Please read the case study and answer the question explaining your answers...also show your work. This is for a managerial accounting class.

Instructional Case: Main Line vs. Basinger: A Case in Relevant Costs and Incremental Analysis Thomas L. Barton, William G. Shenkir and Brian C. Marinas ABSTRACT: Important management accounting techniques, such as contribution analysis and relevant costing, are integral to the widely publicized case of Main Line Pictures vs. Basinger. Main Line sued actress Kim Basinger in 1991, alleging that she caused the company to lose profits of $5 to $10 million by withdrawing from a controversial film project in breach of contract. Main Line argued that it would have earned a pretax profit on the film in the range of $3 million to $8 million if Basinger had remained. The profit figures were calculated from pre-sale contract amounts and the film's budgeted cost. Main Line also argued that it expected to lose $2 million on the film as it was eventually made primarily because Basinger's replacement was of much lower box office appeal. Basinger argued that only a handful of very successful films could generate profits to Main Line in the dollar amounts cited because of the many contractual claims against those profits by others. In addition, her presence in the film was no guarantee that the film would be successful. At issue here are the reliability and reasonableness of the numbers used in Main Line's lost profit computation. The case relies heavily on the identification of relevant costs and the performance of sensitivity analysis as the reader is asked to consider alternative cost and revenue assumptions to ascertain the impact on the lost profit amount. Finally, the reader is asked to prepare his or her own alternative lost profit calculation. In 1991, Main Line Pictures, Inc. sued actress Kim Basinger (and others) for breach of contract. Basinger had been in negotiation with Main Line to star in the film, "Boxing Helena" but had withdrawn from the project. The suit was heard in early 1993 in the Superior Court of the State of California, for the County of Los Angeles with the Honorable Judith C. Chirlin presiding. For the Plantiff (Main Line), Patricia L. Glaser, Attorney at Law: Nobody is saying Miss Basinger has to act in this movie. Nobody ever said that. What we said was when she committed to do the project, when her agents negotiated the terms of the contract, and when she agreed to do this deal, if she wants to walk away because she changed her mind, she's got to pay the piper. She's got to pay for that. And all I'm saying is we're entitled {to} our damages between 5.1 and 9.7 million dollars. We're entitled to that, Ladies and Gentlemen, because there was an oral agreement, and I'm going to show you there is also a written agreement. For the Defendant (Kim Basinger), Howard L. Weitzman, Attorney at Law: First of all, you are being asked to, in effect, order Kin Basinger to pay 5.1 or 9 something or 10, whatever, multiple millions of dollars for a picture that was not made because Mr. Mazzocone [Main Line President] was angry and wanted to make the movie. She's not responsible for that. No way in the world would I suggest to you Carl Mazzocone {or} Main Line Pictures is entitled to $5 or $8 or $10 million because he has a duty under the law to minimize his loss, and it does not include going out and making a picture knowing you are $2 million short, and that's what happened here. BACKGROUND: In the Basinger case, the primary issue for jurists and other legal enthusiasts was whether Basinger breached an actual contractual agreement or simply engaged in the usual caprice of Hollywood deal making. The press was awash with stories declaiming the lack of integrity in Hollywood deals and discussing the possible adverse implications for actors and production companies in general. The film "Boxing Helena" was no less controversial than the legal issue. It involves a woman who is injured in a car accident. The doctor who "rescures" her amputates her injured legs and unhurt arms and keeps her hostage in a box, hoping she will eventually fall in love with him. Basinger testified that she withdrew from the starring role, after ongoing negotiations, because of concerns about her character's personality and graphic scenes of an adult nature. Main Line, however, had $3 million in potential domestic and $7.6 million in foreign pre-sale agreements based on Basinger's participation in the film. After her withdrawal, a lesser known actress, Sherily Fenn (a star of the television series, "Twin Peaks") was engaged, resulting in only $2.7 million in foreign pre-sale agreements and no domestic distributor as of the time of the trial. Main Line contended that it incurred significant financial damages from Basinger's withdrawal from the project. Of concern here is how to value