How Thor Power Hammered Publishing

by Kevin O’Donnell, Jr.

Many of us know that publishing has changed considerably over the last 15 years. More titles see print every year, but the average title sells fewer copies, and goes out of print more quickly, than its late ’70s counterpart. Advances and royalties have dropped in inflation-adjusted terms. More books become insulation and other recycled-paper products earlier than ever before.

Many of us also know that one of the causes of this change was the Supreme Court’s 1979 ruling in Thor Power Tool Company v. Commissioner of Internal Revenue.

Still, over the last 14 years I’ve encountered a number of statements that demonstrate a profound failure to understand either the ruling itself, or its implications for the publishing industry.

The most common such statement says, “Thor Power puts a tax on inventories.”

This is not true. An inventory tax, like a property tax, imposes a certain number of cents in annual tax for every dollar of inventory, regardless of corporate profit or loss.

The Thor Power ruling does involve inventories as they relate to corporate income taxes, but it does not tax inventories.

A Little Background

Companies pay income tax on their profits. Put simply, taxable profits are what’s left after subtracting all legally deductible expenses from gross revenues. The tax that must be paid is a percentage of taxable profits.

    Gross Revenues
    - legally deductible expenses
    ------------------------------
    Taxable Profits
    x tax rate
    ------------------------------
    Income Tax Due

Clearly, higher deductions result in lower profits and, therefore, lower taxes.

One legally deductible expense is “COGS” (cost of goods sold) — the amount the company paid for the items that its customers bought. To determine COGS, many companies use some form of this equation:

              Yearopen     Additions   Yearend
    COGS =    Inventory  + To        - Inventory
              Value        Inventory   Value

American tax law lets a company set a dollar value on its inventory of either its actual cost, or its market value, whichever is lower. When the market value of an inventory item drops below its actual cost, the company can “write down” the value of its inventory to reflect the new lower value. This increases COGS, and thereby reduces taxable income.

Let’s put some numbers into the COGS equation. Assume you (1) start the year with $100 worth of goods in inventory, (2) buy $250 worth of stuff during the year, and (3) end the year with an inventory that cost you $200.

              Yearopen     Additions   Yearend
    COGS =    Inventory  + To        - Inventory
              Value        Inventory   Value

         =    $100       + $250      - $200
         =    $150

Now assume a different set of market conditions. Assume that even though you paid $200 for what you have in your warehouse on December 31, you can only sell it for $150. In this case, the law lets you write down your inventory. Doing this increases COGS:

              Yearopen     Additions   Yearend
    COGS =    Inventory  + To        - Inventory
              Value        Inventory   Value

         =    $100       + $250      - $150
         =    $200

Because COGS is a legal deduction, increasing it like this reduces taxable income by an identical amount.

Prior to Thor Power Tool, companies would often write down the value of slow-moving inventory, even when its market value had not dropped.

Their reasoning went like this: “We have 100 widgets in inventory. Each widget cost us $2. That sets the inventory value at $200. However, at the rate we’re selling them, we’ll only sell 75 widgets before they become obsolete. So, the real value of this inventory is $150 (75 x $2), because 25 of the widgets have no value at all.”

By writing down inventory, they increased COGS, and thus decreased taxable income.

The IRS did not like this, because lower taxable income means lower tax receipts. The IRS said, “Look, you still have 100 widgets. They cost you $2 apiece. The market value is over $2. Therefore, your inventory is worth $200. We will let you value it at $150 only if either (a) the market value of each widget drops to $1.50 or (b) you throw 25 of the widgets out. You can’t have 75 worth $2 and 25 worth nothing. Period.”

So they went to court.

