The New Yorker's Ken Auletta Needs a Calculator, not an E-Book Reader

In the current issue of The New Yorker, writer Ken Auletta contemplates whether the Apple iPad will supplant the Amazon (AMZN) Kindle as dominant e-book platform. But in his discussion of current book publishing economics, he demonstrates that many media journalists would do well with a calculator, a remedial math course, and a Cliff Notes summary of business fundamentals.

Auletta paints an unrealistically dismal vision of how little publishers make per book sale. His errors are many, but start with some basic arithmetic errors and faulty assumptions:

Traditionally, publishers have sold books to stores, with the wholesale price for hardcovers set at fifty per cent of the cover price. Authors are paid royalties at a rate of about fifteen per cent of the cover price. On a twenty-six-dollar book, the publisher receives thirteen dollars, out of which it pays all the costs of making the book. The author gets $3.90 in royalties. Bookstores return about forty per cent of the hardcovers they buy; this accounts for $5.20 per book. Another $3 goes to overhead costs and the price of producing and shipping the book--leaving, in the best case, about a dollar of profit per book.

• He assumes that resellers and wholesalers get a 50 percent discount, which would explain his assumption that a publisher receives $13 on a $26 book. However, some outlets get higher discounts; others, far lower.
• Some writers do, indeed, get 15 percent royalties on the cover price of a hardback, but that is a dying practice. Many writers get significantly less. Paperback volume is much bigger, but the business model is different. Writers then often get 10 to 12 percent of the discounted price the publisher receives, not on the cover price. Suddenly, rather than the 30 percent of revenue that Auletta calculates, the publisher pays roughly two-thirds less. On a $20 paperback, the writer might get $1.
• His calculation of returns is completely off-base. Even if 40 percent are returned to the publisher, that's not an additional 40 percent cost for the remaining books. The only real cost to the publisher is the incremental cost of producing those books, which, as Auletta says, is about $3 each. Furthermore, leftover copies are remaindered, which generally at least covers those costs.

For a $20 paperback at the same volume, we'll make the appropriate adjustments. The writer gets $1 and the printing and overhead costs are probably closer to $2. Assuming everything else is equal, each copy gives the publisher a margin of $7, which is $10 less the $3 of cost. Suddenly, the publisher has $42,000 for the 6,000 copies that sold. Subtract the real cost of the 4,000 copies returned and you've got $34,000 left, or $5.67 a book. The margin is now 56.7 percent.

And so, not only does Auletta err in his understanding of how the mechanism of publishing works and in his basic calculations, he also bases everything on hardbacks, when paperbacks are a big part of the business. These calculations are simplified and don't take into account such things as the big deals that publishers cut with chains or online sellers, low-priced book club editions, or other special arrangements that greatly increase volume of copies and significantly decrease the per-copy revenue. And then there are movie, television, and merchandising deals as well as foreign rights that add money without printing additional copies. Of course the money a publisher makes per volume is higher because there is no way that a 7.8 percent gross product margin is enough to sustain a large publisher's infrastructure and all the work -- design, editing, marketing, and the like -- that it must do.

Auletta's misinformed explanation shows the fundamental problem that book publishers face with e-books. Everyone assumes that higher prices of printed books are due to tangible costs of production. It's not. The real costs of publishing are the labor to create the intellectual property. But because so many consumers think that the physical object is the real cost, they assume that e-books should sell for next to nothing, because there are no printing or distribution costs.

We're back to the disagreement over value. Consumers think they should be able to buy books for little. Big names in e-book selling want low prices to build the market at publishers' expense. The publishers say that their business can't survive on low prices because it's not enough to pay for true costs. That conflict will take more than a calculator to resolve.

[UPDATE: For the sake of simplification, I had intentionally ignored the shaky grounds of one of Auletta's assumptions: that you can attribute overhead as a fixed cost in product sales. As reader passed on what seemed to be a news group email in which publishing consultant Mike Shatzkin said that I made a mistake in allowing that to pass. I agree, so I'm rectifying it here. When you deal with any sort of manufacturing, including books, you generally look at direct costs of manufacturing only, not overhead, R&D, and so on, because they are all costs that are fixed and associated with the company as a whole. You don't want to assume that, say, $3 goes to overhead, because book sales are variable. What if you sell twice as many books one year as the next? Suddenly, the fixed percentage you've calculated is twice as high as it should be, because the costs that go up are variable, depending on volume of manufacturing. Or how do you attribute overhead to two different books that may take substantially different amounts of attention and sell in vastly different quantities?

When you try to attribute fixed overhead to variable product units, you can get a false sense of how profitable the individual units are. So, instead, you focus on product margins and then see whether you bring in enough money to make the enterprise as a whole profitable. So taking out $3, as Auletta does, may work for one book but not another. On the whole, it gives a false sense of understanding and also puts management focus in the wrong place. When profitability is off, you don't look at individual book production to contain costs; you look at the overall structure of the business.]

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