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No. 12
May 2010
International Association for the Protection of Intellectual Property
AIPPI General Secretariat |Toedistrasse 16 | CH-8027 Zurich
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The Efficiency of Anti–counterfeiting (1-3)
Dr. Hans Joachim Fuchs, CHINABRAND Consulting Limited, Munich, Germany and Dr. Shuqin Zhou, CHINABRAND Consulting Limited, Munich, Germany.

Anti–Counterfeiting is under permanent pressure of legitimation. The budgets required by an effi–cient anti–counterfeiting are generally six–digit amounts in middle–sized companies, whereas multi–national groups often spend seven– and eight–digit sums for management and patent protection, trademarks, copy rights, as well as for infringement suits. As a result, managers and executives are increasingly questioning not only the effectiveness, but also the efficiency of such actions. Will the expenses really pay off, i.e. are the costs for protecting intellectual property and for prosecut–ing infringement cases reasonable with regard to the damage prevented?

Costs of protection vs. Damage prevented

Basically, the costs for protection of intellectual property in the long run have to be significantly lower than the damage caused by loss, for instance, due to intellectual property theft by counterfeiters: The cost–benefit ratio of IP protection is best illustrated with the example of product and trademark piracy, because here we can quantify the damages caused by counterfeiting. In contrast, this is not true for other areas of IP damaging, e. g. industrial espionage.

The monetary damages that arise for original manufacturers due to product and brand piracy consist of several components..

1) Short–term: In the current fiscal year, counterfeits entail a direct loss in turnover, since many potential buyers deliberately turn down the original product and buy the copy instead. In addition, cheap fakes make pressure to the prices of original products. In China, Western engineering companies were forced to reduced their prices up to 20 – 25 % to keep competitive with their Chinese counterfeiters. That means that there is often a massive short–term loss in profit due to price pressure.

2) Medium–term: Counterfeiters copy one another. As a result, we can see a snowball effect that very quickly entails large secondary markets and cheap counterfeit products. These competitive, cheap mar–kets slowly but surely undermine the original manufacturers´ turnovers. Thus, the essential problem for the manufacturers is not the current loss in turnover resulting from the counterfeits presently offered for sale on the world markets. Their major problem is the future cumulated loss of market shares and, thereby, of turnover and cash flow caused by the up–rising cheap markets and their counterfeit products damaging businesses and possibly even ruining them.

3) Long–term: Continuous counterfeiting entails damage to the original brand, or rather the reputation of the original manufacturer, because his trademark is steadily degraded by down–trading. It erodes – the brand value decreases.

A further damage possibly results from compensation payments, if original manufacturers are made liable for defects of counterfeit products. The costs caused by such cases are either noted within the company or can be easily identified.

Costs of IP Protection:

The expenses for protection of intellectual property and prosecution of IPR violation can easily be calcu–lated by means of the individual expenditure items. However, they may be reduced if the company receives compensations from successful IP law suits, which is increasingly the case. The obtainable amounts are often quite significant. For example, Chinese Zhongwei Bus was sentenced to pay a compensation of 2.3 million EUR to German Neoplan for copying the famous Starliner bus. What is more, compensation pay–ments in the six–figure range are not so rare in successful infringement cases.

Calculating the damages:

The cumulated expenses for IP protection and prosecuting violations must be significantly lower than the damage caused by short–term losses in turnover, medium–term market share losses, reduction of the mar–ket value, and potential liability cases. The formula for calculating the cost–benefit ratio in IP protection in the case of counterfeiting is as follows:

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But how can the separate components of the damage be calculated?

1. Calculating the short–term losses in turnover:

Short–term losses of turnover that result from product and brand piracy can be traced through experiences of the industry, projections of individual, noted cases and the turnovers of identified counterfeiters.

a) Calculation through industry values:

According to a survey of the German Engineering Federation VDMA, German machine builders lose an average of 3 to 5 % of their yearly turnover due to product and brand piracy. In a company with a yearly turnover of billion Euros this would mean a loss of 30 to 50 million Euros per year. According to VDMA, 71 % of the counterfeits in machine construction come from China. Thus the damage of this enterprise due to Chinese counterfeiters would make up between 21.3 and 35.5 million Euros. For a hypothetical minimal loss of 1 % of the turnover, the company´s loss would still amount to ten million Euros (that is 67.1 million Euros with reference to China only).

These dimensions also apply to other industry branches. For example, the sanitation manufacturer Hans–grohe AG estimates that his damage due to product and brand piracy amounts to approximately three per–cent of the net sales, i.e. ca. 20 million EUR. In contrast to this short–term loss in turnover, Hansgrohe´s expenses for IP protection and fighting counterfeiting are only two to three million EUR. EBM Papst, a German manufacturer of industrial fans, estimates its annual losses from counterfeiting to be 15% of its revenues, which is –150 million a year.

b) Projective calculation of individual cases:

We assume that the dark figure of product and brand piracy amounts to 6 to 10, depending on the industrial branch. That is to say that only 1/6 to 1/10 of all cases are identified through evidences, inspections, or cus–toms controls. If the damage of an individual case is noted, then it can be projected through the dark figure. In January of 2007, 40 tons of counterfeited antifriction bearings worth ca. 8 million EUR were destroyed on the grounds of the FAG factory in Schweinfurt. As the confiscated counterfeits are likely to be a one year´s production, this implies a loss in turnover of 48 million EUR for a dark figure of 6. The loss of turnover rises to 80 million EUR if a dark figure of 10 is assumed.

