forest gump

Pergamon

Journal of Accounting Education, Vol. 15, No. 3, pp. 307--318, 1997 1997 Elsevier Science Ltd. All rights reserved

Printed in Great Britain 0748-5751/97 $17.00 + 0.00

PII: S0748-5751(97)00008-0

Case

ACCOUNTING IS L IKE A BOX OF CHOCOLATES: A

LESSON IN COST BEHAVIOR

Charles E. Davis BAYLOR UNIVERSITY

Abstract: This case is designed to be used in an introductory managerial accounting class to illustrate cost behavior and break-even analysis in a non-manufacturing setting. Revenue and expense information related to Paramount Pictures' hit movie Forrest Gump is provided and students are required to prepare a traditional income statement, identify fixed and variable costs, prepare a contribution format income statement, and consider the effects of changing from a variable cost structure to a fixed cost structure. While not a primary focus of the case, the material does allow for a discussion comparing internal reporting to external financial reporting and the applicability of GAAP in each setting. The short length of the case allows it to be distributed, read and solved within a single 90-minute class period. Suggestions for cooperative learning assignments are also presented. 1997 Elsevier Science Ltd

INTRODUCTION

Forrest Gump was one of the biggest movie hits of 1994. The movie's fortunes continued to climb in 1995, as it took home Oscars in six of the 13 categories in which it was nominated, including best picture, best director and best actor. One analyst has estimated that the film could generate cash flow as much as $350 million for Viacom, Inc., Paramount Pictures' parent company. Such success has insured the film a place among the top grossing films of all times. This is quite an accomplishment for a movie that took nine years to make it to the big screen and whose script was not considered material likely to guarantee a runaway hit movie.

But was Forrest Gump a money maker for Paramount in 1994? Films are typically distributed to theaters under an agreement that splits the gross box office receipts approximately 50/50 between the theater and the movie studio. Under such an agreement, Paramount had received $191 million in gross box office receipts from theaters as of December 31, 1994. Paramount reports that the film cost $112 million to produce, including approximately $15.3 million each paid to star Tom Hanks and director Robert Zemeckis, and 'production overhead' of $14.6 million. This production overhead is charged to the movie at a rate equal to 15% of other production costs.

307

308 c.E. Davis

Not included in the $112 million production costs were the following other expenses associated with the film. Promotion expenses incurred to advertise, premiere, screen, transport, and store the film totaled $67 million at the end of 1994. An additional $6.7 million 'advertising overhead charge' (equal to 10% of the $67 million promotion expenses) was charged to the film by Paramount. These charges represent the film's allocation of the studio's cost of maintaining an in-house advertising department. Paramount also charged the film a 'distribution fee' of 32% of its share of gross box office receipts. This fee is the film's allocation of the costs incurred by Paramount to maintain its studio-wide distribution services. Finally, $6 million in interest on the $112 million in production costs were charged to the film by Paramount.

Required

1. Was Forrest Gump an 'accounting' hit in terms of net income, as computed by Paramount?

2. In their original contracts, actor Tom Hanks and director Robert Zemeckis were to receive $7 million and $5 million, respectively, for their work on Forrest Gump. However, after the studio asked the producers for budget cuts, both Hanks and Zemeckis agreed to forego their standard fee for a percentage of the film's gross box office receipts. Sources estimate that the new agreement guaranteed each of the two 8% of the studio's share of gross box office receipts from the film. Using the information available about the costs of making the film, did Forrest Gump have a positive contribution margin? Assume that all costs not specifically identified as variable are fixed.

3. If Hanks and Zemeckis had demanded their original fees up front instead of taking a percentage of gross box office receipts, would Forrest Gump have made money in 1994?

4. Other individuals associated with the film signed contracts based on a percentage of 'net profits' rather than gross box office receipts, net profits being the film's profit after the recouping of all the studio's expenses. For example, Winston Groom, who wrote the novel on which the movie was based, received $350,000 plus 3% of the film's net profits. Eric Roth, the screenwriter, signed a similar contract with a fixed fee plus 5% of the film's net profits. Based on your calculations above, how much did these two individuals receive from their share of the film's net profits? How much in gross box office receipts will the studio have to receive from theaters before Groom and Roth receive any money under their net profit participation contract?

Lesson in Cost Behavior 309

5. Based on what you now know about contracts in the movie industry, which type of contract would a studio prefer actors, directors, and others associated with a film to have? Why? Which type of contract would the actors, directors and others prefer to have? Why?

