Which of the scenarios below is the correct method of calculating royalty cost as a percentage of the net sales price?
Scenario 1 - $100,000 (Total proposed price before royalties) * 15% (Royalty Rate) = $15,000 Royalty Cost.
Scenario 2 - $100,000 (Total proposed price before royalties) / (1-15% (Royalty Rate)) - $100,000 (Total proposed price before royalties) = $17,647 Royalty Cost.
Note: The licensor believes Scenario 2 is correct because the total amount due to the licensee will be calculated as follows: Total Price including royalties $117,647 * 15% (Royalty Rate) = $17,647. If Scenario 1 is used this approach, (Total Price including royalties $115,000 * 15% (Royalty Rate) = $17,250), the contractor will be at a $2,250 loss ($17,250 - $15,000).
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Good question, unfortunately there is no one method and both of the Scenarios you identify could be authorized. It depends on the contractor’s approved accounting system/methods and the consistent application of that. Normally FAR Table 15-2, see section II.E. Royalties, explains how the contractor should propose.
As a result, we suggest you contact the cognizant CAO and audit agency (DCMA and DCAA) as the answer is most likely contractor specific.
In the meantime, we provide the following references to help guide your conversations with the cognizant agency personnel and the contractor. These have most of the applicable FAR references (note: some are dated).
DCAA Royalty Costs
DPC – ODC Analysis
I would add one thing for a CAS covered contractor, especially one that is full CAS covered and required to provide a Disclosure Statement.
The accounting for royalties and the associated net sales calculation used would most likely be part of the disclosure statement (adequately described), and would have to be compliant with CAS standards.