The Supreme Court’s Decision

“In (Thor Power Tool Company v. Commissioner of Internal Revenue)…the IRS negated Thor’s practice of writing down the value of its spare parts inventory which it held to cover future warranty commitments. Thor contended that, although the sales price on the individual parts did not decline over the years, the probability of all the parts being sold decreased as time passed, and thus so did the net realizable value of the inventory as a whole. The IRS contended that a decline in inventory values for tax purposes must await actual decline in the sales price of the individual parts. The Supreme Court indicated that for tax purposes, the lower of cost or market method was to be applied on an individual item basis and that if no decline in sales price occurred, no loss should be permitted.” (Intermediate Accounting, Kieso & Weygandt, 4th Edition, John Wiley & Sons, 1983, pp. 392-393)

The Aftermath

Most everyone knows that Thor Power has had a major effect on publishing. Unfortunately, too few people know how and why the ruling changed the industry.

The short answer: Thor Power eliminated a tax dodge, and thereby made it more expensive for publishers to carry inventory from year to year. As a result, publishers have cut print runs in order to minimize inventory. They have also become quicker to dispose of inventory — i.e., pulp it — before the end of the fiscal year.

The long answer involves an example. Assume (purely for the sake of using round numbers) a publisher prints 80,000 copies of a book at cost of $1.00 per book. Assume the publisher sells 50,000 copies of that book at $2.00 apiece (we will ignore the problem of returns, here). Assume the publisher pays federal, state, and local income taxes at the rate of 40%. Remember that

              Yearopen     Additions   Yearend
    COGS =    Inventory  + To        - Inventory
              Value        Inventory   Value

Before Thor Power, the publisher would have said, “Well, we have 30,000 copies in the warehouse. We’ll never sell those at full price. Some, yes, but we’ll have to remainder some at 50 cents a pop, and we’ll have to pulp the rest. So really, on average, they’re only worth 50 cents each. That’s a year-end inventory value of $15,000.”

Since Thor Power, the publisher has had to say, “Well, we’ve got 30,000 copies in the warehouse. Each is worth a buck. That’s a year-end inventory value of $30,000.”

    ===========================================
    SIMPLIFIED INCOME STATEMENT
                      PRE-THOR        POST-THOR
    Inventory
         Year Open           0                0
         Additions  +  $80,000       +  $80,000
         Year End   -   15,000       -   30,000
                        ------           ------
    COGS               $65,000           50,000

    Revenues =        $100,000         $100,000
       -COGS            65,000           50,000
                       -------         --------
    Pretax profits  =   35,000           50,000
        x Tax rate         .40              .40
                       -------         --------
    Taxes           =   14,000           20,000
                       -------         --------
    After-tax profits  $21,000          $30,000
    ===========================================

But wait! Isn’t the publisher doing better under the Thor rules? After all, it’s now making $30,000 on a $100,000 investment, whereas before it only made $21,000.

Well…not really. It earns that $30,000 profit only if it manages to sell every copy in the warehouse for $1 apiece. From a cash-flow point of view, that book’s first year looks like this:

    ========================================
    CASH FLOW STATEMENT
                  PRE-THOR         POST-THOR

    Revenues     $100,000          $100,000
    Expenses
         Printing (80,000)          (80,000)
         Taxes    (14,000)          (20,000)
              ------------        ----------
    Change       $  6,000                 0
    ========================================

In other words, under Thor, the publisher has had to spend $6,000 more in the first year than it would have before Thor. Instead of showing an operating profit, it just breaks even.

On the balance sheet, it looks like this:

    =======================================
    BALANCE SHEET
                 PRE-THOR         POST-THOR
    ASSETS
      Inventory   $15,000           $30,000
      Cash          6,000                 0
    LIABILITIES         0                 0
    EQUITY        $21,000           $30,000
    =======================================

Again, one’s first reaction is, hey, Thor raised the publisher’s equity, so all the shareholders are a little richer. Isn’t this good?

Um…it would be — if it were true. But is it? Can the publisher actually sell all those copies for $1 each? (Maybe.) And even if it can, is $1 received in the year 2000 worth as much as $1 received today? (Absolutely not. Think Net Present Value — or compound interest in reverse.)

