The following post by Edward Jay Epstein, author of The Hollywood Economist: The Hidden Financial Reality Behind the Movies (available from Melville House, and reviewed in the Wall Street Journal here), is the 11th in a series of posts celebrating the publication of the book. You can also see Epstein in Oliver Stone‘s forthcoming Wall Street 2: Money Never Sleeps wherein Epstein plays the head of the Fed. Click here to read all posts in the series.

“STUDIO SHAME!,” shouts the headline on Nikki Fink‘s Deadline website, “Even Harry Potter Pic Loses Money Because of Warner Bros. Phony Baloney Net Profit Accounting.” To prove its point, it posted Warner Bros.; September 2009 distribution report for Harry Potter and The Order Of The Phoenix, then reported, as if it revealed some shameful scandal, that while the 2007 film “grossed $938.2 million worldwide,” it still remains over $167 million in the red.

The outpouring of indignation over movie studio accounting may resonate with a public concerned over corporate predatory practices but it misses the point that what is called Hollywood accounting is in reality a form of self-deception.

Every Hollywood production is a temporary collaboration between a studio and hundreds of independent contractors, which includes actors, directors, producers, writers, and technicians. The rules governing how each person will be paid is set forth in their contracts, which in most cases are negotiated and vetted by lawyers, agents, and financial advisers. In almost all cases, they get fixed compensation for their work, which is unaffected by whatever accounting ploys are used to determine the “net profits” and the value of “net points.” They accept the studio’s terms for a good reason, money: they want to be paid the fixed part of the fee and have an opportunity to be in the movie.

It is true that Harry Potter and The Order Of The Phoenix lost money on its theatrical run, but so do almost all Hollywood movies. Here is why. The reported box-office “gross” that so fascinates the media is what the theaters take in, not what the studios get. Of the $938.2 million worth of tickets sold for this Harry Potter sequel, Warner Bros.’ distribution arm got only $459.3 million. Out of that sum, it reimbursed itself the out-of-pocket cost it made to get this film, and an audience, in 7,000 theaters around the world. These cash expenses came to a staggering $182.6 million. They included $29.2 million paid to labs for the prints, $131.1 million paid to TV stations, newspapers and other media for ads, $8 million paid in taxes to foreign governments, $5.6 million paid to dubbing studios, and $3.5 million paid to UPS and others for shipping films abroad. What remained after these expenses was $276.7 million.

Since the negative cost for this Harry Potter film was $315.9 million (which included the payments to the author and other gross players), the film was in the red after its theatrical run. But so what? This was only initial harvest of money. The real profits in Hollywood come from harvesting the back-end, which includes the DVD market, Pay-TV (HBO), and TV network and cable licensing.

The reality is Harry Potter and The Order Of The Phoenix made money for everyone involved in it. For its part, Warner Bros. had a 30 percent distribution fee that it raked off the top of all revenues, with the exception of those from DVDs . In September 2009, even before most of the lucrative TV licensing revenue, it had earned $211.8 million. And DVDs were even a richer deal. After paying a 20 percent royalty into the account of the film, its video distribution arm got the other 80 percent. On $440 million of DVD sales and licensing, this amounted to $352 million. Even after paying the cost of manufacturing and warehousing the DVDs, and a percent to J.K. Rowling, who had a “100 percent” accounting clause in her contract, it was left with a bonanza of about $200 million.

The guilds and unions got paid. Their residuals on television licensing and DVD sales amounted to $10.2 million in 2009, and would rise as the film was released in TV markets over the next 30 years.

The gross players also get paid. They got a percent of the revenues, either from ” first dollar,” as was the case of J.K. Rowling, or when the film reached the “cash break-even” point defined in their contract.

And of course everyone else gets paid their agreed-upon fixed compensation. To be sure, some of them, including writers, actors, and producers, also were given “net points” which entitled them to a share of the net profit, if ever there are any, and, because of the way these profits are defined, they are unlikely to ever see money from their net points. But they were not duped. Their contract specified that their net profit horizon would recede further and further away as payment were made to the gross players, including Warner Bros., and with each semi-annual interest charge. So, on a film with a 30 percent distribution fee and gross players, these participants – and their agents – had no reason to expect any additional compensation from net points. What they got is bragging rights in a community in which ego satisfaction is the coin of the realm.

Edward Jay Epstein studied government at Cornell and Harvard, and received his Ph.D from Harvard in 1973. His master’s thesis on the search for political truth (Inquest: The Warren Commission and the Establishment of Truth) and his doctoral dissertation (News From Nowhere) were both published as books. He is also the author of The Big Picture: Money and Power in Hollywood.