Virulent Word of Mouse

January 26, 2010

A few riffs on the cost of a smart phone


Sometimes one simple fact illuminates many others. Here is one about smart phones: They cost less than $200 to manufacturer. You heard that right, less than $200.

This fact comes to us from the Economist, which ran a wonderful article about the art of tear-downs — namely, taking apart products to understand how they work. I recommend the article. The facts about smart phones emerge as the article explains its broad theme.

The table at the left (taken directly from the story) gets the key point across. These pieces of hardware cost very little. Look at it. Somebody took apart phones, analyzing the costs of the components, and could find no more than $170 worth of components and other parts.

Think about it. That is not much money. Let’s riff a bit on this simple fact. I invite you to riff on it as well. (In case you are unfamiliar with the phrase, according to Webster’s online dictionary, a “riff” is an ostinato phrase — as in jazz — typically supporting a solo improvisation. )

Here are my riffs

1. How do I know that $200 is not much money? Here is my reasoning. The cellular industry generates $145 billion in revenue each year in the US alone. Even if 100 million smart phones were sold in a year, which would reach an impossible one per household,  it amounts to less than $20 billion in cost. Ergo, even with extreme numbers, this cannot be a big part of expense in this industry.

2. Market value goes to the resource that is rare. If devices are not the expensive component, what is? Towers? At a cost of $100-150 thousand a tower I doubt it is the tower. I would guess that spectrum is the rare resource, and in some situations the interconnection charges with the land-line network must also be a large cost.

3. The Economist goes on to point out that manufacturing cost does not dominate the price of the cell phone. As it states, “Most smart-phones’ retail prices (before operator subsidies) are around $500-$600. Not all of the difference is profit. There are many other costs, such as research, design, marketing and patent fees, as well as the retailer’s own costs.” I am sorry, but the Economist is usually more precise about its economics. That list mushes two things, costs tied to the unit and costs that do not depend on scale of sales. It also mushes short and long time horizons.

4. Manufacturers care about scale and horizons, and do not mix them up this way. Patent fees are directly tied to unit costs, and retailer time often can be.   Research, design and marketing are largely fixed in the short run, independent of sales, adjusting to volumes only after long cycles of trial and error with user demand. I do not believe patent fees amount to more than a few dollars, nor does selling time of employees. Even if both those add up to $50 per phone that still leaves an enormous margin between short run unit costs and selling price. Sure, there should be some margin there, as a way to cover the bank loan or working capital cost which covered those fixed costs. When a phone sells well, it covers those fixed costs. When not, it does not. That is how the firms think about it, so why not say it that way?

5. That still leaves me wondering… $500-$600? With so little money on the table why do we presently have a system where carriers subsidize the cost to users, then make up for it with profits on the carrying charges? It is as if the carriers lend money to the buyer, then get it back with interest with all sorts of charges on a two year contract. Some users must like this system, to be sure, and it probably made a lot of sense twenty years ago when the product was new, unknown, and seemingly risky. So its origins do not seem crazy on the surface. Even today it does not seem crazy. Many low income and young buyers probably still like it (academic economists often call such buyers “credit-constrained”). But saying that some users like it is not the same as saying that all like it.

6. I am just going to think out loud for a minute. Some buyers probably would be happy with another system, one where they pay as they go, namely, pay for each component with a separate charge. So the question is: why is the borrow-from-carriers the only system in the US? Why are there no alternatives?

7. In stereos, computers, and plenty of other markets for electronics we let users mix and match components from different suppliers. For example, users can get everything from Dell if they want to, or get their printer from one firm, their screen from another, and their CPU from another. That latter is called mix and match. Maybe that will work here or maybe not, but why is this not an option?  In such a situation, things would not be much different. Carriers would use different digital technologies or whatever they wanted to use — and that type of differentiation/experimentation seems all for the good. After all, competition between carriers is great for users. But I can imagine a system that would have one more thing: users would be able to experiment too. In other words, with such a cheap good why don’t we have a market where users buy a handset, pop a card or antennae into the back to make it work with different networks? Why not let Apple and HTC figure out how to design it, if they can, and why not let users decide if they like this option or not? What stands in the way of such a marketplace? It makes me wonder.

8. Let me be real precise…. There are many economic reasons in theory which could explain why we have only one system in the US, and not more than one. It is possible in theory for the present system to have some very good features. That is not the question I am asking. I just want to know why we have this system historically and presently. Did the FCC encourage this system at the beginning of the cellular networks? What barriers has Google encountered, for example, as it tries to make the Nexus available for mix and match among carriers? Does anybody out there know?

Like I said, I was just riffing a bit on a simple fact. Please add your riffs.

3 Comments »

  1. Here’s two Riffs:

    How big are those patent costs, really? While it’s frustratingly hard to tell, they might be larger than you suggest. Let’s start with Qualcomm’s $3.11 billion in licensing royalties for 2008. If we estimate that half of this comes from the USA, and take your assumption of 100 million handsets, that’s roughly $15 apiece. These costs will be larger for newer handsets, and if we assume that other licensors are collectively about equal to Qualcomm that gets us above $30 / phone. Yes, the margins will still be there, but these are not trivial costs. (One caveat, some of those royalties may already show up in the Economists costs estimates for the IC’s).

    How did we get to the current system? I suspect that standards fragmentation played a role in the evolution of the US handset market. Europe was on a single standard (GSM), by around 1991. In the USA, the GSM/TDMA/CDMA standards kerfuffle lasted until at least the late 1990’s. As a result, US carriers grew their networks and business models at a time/place where handsets were carrier-specific. Perhaps they came to see some advantages of the “handset leasing” model, particularly if customers are not very good at thinking about the long-term costs and benefits of a complex pricing plan when confronted with a shiny new phone? Now that most phones are multi-protocol, and everything is moving to CDMA anyhow, it would be easier to have a “mix and match” market except for legal and technical barriers to switching. (What’s going to happen when I jail-break my iPhone? and do I void the warranty?) Interestingly, the branch of government that decides on the legality of technical efforts to enforce handset exclusivity under the DMCA is the librarian of Congress. (http://www.copyright.gov/title17/92chap12.html#1201)

    Comment by Tim Simcoe — January 27, 2010 @ 10:10 am | Reply

  2. My 2 cents:
    From my limited experience in the mobile devices industry, on the sales side, I would expect 35% – 40% gross margins on high end smartphones. While this seems high, it is still not a final profit per unit since other corporate expenses have to be considered.
    In genenral I can think of two reasons for the high margins in smartphones.
    1.- Smartphones are still on the mid to upper end of a product portfolio and therefore are used to “subsidize” the lower margins obtained in low end mass products.
    The need for this subsidy can be extreme, I remember seeing examples of low end handsets that were sold at 0% gross margin effectively generating a loss for the compañy for each unit sold.

    2.- As with any technology product, there is risk in developing a nice piece of hardware only to get slammed by the nit-picky consumer who refuses to buy. Sales in a season tend to concentrate around a relative few winning handsets leaving a number of also-rans struggling to meet development costs or turn a profit. This makes profit maximization especially important when you manage to have a hit product to offer (emphasis on ther “when”).

    Comment by E. Tyszka — February 5, 2010 @ 8:35 am | Reply


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