A notional, appropriate cost of capital and the mix of debt and equity are both relevant to a determination of profits, whereas the capital structure of each party is not. As Exhibit 2 indicates, whether one focusses on costs to subtract from gross revenue in order to determine profit, or one determines the proper definition of pro-forma profit and then the implied relevant costs based on that definition, the same conclusion should be reached. The nature of the businesses, the technology and the licensing details will determine whether the focus ought to be on cost or on profit. The nature of the licensing arrangement, the technology, the product's sales, the time frame and complementary assets brought to bear all contribute to an appropriate determination of profit as defined by the two parties. Incremental profit is not the proper basis for sharing between a licensor and licensee involved in negotiations for a long-term royalty.
Incremental profits are generally short-term in nature.
Rarely can a successful company acquire, license or develop technology and have incremental profits that fairly represent long-term profitability. For the purposes of computing damages, however, incremental profits may be an appropriate basis, depending on the facts and the law. The inadequacy of GAAP Generally accepted accounting principles are not an adequate basis for determining full or partial absorption, or variable costing. Among other failures, conventional accounting statements do not recognize the true cost and benefit of goodwill, intellectual capital, distribution networks, brands and other intangibles. No less an investor than Warren Buffett finds GAAP a starting point, at best, for financial analysis.