the actual damages incurred by Main Line if there were a breach of contract. Any value is particularly tenuous given the fact that (1) a film with Basinger was never made, and (2) a reliable revenue prediction for a specific film is very difficult, and frequently impossible, to obtain before the film is released. Both Main Line and Basinger presented expert witnesses to deal with the problem. REVENUES AND COSTS FOR A FILM PRODUCTION: A film project generates revenue to its producer through rentals based on box office receipts and ancillary sources such, as home video, cable and network television. Independent producers (i.e., those not affiliated with major studios) typically attempt to raise the capital to produce their films through pre-sale contracts. In a pre-sale contract, a film distributor will agree to distribute a film to theaters in a certain geographic area in return for a fee guarantee. For example, a distributor in Europe contracts to distribute a film and agrees to pay the producer $5 million against an amount calculated as the revenue to the distributor (based on box office receipts or "gross") less a 40 percent distribution fee and less the costs of advertising, making the copies of the movie (prints), and other distribution elements such as freight. The producer can then borrow against that contract from a bank to help finance the film's production cost, or the distributor can advance production funds to the producer against its own contract. If the film generates revenue to the distributor in Europe of , say, $15 million (based on total tickets sold), the distributor will calculate the payment to the producer as $15 million less the 40 percent distribution fee less the cost of prints, advertising and other miscellaneous distribution costs. Suppose the cost of prints, advertising and other distribution elements is $3 million. Then the producer would be paid: $15 million - (40 percent x $15 million) - $3 million = $6 million. But regardless of the film's actual success at the box office, the payment could not be less than the guarantee of $5 million. The producer's costs of a film production are the outlays for acquiring the rights to the script, fees to the actors, director and production personnel, film stock and processing, camera rentals, sets, costumes, special effects, and post-production costs of editing, sound and music. The producer will deliver a master copy of the film from which prints can be made but the actual cost of the prints, advertising and other distribution elements are borne by the distributor until they are recouped from the producer's share of the box office receipts. Often there will be contractual arrangements that will call for the producer to share net profits, and in some cases revenues, with key actor, the director and others. While direct costs are charged to the individual film projects as incurred (job order costing), there can be common overhead costs that will require allocation to individual films. This allocation, of course, will affect the payments made to net profit participants and has been a longstanding source of controversy--and litigation--in the industry. But overhead allocation is more of an issue with major studios who produce 15 to 20 films a year than with independent producers who may produce only one or two films a year. TESTIMONY BY MAIN LINE'S EXPERT: Louis L. Wilde, professor of economics and consultant, appeared as an expert witness for the plaintiff. Wilde testified that the minimum profit differential ( and therefore financial loss to Main Line) was $5.1 million. This analysis is presented in table 1. Wilde worked form the definition that damages were "a measure of the compensation that would be required to put the person [ who was breached] in the position [he] would gave been in had there not been a breach in terms of the economic losses to [him]..." Wilde simply compared what Main Line expected to make with Basinger to what Main Line actually was able to make on the same package without Basinger -- the difference (presumably a loss) was the damage to Main Line. Wilde emphasized that a focus on "net profit differential" was especially appropriate because a differential, or incremental value, is independent of the specific values for revenue or expenses. For example, suppose the film without Basinger eventually performed better than the $2.7 million pre-sale amount, generating ultimate revenues of $12.7 million. Wilde claimed that his profit differential of $5.1 million would still hold even at the higher revenue amount. Revenues of $12.7 million for the film without Basinger equate to a profit of $7.9 million ($12.7 in revenue less $4.8 in costs). So, according to Wilde, the Basinger film would have earned a profit of #13 million ($7.9 plus $5.1). TABLE 1 Minimum Damages, Plaintiff Expert With Basinger Without