TEACHING NOTES

Introduction and Purpose

This case gives students the opportunity to analyze costs and perform break-even analysis in the film-making industry using cost data about a film that many students will have seen, Paramount's Forrest Gurnp. Cost behavior and break-even analysis are topics covered in most introductory managerial accounting courses. These topics are typically presented from a manufacturing viewpoint with 'volume' being measured in units of product. However, these techniques also are useful in non-manufacturing settings, as demonstrated in the case.

The case is designed for use in an introductory managerial accounting class following discussion of cost behavior, break-even analysis, and C V-P analysis. It may also be modified slightly to illustrate allocation of common costs in a segment reporting setting.

Facts in the case were gathered from public sources (Lippman, 1995; Munk, 1995; Weinraub, 1995), some of which contained seemingly contradictory information. In speaking with the author of one of the articles, it became apparent that some of the numbers were estimates based on other information gathered from various sources. As can be imagined, studios and entertainment lawyers are reluctant to divulge all the specifics associated with the costs of producing a particular film. Therefore, while trying to remain true to the reported performance of Forrest Gurnp, the numbers presented in the case may not be the actual results recorded by Paramount. The numbers do, however, serve to illustrate the effect that cost behavior can have on reported income and on contract selection. The accounting methods used for this film led novelist Winston Groom, the creator of Forrest Gump, to file a lawsuit against Paramount for additional payment from the movie. The case was eventually settled out of court after Groom received a seven-figure commitment for the movie rights to a Forrest Gurnp sequel that also included a gross profit participation clause.

Accounting in the motion picture industry is an interesting, and often confusing, topic. Instructors desiring additional details concerning common accounting practices in this industry may wish to see Cheatham et al. (1996) and SFAS No. 53 (FASB, 1981). Pfeiffer et al. (1997) also offer additional background information on motion picture accounting, as

310 C.E. Davis

well as additional information concerning the accounting for Forrest Gump.

Teaching Approaches

The case lends itself to several teaching methods. First, it may be used as an outside assignment. Selected students, either individually or in groups, could present their solutions to the class. Alternatively, the case may be used as an in-class exercise. If distributed at the beginning of class as an in-class exercise, approximately 45-50 minutes should be allowed for solution preparation. Discussion of solutions requires an additional 20- 25 minutes, and may be done within the same class period or during the following class.

Additionally, the case lends itself to the use of several cooperative learning techniques. In the 'jigsaw' structure (Aronson et al., 1978), students can be assigned to one of four expert learning groups: calculation of net income, identification of variable costs, identification of fixed costs, and calculation of net income effect resulting from the change to a fixed- fee contract for Hanks and Zemeckis. One person from each group would then join to form a team to complete the case. A 'within-team jigsaw' (Stone, 1989) could also be used with a team being divided into two groups. One group would prepare a functional income statement and the other team would prepare a contribution format income statement. The teams would reconvene and compare net incomes. Any differences would be reconciled within the teams. The teams could then complete the remaining assignments. Finally, the 'discovery method' (Davidson, 1990) could be employed where students are given a basic introduction to cost behavior and break-even analysis and are then divided into teams to solve the case. In addition to the citations for the individual methods, see Cottell & Millis (1993) for further discussion on using cooperative learning techniques in accounting.

Suggested Solutions

Question 1: Was Forrest Gump an 'accounting' hit in terms of net income as computed by Paramount?

To answer this question, students should prepare a functional income statement for the film as of December 31, 1994, using the revenue and cost information provided in the case, as shown in Table I. As mentioned earlier, the sources of the expense information contained contradictions and heavy use of rounding. For consistency and ease in calculation, the amounts in the suggested solution have been rounded to one decimal


Table 1. Functional Income statement for Forrest Gump (in $millions)

Revenue $191.0 Less:

Production costs 1 112.0 Gross margin 79.0 Less SG and A:

Promotion expenses 2 67.0 Advert is ing overhead 6.7 Distr ibution fee 61.1 Interest 6.0

Net income (loss) $(61.8)

1These costs are typically called 'negative costs' in the motion picture industry. However, the term 'production costs' is used in this case to avoid confusion and to use standard accounting terminology. 2These costs are typically called 'distribution expenses' in the motion picture industry. However, the term 'promotion expense' is used in this case to avoid confusion with 'distribution fee'.

place. Instructors desiring more accuracy should adjust the solution accordingly.

