Amazon's Inverse Kindle Strategy: Hardware Subsidizes Media

Last Updated Jul 9, 2009 8:20 AM EDT

Yesterday, Amazon dropped the price of the Kindle 2 to $299. It's undoubtedly intended to drive increased volume. But the really interesting story is how margins on the device allow Amazon to sell e-books below cost and convert enough customers that it can make itself the de facto sole outlet for books and virtually own the publishing industry.

This is a story built on numbers. Start with the hardware costs of the Kindle. According to iSuppli, the Kindle 2 probably costs $185.49 to build. That includes manufacturing expenses and battery, with 41.5 percent of the cost attributable to the display. According to Larry Dignan at our sister site ZDNet, the cut is likely a result of consolidation in the Kindle supply chain.

Even at a selling price of $299, that would leave $113.51 in margin for Amazon, because it sells direct. Although I couldn't find a teardown of the Kindle DX, it only seems reasonable to assume that it will have at least as high a percentage margin as the Kindle 2, which, at about 38 percent, would be about $187.29. It is probably even more accurate to assume that the DX would still have the margin that the regular model had up until Tuesday, which, at the $359 price, was a bit over 48 percent. That would leave the margin dollars on the $489 DX at about $234.72.

The ordinary approach of tech execs might be to cut the cost of the hardware as much as possible, maybe even below cost with an electronic equivalent of a book club. The consumer buys so many books and gets discounted hardware. But there's a problem: there is still the paper option. If Amazon can get enough buy-in from consumers, particularly the ones that buy the most books a year, it can effectively push its real competitors, the other booksellers, out of the way with its proprietary format. Instead of looking to make the hardware as cheap as possible, it instead makes the books as cheap as possible. From a marketing view, that creates an emotional perception on the part of consumers that the real savings in the long run is to go electronic.

Right now, Amazon is subsidizing e-book prices. Bloomberg quotes Sanford C. Bernstein & Co. as saying that publishers earn about $2.15 for an digital version of a book and about 26 cents for a paper copy. Given that publishers are taking in much more than 26 cents on paper books, I must think that the amount reflects the money received minus all production, marketing, sales, author royalties, and overhead costs.

According to this story, the Authors Guild suggests that Amazon pays publishers between $12 and $13 for Kindle editions of books on the New York Times best sellers list. That means Amazon is shelling out $2 to $3 for each copy it sells, which practically begs for the old business joke about losing money on every sale but making it up in volume.

That volume is there. Although Jeff Bezos hasn't said how many Kindles the company has sold, back in May, at the launch of the big-screen DX model, he said that "when Kindle titles are available, they now represent 35% of those books' sales." That's where the Kindle margin comes in. Amazon clearly doesn't depend on sales of the device, but having $113 extra in the pocket means that the company can subsidize nearly 38 books per reader. At least. Figuring that the average customer will buy six titles a year (why else pay for the hardware?), Amazon has upwards of a nine year window in which to continue driving e-book prices down to capture more customers. Is the six a year figure too low? Double it. That still gives the company nearly five years to grow the market.

When it hits whatever magic number management there has calculated, then the Kindle will have enough market share that publishers can no longer afford to think of it as an option. That's when Amazon can force a shift in the economics, either by slowly raising prices to consumers, or, more likely in my book, making publishers accept a minority cut of whatever price it puts on the titles. At that point, Amazon owns publishing and all other players, whether a Sony, Apple, or Borders, continue to play catch-up and then try to become compatible with Amazon's format, possibly even licensing it.

Kindle 2 image courtesy of Amazon.com

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    Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.