Here’s an example of how Royalties work using a hammer as an analogy.

Instead of making and selling the hammer which would require much more time and risk, the inventor could decide to pursue a licensing arrangement with a manufacturer to produce it and sell it into mass retail chain stores like The Home Depot™ and Lowe’s™.

If the hammer retails for $20.00, a typical 50% profit margin for a big box retailer would have a wholesale cost of $10.00. This wholesale cost is the price the retailer pays to take inventory of the product and sell at their retail locations. In many cases, retailers will receive more than 50% with large quantity purchases, fast pay discounts, rebates, new store discounts, etc.

Now, let’s say the inventor’s licensing deal with the manufacturer earns a royalty of 10% based on the wholesale cost. Royalty rates vary based on different factors but we’ll use 10% in this case because it makes the numbers easier to compute and understand. That means that the hammer inventor would earn a royalty of $1 per hammer sold at wholesale. This is because the inventor would earn 10% of the $10 wholesale cost of a $20 retail price hammer.

$1 may not sound like much in this day and age. An important thing to consider though is that a lot of manufacturers already have their supply chains and distribution in place already. In the United States alone, The Home Depot™ has about 2,200 locations with Lowe’s stores coming in closer to 1,800. If each store puts in a conservative 10 unit purchase order for each store for the holidays, the inventor would make $40,000 dollars on the first order. If the product was also lucky enough to get into Wal-Mart™, this initial order would soar to $90,000 with their 5,000 U.S. locations.