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c) Calculation through counterfeiters´ sales:

The total amount of imitations produced by one counterfeiter is generally not known. Even so, what we can assess are the turnovers of counterfeiting companies. That way, the damage arising for the original pro–ducer can be calculated. However, it is important here to take into account the consumer behavior as well as the price difference between original and counterfeit.

The current loss in turnover at the point of time t (e.g. in the year 2010) is calculated indirectly via the coun–terfeiters´turnover: Earnings of the counterfeiter => Loss of the original manufacturer. A price determinant indicates the ratio of fake price to original price on the market. For a ratio copy – original = 1 – 5, the price determinant is 5, i.e. the original producer´s loss is five times as high as the counterfeiters profit.

Since depending on customer behaviors, the different counterfeiters have varying effects on the turnover of the original manufacturer, they lever divergently with the leverage factor h. ROLEX counterfeits will have little or no effect on the sales of the original producer, for the copies are not considered to be equivalent substitutes for originals. No fake buyer will purchase an original ROLEX watch and no well–off ROLEX buyer will switch to an imitation. The levering factor that represents the effects of counterfeits on the sales of the original manufacturer will in this case tend toward zero. It is quite different for counterfeits that are real substitutes for originals. In the case of frequently copied fashion labels like Polo Ralph Lauren we es–timate a leverage factor of 0.2 to 0.3. For producers of –perfect– fakes, which cannot be distinguished from the original and deceive the customer, a levering factor of 1 is applicable.

However, the effective loss in cash is reduced through absent variable costs, such as saved material due to lacking sales of originals. If one has fewer sales of original products due to counterfeiting, one also has fewer variable costs.

2. Calculating the medium–term damages due to lost market shares:

The medium–term damage due to lost market shares is calculated with the Net Present Value or Dis–counted Cash Flow, i.e. the cash value at the present time. Through the permanent loss of market shares due to quickly growing secondary markets, cumulated losses of cash flow arise over a period (e.g. 2010 till 2015) and reach very high levels over the years. Damages that occur at different, later points in time are not equivalent in relation to the present moment. In order to evaluate the cash value of the future damage, the capital costs rate is applicable which is normally higher than the interest rate for outside financing as it takes into consideration the opportunity costs of the invested capital. The capital cost rate is the minimum rate of return that a company should generate. Normally the capital costs rate is not suited for discounting the losses. When it comes to evaluating the profitability of anti–counterfeiting, the assessment is the same as that of an investment project. The decrease of losses in turnover or cash represents the profit due to the investment.

There was a permanent loss of market shares of an American brand between August of 1995 and May of 1998 in China. While the brand´s market share assessed by market researching apparently remained nearly unchanged, deliveries of the original brand to Beijing steadily decreased. This means that over the years original products were increasingly superseded by counterfeits. The counterfeiters took over the brand. In a relatively short period of time the German Stihl GmbH lost half of its market share in Indonesia to counterfeiters – it fell from 80 to 40%.

3. Calculating the long-term loss due to brand damaging:

Through the extensive spread of counterfeited products and copied trademarks, the original brand is con–tinually ablated, i.e. weakened within the market. It loses its exclusiveness and attraction, and that signifi–cantly lessens its monetary value over time. Since leading brands are often highly valued, even small dam–age factors of a few percent already have relatively strong monetary effects. Example: 5 % loss of 1 billion EUR brand value = 50 mill. EUR fall in value. The damage factor has to be estimated. Through massive counterfeiting of poor quality, the value of a former premium brand such as Polo Ralph Lauren might be reduced by 10 %. The brand today is considered main stream. The brand value is often known or calcula–ble with various methods, for example, with INTERBRAND which is well–known in many companies. The damage factor is industry and company–specific and varies between 5 and 30%. Various brand rankings also provide general criterions for potential losses in brand value.

Losses that result from liability due to IPR violations are a noted factor in the company and can be incorpo–rated into the calculation of the total damage as a fixed position.

4. Calculation of the total damage:

The total damage arising for a company due to counterfeiting is calculated by adding the short–term, me–dium–term and long–term damages as well as compensations paid or as yet to be paid:

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The results of such calculations show impressively that the damages of intellectual property that result from losses and illegal abuse of intellectual property may be tenfold higher than the costs produced by IP protec–tion. The positive cost–benefit relation has not yet been recognized in the management boards of many companies. It is true that we are seeing a growing understanding of the fact that the evaluation of underes–timated immaterial capital – especially in form of business protection rights – is playing an increasingly im–portant role in commerce.

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