Students have difficulty with this question in understanding why Paramount is paying itself a distribution fee and interest on the funds tied up in production costs. They generally feel that if Paramount is paying itself, it is not an expense of the movie. Two points must be made clear to the students concerning these costs. First, Paramount is preparing an income statement for the film Forrest Gump, not for Paramount as a whole. In other words, the costs reported in the movie's income statement are analogous to those contained in a job order cost sheet for the typical manufactured product. Second, the Forrest Gump income statement is for internal purposes only, not for external financial reporting purposes. Therefore, GAAP is not an issue in the preparation of the statement. Acknowledgment of this point can be used as a springboard to discuss internal reporting requirements versus external financial reporting requirements.

The fact that the income statement is for the movie, and not the studio, raises the issue of allocation of common costs to the individual movie. For example, instructors may ask students how Paramount determined the advertising overhead charge of 10% of promotion expenses and the distribution fee of 32% of gross box office receipts. Apparently these are arbitrary allocation methods that have no relation to the actual activities used and resources consumed by the film Forrest Gump. Students may be asked to provide more appropriate cost assignment bases, and instructors may include a discussion of activities and cost drivers as well as the

312 c.E. Davis

difference between assigning costs based on cause-and-effect as compared to allocations of joint or common costs.

The impact of arbitrary allocations of a studio's common costs to specific movies is apparent from the movie Coming to America. The distribution fees of $42.3 million charged to this movie in 1987 were more than the annual cost of maintaining Paramount's worldwide distribution network for an entire year Cheatham et al. (1996). This example also provides a compelling illustration why arbitrary allocation of common costs can drastically distort true product costs.

Question 2: In their original contracts, actor Tom Hanks and director Robert Zemeckis were to receive $7 million and $5 million, respectively, for their work on Forrest Gump. However, after the studio asked the producers .[or budget cuts, both Hanks and Zemeckis agreed to forego their standard .fee ./'or a percentage of the film's gross box qffice receipts. Sources estimate that the new agreement guaranteed each of the two 8% of the studio's share of gross box office receipts from the film. Using the information available about the costs of making the film, did Forrest Gump have a positive contribution margin? Assume that all costs not specifically identified as variable are fixed.

This question requires that students identify each cost of the film as variable or fixed and then prepare a contribution format income statement for the film, as shown in Table 2. Based on the information provided, the film did have a positive contribution margin.

Students' biggest problem with this question is identifying variable costs. An important thing for them to remember is that the unit of volume for identifying variable costs is gross box office receipts, or number of tickets

Table 2. Contribution format income statement for Forrest Gump (in $millions)

Revenue $191.0 Less variable costs:

Payment to Tom Hanks 15.3 Payment to Robert Zemeckis 15.3 Variable production overhead 4.6 Distribution fee 61.1

Contribution margin $94.7 Less fixed costs:

Production costs 76.8 Promotion expenses 67.0 Advertising overhead 6.7 Interest 6.0



sold at individual theaters. Once this is understood, it should be fairly easy to identify Hanks's and Zemeckis's salaries, as well as the distribution fee, as variable costs. However, it is more difficult for the students to recognize the variable production overhead. Since the studio calculates production overhead as 15% of production costs, and since these salaries are variable production costs, 15% of the variable salaries becomes variable production overhead. This is equal to 2.4% of gross box office receipts. The actual amount of variable production overhead as of December 31, 1994, is thus $4.6 million [($15.3 + $15.3) x 15%],

Question 3: If Hanks and Zemeckis had demanded their original fees upfront instead of taking a percentage of gross box qffice receipts, would Forrest Gump have made money in 1994?

I f Hanks and Zemeckis had kept their fixed-fee contracts, their salaries would have been fixed costs. The associated production overhead would also have been fixed. These changes would have resulted in the income statement presented in Table 3.

Summary of Production Costs:

With 8% Contracts With Fixed-fee Contracts Payment to Hanks $15.3 $7.0 Payment to Zemeckis 15.3 5.0 Other Production Costs 66.8 66.8 Subtotal $97.4 $78.8 15% Production Overhead 14.6 11.8 Total Production Costs $112.0 $90.6

This question presents an opportunity to discuss the merits of a variable cost structure versus a fixed cost structure, as well as the risks associated with each. The discussion can also be used as a lead into question 5.

An additional area of discussion at this point could be the indifference point between a fixed-fee contract and a participation contract for each

Table 3. Income statement for Forrest Gump assuming fixed-fee contracts (in $mUlions)

Revenue $191.0 Less:

Payment to Tom Hanks 7.0 Payment to Robert Zemeckis 5.0 Other production costs 66.8 Production overhead 11.8 Distribution fee 61.1 Promotion expenses 67.0 Advertising overhead 6.7 Interest 6.0


314 C.E. Davis

party. For instance, students could be asked to answer the following questions:

At what level of gross box office receipts would Tom Hanks have been indifferent between receiving his regular fixed fee of $7 million or receiving 8% of the gross box office receipts? At what level of gross box office receipts would Robert Zemeekis have been indifferent? At what level of gross box office receipts would Paramount Studios have been indifferent?

