dozens of factors and variations contribute to the model. Regardless, the model is very accurate as a whole, and the concepts shine through because we used industry-wide stats, values present in standard music contracts, and the Law of Large Numbers. By the time we’re finished, we will have derived a comprehensive cash flow diagram. For this issue, we will only cover Retailers and the Government. The following diagram illustrates the cash flow that we’ll explain in this issue:

MAJ 3 pic 1

A little intrigued? Let’s start explaining all the interesting facts that our model illuminates.

Retailer Cut: $1.46 (8.7% of the total money out of your pocket) – and they took it from you when you bought something besides the CD

Stay with me, because the retailer is a tricky player. We have to start here, because…well, that is where you spend your money! It all starts with your decision to buy a CD at a retailer like Best Buy, Amazon.com, or Walmart.

Let’s determine the average price of a CD in 2007. Well that shouldn’t be too hard…or should it? Based on the 2007 RIAA Market Sales Report, the number of physical CD units shipped was 511.1M. The gross revenue for CDs was $7,452.3M. Their numbers are very accurate because they only count the manufacturer’s unit shipments and retail value, after returns. In addition, we dug around to find prices online offered by various companies for wholesale CD lots (minus the ones who sell liquidated inventories). Interestingly enough, typical wholesale costs for CDs were right in line with the RIAA Market Sales Report. So we estimate the average wholesale price of one CD in 2007 to be:

MAJ 3 pic 3

Now this might give you pause. When you go to Walmart, Best Buy, or Amazon.com, you will rarely pay more than $14.58. So am I telling you that when you buy a CD for less than $14.58, that the retailer who sells it to you is not making any money, and in some cases, losing money? Yes, that’s what I’m telling you – at least the vast majority of the time.

Sometimes there are “bargain” CDs that have been slashed in price by the record label, and sometimes CDs are priced higher for special features like dual disc or DVD extras. But those outlier cases are negligible in our model thanks to the Law of Large Numbers (we’re estimating here, folks).

You ask, why in the world would a merchant sell something at a price that makes them lose money? This is nothing new in retail. It’s called a loss leader. Those retailers are making huge amounts of money on your other purchases for electronics and other devices; they use CDs to bait you and increase the frequency that you go to their stores. In addition, the volume of sales for their media products is so large that even if they make a small amount on the normally priced items, it also subsidizes the low-priced CDs.

So don’t feel like retailers are doing any favors for you – if you’ve ever bought something other than media from them, then you’re paying more than the difference out of your own pocket.

You can even do your own little experiment (not that MYnstrel has tried this, or recommends it). Put on your spy hat and go to your local electronics retailer like Best Buy or any other. Start up a friendly conversation with any worker, and ask them, “What is your employee discount on store items?” They’ll tell you “We get huge discounts on car audio devices. We never get discounts on CDs that cost $10 to $13, because they call them ‘sale’ items. Even on CDs that are $15 or $16, we barely get any discount.”

Now you might be asking, “Why do retailers choose to sell CDs at a loss?” Let’s drive the point home: because it generates lots of foot traffic and you will then buy other things with huge profit margins. Oh, and there is one more concealed motivation – running other companies out of business, and ensuring that no more pesky music-only stores can pop up as time rolls on. Look to the lawsuit filed in August, 2000 by 29 states, led by New York, Florida, California, and Texas. But that’s a story for another day. Trust me, these large retailers are profitable for discernable reasons.

So let’s do this. Let’s say the average price of a CD to the CD buyer is $12.99. Sounds fair, right? Now consider a gross profit margin for a large retailer like Best Buy during a quarter close to the time we did this analysis – 23.5%. They’re hedging their bets that in a macro sense, their items will yield a 23.5% gross profit margin, and that foot traffic they generated with the undercut CD price will yield 23.5% return on that $12.99 CD purchase you made. So what do they get out of it? They get:

MAJ 3 pic 4

Consequently, the electronics-buying customer is subsidizing the $1.59 loss on the purchase, and giving the retailer an additional $1.46 in profit. A company like Best Buy will actually pay the loss of $1.59 per CD to the record distributor, hedging their bets that using the CD as bait to increase foot traffic will continue to drive a typical gross profit in 2005 of 23.5% – 25%.

By doing this, even though they’re selling the CD to you at a loss, they still get a net positive from subsidizing that with volume transactions and sales of more profitable items – the sales that the CD foot traffic drive. In addition, they get to monopolize the retail space so that all those small pesky music-only stores can’t come back and take some small bites out of the business. Let’s face it – it’s a lot more expensive to make a new Best Buy/Circuit City/Walmart chain than it is to open a music-store chain.

Among the large retailers, they now all possess nearly the same business model. I’ve got news for the judges, state governments, and plaintiffs involved in that lawsuit – consumers are still paying the $1.59 per CD, we’re just doing it through an obscure process.

So what about those music-focused stores? If you’re really motivated, maybe you’ll be able to put small record stores in malls where there is a lot of foot traffic and people will pay a little bit more for the CDs, and forget about the cheaper prices while they’re out with their friends at the mall (FYE, anyone?).

Next up, what else but…

The Government: $0.79 (4.7% of the total money out of your pocket)

With an average retail sales tax of 4.9%, the Government is taking $0.79 of the sale from the customer’s pocket (the handful of states with zero sales tax drag the average down). Of the total money out of your pocket, that turns out to be 4.7%. This is over and above the $12.99, because we will credit the tax on the loss leader subsidy and total revenue generated by the CD since the retailer attributes that “foot traffic” to generating the subsidy revenue and more. These facts yield the average sales tax revenue from a CD sale:

MAJ 3 pic 5

Your average CD cost: $16.83

Let’s now summarize the average figures for a CD sale. The record distributor sells the CD to your retail store for $14.58. In turn, the retail store offers it to you for $12.99, but you pay an additional $3.05 out of your own pocket whenever you purchase something else with a higher profit margin. The tax on the final cost of $16.04 comes out of your pocket too, for a total of $0.79 per CD.

You can look at it one of two ways: either you’re paying too much for the price of electronics that subsidize the cheaper CD, or you’re getting a steal on the CD by never buying electronics from such retailers, instead opting for bargain hunting online for electronics (in which case, other consumers are paying for your discount). Whatever way you look at it, $16.83 is coming out of your pocket. The retailer gets huge amounts of profit as they draw you to the store to purchase high-profit items using CDs as bait.

So what amount of money is headed to the music companies and artists? You got it – $14.58 per CD on average, as depicted below (average wholesale price for one album):

MAJ 3 pic 2

Next time…

In Part 1 “Yin and Yang”, we laid out the concepts surrounding music piracy and exemplified the philosophies with an entertaining story.

In this article, Part 2, we have established a robust analytical model to determine where all of your money goes when you buy a single CD.

In the next article, Part 3 “Stratification & Levies”, we will show you what happens to your money on the back end after the retailer has made the sale. Who exactly is responsible for getting a great-sounding recorded piece of music in your hands? What do they get paid for their labor from that CD sale?

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