Hollywood accounting has a certain mystique around it, and not for a good reason. Films that earn staggering sums of money are claimed to be hopelessly far from breaking even. Profit participants regularly file suit against the studios claiming they've been defrauded. What gives? How can a studio claim to lose money on a big hit with a straight face? Let's take a closer look!
In the glory days of Hollywood during the studio system era, every major studio directly made its films. They operated like factories with an entire infrastructure in place to make movies. Studio bosses acquired scripts, put together projects and took advantage of their lot's infrastructure to keep feeding the theaters of the world with product. Each project was funded directly, with studio bosses authorizing budgets and setting up their yearly slates of pictures. Movie making was a full time business, and the studios had to keep the various pieces working and profitable. This all changed in the 1960's.
The collapse of the studio system and the huge new budgets required to produce the sort of films that would entice people away from their televisions and out to the cinema brought new challenges to Hollywood. The textbook example of a film that could court disaster because of a runaway budget was 20th Century Fox's Cleopatra. The film suffered from huge cost overruns, tearing through its initial budget in record time, with only unusable footage to show for it. The film's failure nearly brought down the studio, requiring it to sell off much of its storied backlot to prevent bankruptcy. The studios, shocked at what the future might hold for them, upended their existing processes and changed up their business plans to deal with this new reality.
The studios themselves stopped directly making films. Instead, they began operating as big banks who mainly financed projects produced by other companies. The films were still controlled and released by the studios, but they were technically produced by smaller production companies who were, on paper, separate entities. To better understand this, let's use an example- The Wizard of Oz.
In the traditional studio system, a studio head at MGM such as Louis B. Mayer would green light the picture and set a budget for it. Studio executives would then begin lining up talent and resources from around the studio based on the allotted budget and begin production. In this example, MGM would be considered the producer of the film and would have to cover all associated costs or overruns. The different departments would chargeback their expenses against the production, knowing that they were all working for the same company. The "charges" incurred by a film would mainly be recorded for accounting purposes.
In the new studio system, MGM would create a new company called "OzCorp.", an independent business entity that solely exists to make Wizard of Oz. MGM, Inc. would then "loan" the entity the money it needs to make the film. A production staff would then begin assembling the talent and resources needed to make the film. Now here's where the accounting trickery comes into play. Under the old system, the studio machine shop would merely charge the production a fee that equaled the cost of providing the service. After all, they all work for the same company, right? Under the new system, the studio machine shop is expected to produce a profit. And technically, OzCorp. is a separate entity from MGM, Inc. So they are encouraged to charge the actual cost plus a certain percentage. Multiply this out over all of the various services and facility costs provided in support of the film and you can see how quickly a film's production can be padded by the studio. All of these costs add up, eating away at the net profits, though the studio is profiting all along the way.
If the movie successfully completes production with a reasonable budget, the studio then "buys" OzCorp., combining it with MGM, Inc. who then releases the film to the world. If the movie went hugely over budget and its cost overruns threaten the solvency of MGM, Inc., the company can merely wash its hands of the film. Since OzCorp. is legally considered to be a company separate of MGM, Inc., creditors can't arrive at MGM's gates expecting to be made whole. In fact, MGM, Inc. can make a claim of its own; after all, it loaned the original startup costs. This arrangement protects the studio's assets and is perfectly legal. If 20th Century Fox had produced Cleopatra in this manner, it wouldn't have had to sell off any of its storied backlot to pay off creditors. It could have written off "CleoInc." and thrown the film itself to the wolves.
In fact, protecting the studio is the primary reason for running things this way. That they can then pad production costs to deprive profit participants of their cut is but a fringe benefit of the scheme.