To find these points of indifference, students must realize that at the point of indifference, payments from the fixed-fee contract and the participation contract are equal. Thus, the indifference points for these three parties are:

Hanks:

Zemeckis:

Paramount:

$7 million=8% * (Gross Box Office Receipts) Gross Box Office Receipts=S87.5 million ($175 million in theater

receipts) $5 million =8% * (Gross Box Office Receipts) Gross Box Office Receipts=S62.5 million ($125 million in theater

receipts) $12 million = 16% * (Gross Box Office Receipts) Gross Box Office Receipts=S75 million ($150 million in theater

receipts)

Question 4: Other individuals associated with the film signed contracts based on a percentage of 'net profits" rather than gross box office receipts, net profits being the film's profit after the recouping of all the studio's expenses. For example, Winston Groom, who wrote the novel on which the movie was based, received $350,000 plus 3% of the film's net profits. Eric Roth, the screenwriter, signed a similar contract with a fixed fee plus 5% of the film's net profits. Based on your calculations above, how much did these two individuals receive from their share qf the film's net profits? How much in gross box office receipts will the studio have to receive .from theaters be/ore Groom and Roth receive any money under their net profit participation contract?

Based on the net loss reported in the income statements prepared in questions 1 and 2, Roth and Groom have received no payments based on their share of net profits. Break-even analysis can be performed to determine how much Forrest Gump must generate in gross box office receipts before Roth and Groom can participate in net profits. Based on the contribution format income statement prepared for question 2, Forrest Gump must generate $315.5 million in gross box office receipts for the studio before the film will show a profit.


Total Fixed Costs = $156.5 million

$94.7 Contribution Margin Ratio = = 49.6%

$191

$156.5 Break-even point in sales dollars = ~ = $315.5 million

.496

Break-even analysis of this sort is generally performed 'before the fact' as a means of evaluating decision alternatives. While the above calculations are based on 'after the fact' actual costs and revenues, break-even analysis could have been performed based on the film's budget. For example, Groom and Roth could have performed break-even analysis using budgeted costs and revenues to determine the level of gross box office receipts required before their net profit participation contract would begin paying off. Such an analysis may have led them to negotiate a different contract with Paramount.

It is interesting to note that after Groom's lawsuit against Paramount was filed, Paramount advanced Groom $250,000 against future gross box office receipts. At the time of the advance, Forrest Gump had generated approximately $330 million in gross box office receipts for Paramount, putting the film above the calculated break-even point.

At the heart of the problems for Groom and Roth was a misunderstanding of the definition of 'net profits' in their contracts, which was different from the normal definition used by accountants. This misunderstanding highlights the importance of accurate use of accounting terms and the need to clarify terms between parties. For instance, a common misuse of terms occurs when students use the term 'cost' when they actually mean 'price.'

Question 5: Based on what you now know about contracts in the movie industry, which type of contract would a studio prefer actors, directors, and others associated with a film to have? Why? Which type of contract would the actors, directors and others prefer to have? Why?

The preference for a given type of contract will depend on the party's expectations for the film's success. In most instances, a contract based on net profits would result in the studio paying the least amount to those involved in the making of the movie. As illustrated by Forrest Gump, an incredibly successful movie often shows a net loss based on the studio's internal accounting methods. The next preferred contract from the studio's standpoint would be a fixed-fee contract. This type of contract results in no uncertainty about the cost to produce the film. If the film is a success, the fixed fee will likely result in lower payments than one based on a percentage of gross box office receipts.

316 C.E. Davis

The preferences of individuals associated with the film are likely opposite those from the studio's standpoint. If the film is thought to be a potential hit, it may be in the party's best interest to negotiate a contract based on gross box office receipts. However, this type of contract can backfire, as Arnold Schwarzeneger found out with Junior, when he deferred his usual $15 million fee for profit participation. If the party is risk-averse and/or the success of the film is questionable, a fixed-fee contract may be preferred. It is unlikely that given a choice, anyone associated with the film would prefer a contract based on net profits. In fact, it was this type of contract that led Groom to question Paramount's accounting practices and file legal action against the studio. In addition, Forrest Gump is not the first film that has caused Paramount accounting nightmares. Similar practices led Art Buchwald to sue the studio based on the performance of Coming to America (Wechsler, 1990).