Basinger Foreign Pre-Sales Films Probable Total Foreign Domestic Pre-Sale Total Revenue Production Budget Net Profit/ (Loss) a b $6.8 0.8 7.6 3.0 10.6 (7.6)a $3.0 $2.7 NA 2.7 0.0 2.7 (4.8)b ($2.1) Difference $4.1 0.8 4.9 3.0 7.9 (2.8) $5.1 Per testimony of producer that film would be made for amount of foreign pre-sale. Actual budget for film as produced. Wilde also calculated a maximum profit differential (table 2). He argued that the private negotiations for the price of domestic distribution lacked market efficiency and, therefore, did not fully reflect the eventual market price of the film if it were released. This flaw in the domestic revenue estimate did not apply to the foreign pre-sales, according to Wilde, because "the foreign pre-sale markets are very well organized. They meet in well-defined places. ....Buyers and sellers come together. The products are there. The transactions take place. Not down in the pit the way the stock market works, but in a relatively short period of time. Information is very good." Therefore, the foreign pre-sale markets (e.g., Cannes Film Festival, American Film Market, MIFED-International Film, TV Film and Documentary Market, etc.) possess greater market efficiency. TABLE 2 Maximum Damages, Plaintiff Expert With Basinger Without Basinger Foreign Pre-Sales Firm Probable Total Foreign Domestic Pre-Sales Total Revenue Production Budget Net Profit/ (Loss) Difference $6.8 0.8 7.6 7.6a 15.2 (7.6)b $7.6 $4.1 0.8 4.9 7.6 12.5 (2.8) 9.7 $2.7 NA 2.7 0.0 2.7 (4.8)c ($2.1) a Domestic pre-sale adjusted for market inefficiency. Put into 1 to 1 ratio with foreign pre-sales. Per testimony of producer that film would be made for amount of foreign pre-sales. c Actual budget for film as produced. b To adjust the privately negotiated domestic price to what would be expected in the public market (i.e., box office), Wilde studied the average ratios of domestic to foreign sales for movies of the same genre. Wilde concluded that the ratio of domestic to foreign for this type of film was one to one. Therefore, the potential domestic revenue amount should be revised so that it equals the foreign pre-sales amount. This means an upward adjustment of $4.6 million in the domestic revenue to $7.6 million. With this change, the maximum profit differential is $9.7 million. As a "gut level check" of his analysis and the revenue differentials, Wilde also compared the average revenue of Basinger films (excluding "Batman") with the average revenue of Fenn films, an average revenue of $1.6 million. TESTIMONY BY BASINGER'S EXPERT: Bruce St. J Lilliston, an attorney and specialist in independent film finance and production contracts, appeared as an expert witness for Basinger. Lilliston took the position that in order for an independently produced film to yield a net profit of $5.1 million to Main Line ( the minimum profit differential of Main Line's expert), it would have to generate worldwide distribution revenues of $82 million. This would come primarily from theaters, video and television (table 3). The analysis assumes the film without Basinger exactly breaks even. If total revenue this large was generated by "Boxing Helean," it would place it number 4 on the list of top performing independent films released between 1985 and 1991, following "Dirty Dancing" and above "Nightmare on Elm Street, Part IV." Lilliston also presented evidence that to yield the maximum profit differential of $9.6 million, " Boxing Helena" would have to generate worldwide distribution revenues of $144 million, placing it number 3 on the list of top performing independent films, following "Teenage Mutant Ninja Turtles" and above "Dirty Dancing". Lilliston then testified that "big stars in a movie" do not necessarily equate to big revenues. He displayed a char showing a list of films with well-known stars that had underperformed at the box office. Included in the list was "Homer and Eddie" starring Whoopi Goldberg, which had a box office gross or $14 thousand against a cost of $14 million. Also appearing in the list was "Hudson Hawk" starring Bruce Willis, which generated a box office gross of $17 million versus a cost of $54 million. TABLE 3 Revenue Needed for Profit Differentials, Defense Expert Maximum Total Revenue $144,207,655 Avg. Worldwide Distribution Fees(40%) (57,683,062) Prints and Advertising (12,000,000) Amount Payable to Producer 74,524,593 Production Budget (assumed) (7,600,000) Gross Profit 66,924,593 Deferment Payment to Main Line (250,000) Deferment Payable to Calanda (250,000) Net Profit 66,424,593 Participation Payment (20.5%)b (13,617,042) Net Profit after Participation 52,807,551 Level 1 Split: 50% to Main Line to $2 Million (2,000,000) 50% to Caland to $2 Million (2,000,000) Net Profit for Level 2 Split 48,807,551 Level 2 Split: 15% to Main Line (7,321,132) 85% to Caland (41,486,419) (2,890,792) (16,381,155) Summary of Payment to Main Line: Deferment Level 1 Level 2 Total Payments to Main Line $250,000 2,000,000 2,890,792 $5,140,792 $250,000 2,000,000 7,321,132 $9,571,132 Minimum $82,288,150 (32,915,260) (12,000,000) 37,372,890 (7,600,000) 29,772,890 (250,000) (250,000) 29,272,890 (6,000,943) 23,271,947 (2,000,000) (2,000,000) 19,271,947 a Philipee Caland is identified in court documents as a partner with Main Line in the project but is not a plaintiff in the lawsuit. b Profit participation to actors Kim Basinger and Ed Harris, and writer/director Jennifer Lynch. NOTE:"Amount Payable to Producer" in this table is called "Total Revenue" in tables 1 and 2. ADDITIONAL INFORMATION: Basinger was to be paid $600,000 in guaranteed compensation to appear in " Boxing Helena" with another $400,000 to be paid out of producer revenues "before the bank" was paid on the production loan to finance the film. She received $3 million to appear in "Final Analysis" following her withdrawal from "Boxing Helena". As mentioned previously, foreign pre-sales are typically used by independent producers to secure production loans from banks that provide financing for the production costs. This was the case with "Boxing Helena." The domestic distribution deal cited in Wilde's testimony had not been finalized before Basinger withdrew from the project. One of the partners in Main Line advanced $1.7 million against domestic revenues to help cover production costs on the Fenn film. In other words, the advance would be repaid from domestic revenues. Main Line president Carl Mazzocone testified about the $2.8 million difference between the two production budgets (with and without Basinger): "Well, Miss Fenn and [co-star] Julian Sands both received $100,000. The difference is Kim Basinger would have received $1 million. I had to bank $1 million even though I was paying $600,000 up front, and Mr. Harris [co-star] would have made $500,000. So there is a difference there. I also would have had increased producer's fees and would have made more money. And lastly; the other increase was that I wanted to build a set of this[on a soundstage] instead of using a real house, you have so many limitations and drawbacks [with a real house]. It takes longer. So when you build a set, even though it costs more money to build a set, you will actually save money because it's faster. Neither expert witness used Statement of Financial Accounting Standards (SFAS 1981) No. 53 in his analysis. SFAS No. 53 requires film companies to amortize film production costs using actual revenues for the period as a percentage of total estimated ultimate revenues for the film. For example, suppose a film cost $5 million to produce and is expected to generate revenues of $7 million over its economic life. During year 1, actual revenues are $3 million. The film company would "expense" 3/7 of the $5 million production cost in year 1, or $2.1 million. THE VERDICT: The jury (in a 9-3 vote) awarded Main Line $7,421,694 in damages for breach of contract and unanimously added $1,500,000 for bad faith denial of the contract. A request for punitive damages of $1 million to $2 million was denied. Basinger appealed the decision and later filed for bankruptcy protection. In 1994, the judgement was reversed on appeal and remanded to the lower court. The Appeals Court concluded that jury instructions failed to draw a sufficient distinction between the liability of Basinger and the liability of her production company, Mighty Wind Productions. QUESTIONS: 1. Should Main Lines maximum and minimum lost profit amounts be revised downward for the following? Why? a. The domestic distribution revenues of $3 million because the deal had not been finalized. b. The $800,000 of foreign pre-sales because they were "probable" not actual. c. The loss of $2.1 million on the "Without Basinger" film. 2. Are the following relevant to the determination of lost profits to Main Line? Why? a. Basinger's $3 million salary for "Final Analysis." b. SFAS No. 53. c. The comparison of revenues for Basinger films with revenues for Fenn films. 3. Is plaintiff's expert correct in not attempting to estimate revenues for "Boxing Helena" beyond pre-sale amounts? Why? 4. Should Main Line's lost profits be adjusted downward to include an estimate of domestic revenues for "Without Basinger" film? Would it have been valid to use the $1.7 million advance against domestic revenues as the estimate? Explain. 5. Suppose Basinger had remained with the film and assume the $3 million profit shown in the plaintiff expert's minimum damage calculation was correct. Is it reasonable to assume that Main Line's pretax cash position would have increased by $3 million or would some part of this have been paid to others? Why? 6. If you disagree with the jury's lost profit assessment, briefly prepare one of your own