How Apple Drives Down Prices While Keeping Its Cachet

Apple (AAPL) COO Tim Cook strongly hinted at a low-cost iPhone in the near future, according to a Business Insider interview with Bernstein analyst Toni Sacconaghi. Apple supposedly wants to make products "for everyone" and not "just for the rich." That shouldn't be a surprise.

What has mystified some people, though, is just how Apple can create products like the iPad that seem to sell at a lower price than competitors and still retain healthy margin and public appeal. The answer is simple: Apple's already huge volume production of the iPhone.

Apple is considering cheaper iPhone models because the company knows that sitting still is death. Stay put, and Google (GOOG) Android will march over its bruised body. So far, the handset vendors using Android haven't had the same leverage over carriers that Apple has. If the carriers can close a service contract deal with a consumer and sell something other than an iPhone, it's probably in their economic self-interest to do so.

Escaping the box
Without a secondary product offering that targets more price sensitive markets, Apple could find itself boxed in. Although Apple has created a premium product positioning for itself, it also has always known the danger of being too exclusive. For example, Apple released the first sub-$1,000 MacBook in 2008.

There were much cheaper laptops already around, and given the general state of the economy, staying above $1,000 would have limited sales. Apple has one of the savviest understandings of the power and psychology of pricing as a marketing tool.

That's why starting to raise the possibility of cheaper iPhones is now important, especially as new generations of chips make smartphones far cheaper than they have been previously.
There's already evidence that Apple has begun adjusting prices, first with the iPhone 3Gs. And at the introduction of the first iPad, Apple emphasized the, for the company, relatively low price.

How Apple doesn't do it
So let's look at how Apple drives down prices while still providing products that maintain its brand cachet. Jason Hiner on our sister site TechRepublic thought Apple drives a significant portion of sales through its own retail stores and thus saves the discounts it would give other retailers. But as Hiner eventually learned from his readers in retail, Apple offers very low margins to its retailers. I worked in distribution many years ago, and can attest that it's been true for a long time.

Brian Chen at Wired attributed it to Apple's vertical integration. First, I think he may misunderstand how manufacturers look at product costs. For example, parts breakdowns of an iPad don't need to include R&D costs, because they aren't generally attributed on a per-product basis.

Furthermore, I'd have to strongly disagree that vertical integration offers great savings. Chen assumes that Apple pays no license fees to third parties to use their intellectual property, which is incorrect. The A4 chip was developed in house, but on the back of the ARM architecture, and Apple has clearly licensed that. No, cost savings aren't what drive vertical integration. If they were, all semiconductor companies would own fabrication plants rather than outsource the building, as most do.

What vertical integration does provide Apple is the ability to control quality and price. There are no other iPhone or iPad or Mac manufacturers. That means there's no economic pressure, other than consumer reaction (as happened with the first iPhone), to drive down prices.

How Apple does it
More important, Apple has massive scale in components. It sells many tens of millions of iPhones a year at 70 percent margins, and they all use the same chip that the iPad uses. Volume helps control prices of CPUs, which are typically one of the more expensive components in a device.

Purchase lots of RAM and you get deals that few others can request. Buy tens of millions of screens and vendors start tripping over themselves to get you larger ones at a cost that might tempt you to switch. (Not that the iPad at this point needs help to gain volume unit movement.)

Furthermore, Apple will design an iPhone that is still elegant, but more restricted in capabilities and hardware features. That will let it sell cheaper phones while still making more than healthy margins -- and confounding competitors and market observers.

Related:

• iPhones Make Far More Margin -- 70% -- Than Analysts and Apple Watchers Think
• Competition Begins To Drive Down iPhone Prices
• Cheap Smartphones Will Reshape Mobile -- for Better and Worse