Additional Discussion Opportunities

As mentioned in the solution to question 1, much of the costs assigned by Paramount to Forrest Gump are based on arbitrary allocations of common costs. These costs are necessary costs of running a film studio and must ultimately be recovered through the films produced by the studio. However, the issue is the method for charging these costs to a specific film for profit determination. One might even argue that Paramount is using the current allocation method to 'hide' the profitability of blockbuster hits in order to reduce the payouts based on net profit participation contracts. While not originally intended as a major point of discussion for this case, the case certainly allows the flexibility of addressing this issue, either concurrently or at a later point in time.

Instructors wishing to explore the common cost allocation issue could ask students to respond to the following question:

Assume that you are the judge presiding over a suit brought against Paramount by Groom over the lack of their share of net profits.from Forrest Gump. What information would you request for use in your decision .[or or against Paramount? How would this information assist you in reaching your decision?

Students could be assigned roles as either plaintiff or defendant attorneys and asked what information they would use to support their arguments before the judge. Any information that would assist in determining the costs actually attributable to the making of Forrest Gump would be of benefit to the judge. Specific information concerning the total of the studio's common costs allocated to all movies produced during the yem- and the total actual costs incurred by the studio would uncover any over-allocation of these costs such as the example from Coming to America discussed in question 1. A judge would also benefit from details of


the contract negotiation process, including the disclosure of computational procedures to the contracting parties prior to the signing of the contract. Additionally, were these contracts reconsidered after Hanks and Zemeckis agreed to a percentage of gross box office receipts?

If time permits, an interesting avenue for discussion is how individual theaters decide which films to screen and how long to schedule the film's run. While the gross box office receipts average a 50/50 split between the studio and the theater, the actual split is based on a sliding scale depending on how long the film has been shown in the theater. For example, in the first two weeks a film is shown, theaters may keep only 30% of the gross box office receipts, while after a film has shown for 12 weeks, the theater may keep 90% of the gross box office receipts (see Biederman et al., 1992, pp. 518--519). This sliding scale is used because the longer the film is shown at a particular theater, the smaller the gross box office receipts. The higher percentage given to the theaters in the later weeks encourages the theater to continue to show the film with the lower attendance.

The interesting issue with this sliding scale is how multi-screen theaters decide which films to screen and how long to continue showing a particular film. The problem can be viewed as a product mix problem, where the various films have differing contribution margins depending on the length of the films' runs. The theater would also need to consider concessions as part of the product mix issues. This example can illustrate to the students that most organizations do not operate in a single-product world, and break-even and C-V-P analysis can be more difficult in the real world than typical textbook problems may indicate.

Acknowledgements--The author gratefully acknowledges the comments of Bob Capettini, Elizabeth Davis, Becky Jones, Charlene Spoede, participants at the AAA 1996 Management Accounting Conference, and the anonymous reviewers on earlier versions of this case.

REFERENCES

Aronson, E., Blaney, N., Stephan, C., Sikes, J., & Snapp, M. (1978). The.iigsaw chtssroom. Beverly Hills, CA: Sage Publications.

Biederman, D., Pierson, R., Silfen, M., Glasser, J., & Berry, R. i 1992). Law and bus#Tess ~!] the entertainment industries, 2nd edn. New York: Praeger.

Cheatham, C., Davis, D. A., & Cheatham, L. R. (1996). Hollywood profits: Gone with the wind'? The CPA Journal, February, 32-34.

Cottell, P. G., & Millis, B. J. (1993). Cooperative learning structures in the instruction of accounting Issues in Accounting Education, 8, 40-59.

Davidson, N. (1990). Cooperative learning in mathematics." A handbook jor teachers. Menlo Park, CA: Addison-Wesley.

Financial Accounting Standards Board (FASB). (1981). Statement ~[ Accounting Standards No. 53." Financial Reporting by Producers ~f Motion Picture Films. Stamford, CT: FASB.

318 C.E. Davis

Lippman, J. (1995). Star and director of 'Gump' took risk, reaped millions. Wall Street Journal, March 7, BI, BI 1.

Munk, N. (1995). Now you see it, now you don't. Forbes, June 5, 42-43. Pfeiffer, G., Capettini, R., & Whittenberg, G. (1997). Forrest Gump--Accountant. The

Journal of Accounting Education, 15, 319-344. Stone, J. M. (1989). Cooperative learning and language arts." A multi-structural approach. San

Capistrano, CA: Resources for Teachers. Wechsler, D. (1990). Profits? What profits? Forbes, February 19, 38-40. Weinraub, B. (1995). 'Gump', A huge hit, still isn't raking in huge profits? Hmm. New York

Times, May 25, C15, C19.

forest gump

Documents