Fixed Costs and Apple

Apple's cost of production includes both the cost of goods sold and the fixed costs associated with running its operation. The company's business model is that it handles the design and marketing of its products, and then contracts a third party company to produce them, usually in China. Apple maintains a gross margin of 39%, and this up from 37% in 2013, which is a reflection of the company's pricing power in the market as much as anything else.

Component costs for Apple's flagship phones have been broken down and one of the trends that stands out is that the larger phones carry with them higher margins. For example, the 7 Plus carries with it $84.50 more in gross profit for the company (Mayo & Mayo, 2017). The components are slightly more expensive, and the company charges significantly more for the device.

This perhaps explains the upward creep in the company's gross margins, as larger phones have become increasingly popular in recent years due to the trend towards mobile browsing on phones over conventional browsing on computers. Operating costs last year were 11.2% of revenues, compared with 8.9% in 2013, indicating an upward shift in operating expenses. The biggest factor there is actually R&D expense. The basic SGA expense for 2016 was 6.5% versus 6.3% in 2013. R&D, however, increased by $5.5 billion, 4.6% of revenues, versus 2.6% of revenue in 2013.

This jump in R&D expenses is unrelated to iPhones or other core products, and is actually related to the company's efforts in developing self-driving cars. Apple is funding that effort from its massive cash pile, rather than its ongoing operations. Basically what this means is that the $5.5 billion that has increased the company's fixed costs so significantly relates to a different business entirely (Campbell, 2016), and the income statement has to be viewed with that in mind. The company's fixed costs have actually changed little.

Fixed costs therefore have little to do with Apple's output decisions. The company makes money like no other, and has no problems paying whatever it costs on the fixed side. There is some evidence that the company takes variable costs into account in its production decisions, however. It makes more money on a large phone than a small phone, so it wants to guide consumers towards the larger phones.

To do this, it makes the small phones quite small in terms of memory, discouraging consumers from purchasing them, roughly analogous to super sizing at a fast food restaurant. Apple focuses production and marketing on the larger, more expensive products because those come with the higher margins. It does this in order to maximize shareholder value from each of its products.

It knows that if someone is going to buy one phone every three years or so, that it needs to maximize the return it gets on each transaction, and it can do that by producing more of the bigger phones and orienting its marketing towards them. Apple's Market The biggest product by far for Apple is the iPhone. In that market, Apple holds a 14.5% share, putting it in second place behind Samsung, which has 20.8% share. Apple's share is gaining, however.

The 14.5% figure is for all of 2016, but in Q4 Apple held a 17.8%, good for market lead, largely because of the Note 7 scandal, which severely damaged Samsung's reputation as well as taking one of its major products off the market (Strategy Analytics, 2017). The industry is basically split into high end and low end. High end phones are the norm in developed countries and among wealthy consumers worldwide. In less developed countries, the massive middle classes own cheaper phones. Last year, 44.9% of the market was held by firms outside of the top 5.

Unknown companies like OPPO and Vivo were in the top 5, indicating that at the high end there is really only Apple and Samsun in a duopoly, with all other firms fighting over the undifferentiated segment of the market. Apple and Samsung hold roughly 35% of unit sales but a much higher figure for dollar sales. That these two companies are essentially splitting their niche illustrates the duopoly nature of the business -- when Samsung faltered, Apple gained. Samsung lost 3.1% share, Apple gained 3.3%. The duopoly is protected by high barriers to entry.

The low end is chaotic, with firms joining the market, winning share, and then getting overtaken by other new firms. It is not difficult to enter the smartphone market, but nobody has been able to break into the high end for years. The cost of developing both the cutting edge technology offered by Samsung and Apple, and the high cost of developing their sophisticated marketing operations, remain major barriers to entry.

Those firms attract top talent, and have enormous cash supplies with which to outspend the competition, further strengthening the barriers to entering the high end of the smartphone market. Samsung and Apple split the market with operating systems as well -- the two different operating systems are among the major differentiators, and those who prefer Android or iOS will gravitate towards the company that supports that.

Apple's integrated technology and less flexible approach to consumer choice has always made it a challenge for the company to win a market -- Apple is okay with being a niche because of high loyalty of its consumers. Apple has stronger share in North America and Europe than it does in other countries of the world. Recommendation Apple is in a great position going forward. Its approach to maximizing product size (and thus revenue) is great.

It can, if it so chooses, simply sit on this cash cow and never worry about a thing again. However, Apple could also accelerate the pace of innovation, perhaps implementing more of a lean, DevOps sort of approach, where instead of having a new product launch every12-18 months, it launches more frequently, with incremental gains. The reason this works from a marketing perspective is that it can shorten the cycle by which a consumer buys a new phone.

If consumers wait six months for the next release, past the point at which they decide to buy a new phone, that is six months where Apple isn't making money. They make more money, and make it sooner, by shortening the consumer phone turnover cycle. But that requires changes at the development level, and a shift in the company's approach to marketing as well. Apple can take this approach easily -- it is in a duopoly but at the same time it has high brand.