From the writer’s point of view, another danger lurks there: One measure that Wall Street uses to judge a company is Return on Equity (ROE — profits divided by equity). If the publisher’s ROE is low, by industry standards, then its stock price goes down. By raising net worth (equity), Thor has forced the publisher to earn higher profits just to keep its ROE (and its stock price) constant. Publishers thus become even more averse to “risky” books — like first novels, or works of high art and low sales.

So how have publishers adapted to Thor Power? By setting print runs closer to the level of advance orders, and by purging inventory. Here’s how the numbers look when a publisher prints 60,000 copies (instead of 80,000) and pulps the 10,000 it couldn’t sell before year’s end:

    ===========================================
    SIMPLIFIED INCOME STATEMENT
                  PRE-THOR           POST-THOR,
                                  FULLY ADAPTED
    Inventory
         Year Open           0                0
         Additions  +  $80,000       +  $60,000
         Year End   -   15,000       -        0
                        ------           ------
    COGS               $65,000           60,000

    Revenues =        $100,000         $100,000
       -COGS    =       65,000           60,000
                       -------         --------
    Pretax profits  =   35,000           40,000
        x Tax rate         .40              .40
                       -------         --------
    Taxes    =          14,000           16,000
                       -------         --------
    After-tax profits  $21,000          $24,000
    ===========================================

By printing fewer copies, and physically destroying any it couldn’t sell, the publisher has locked in a profit of $24,000 and reduced future costs (primarily warehousing, but also including sales, distribution, and accounting). It has sacrificed potential profits, to be sure. On the other hand, it has improved its cash flow:

    ========================================
    CASH FLOW STATEMENT
               PRE-THOR           POST-THOR
                              FULLY ADAPTED
    Revenues     $100,000          $100,000
    Expenses
         Printing (80,000)          (60,000)
         Taxes    (14,000)          (16,000)
              ------------        ----------
    Change         $6,000          $ 24,000
    ========================================

By reducing print runs and inventory, the publisher has deposited an extra $18,000 into its checking account. It has also strengthened its balance sheet with hard cash, as opposed to hard-to-move inventory.

    ========================================
    BALANCE SHEET
               PRE-THOR           POST-THOR
                              FULLY ADAPTED
    ASSETS
      Inventory   $15,000                 0
      Cash          6,000            24,000
    LIABILITIES         0                 0
    EQUITY        $21,000           $24,000
    ========================================

And now comes a real kicker for writers: Because this book is out of print, the publisher has an opening on its list, more cash to invest, and a serious need to replace the steady (if small) income stream that book would have generated. So the publisher must release not only the new title it would have published anyway, but a second new one, to make up for its lack of a backlist.

This results in title proliferation, which itself promotes both lower advance orders on the part of major buyers, and a higher return rate. That means writers must write more, and sell more often, in order to survive.

Is There A Solution?

Although rewriting the tax code to permit writedowns of slow-moving inventory would make maintaining a backlist slightly more attractive to publishers, we cannot return to the old ways. Title proliferation, competition for rack space, and a product life cycle measured in weeks have forced publishers to focus their resources on the future. Only a savage, industry-wide cutting of new releases and strong consumer demand for backlist titles will change things.

I am not optimistic.
____________________

Kevin O’Donnell, Jr. has been selling words since he graduated from Yale in 1972. Periodicals ranging from Alfred Hitchcock’s Mystery Magazine to OMNI have printed more than seventy of his shorter works, a number of which have also been anthologized, both in the United States and overseas. A member of the Science Fiction and Fantasy Writers of America, he has published ten books in America, and has been reprinted in Britain, France, Israel, the Netherlands, Spain, and West Germany.

Copyright © 1993 by Kevin O’Donnell, Jr. First published in the Bulletin of Science Fiction and Fantasy Writers of America, Spring, 1993 (Volume 27, Issue 1; Whole Number 119).

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