Apple's Cost Structure, Market Position, and Strategy

Apple's Cost Structure and Gross Margins

Apple's cost of production includes both the cost of goods sold and the fixed costs associated with running its operations. The company's business model centers on handling the design and marketing of its products, then contracting a third-party manufacturer — typically based in China — to produce them. Apple maintains a gross margin of 39%, up from 37% in 2013, which reflects the company's considerable pricing power in the market. Component costs for Apple's flagship phones have been broken down, and one notable trend is that larger phones carry higher margins. For example, the iPhone 7 Plus generates $84.50 more in gross profit per unit than the standard model (Mayo & Mayo, 2017). The components are slightly more expensive, but the company charges significantly more for the device.

This dynamic helps explain the upward creep in Apple's gross margins. Larger phones have become increasingly popular in recent years, driven by the broader consumer shift toward mobile browsing on smartphones rather than conventional browsing on desktop or laptop computers. As consumer preference has tilted toward larger, premium devices, Apple's margins have benefited accordingly.

Fixed Costs, R&D, and Output Decisions

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 is R&D spending. Basic selling, general, and administrative (SG&A) expense for 2016 was 6.5% of revenues, up only modestly from 6.3% in 2013. R&D, however, increased by $5.5 billion, representing 4.6% of revenues, versus 2.6% in 2013. This jump in R&D expenses is unrelated to iPhones or other core products; it is instead tied to the company's efforts in developing self-driving car technology. Apple is funding that effort from its massive cash reserves rather than from ongoing operations. In practical terms, the $5.5 billion increase that has significantly raised the company's reported fixed costs relates to an entirely separate business line (Campbell, 2016), and the income statement must be read with that context in mind. Apple's core fixed costs have actually changed little.

Fixed costs therefore have little bearing on Apple's output decisions for its consumer products. The company generates extraordinary profits and has no difficulty covering its fixed-side obligations. There is evidence, however, that Apple does take variable costs into account in its production decisions. Because it earns more on a larger phone than a smaller one, Apple has an incentive to steer consumers toward the higher-margin devices. One way it does this is by offering the smaller phones with very limited memory, discouraging consumers from purchasing them — a strategy roughly analogous to upselling at a fast-food restaurant. Apple focuses production and marketing on larger, more expensive products because those carry the highest margins, and does so in order to maximize shareholder value from each transaction. Given that consumers typically replace their phones only once every three years or so, the company seeks to maximize the return on each sale by producing more of the bigger devices and orienting its marketing accordingly.

Apple's Market and the Samsung Duopoly

The iPhone is by far Apple's biggest product. In the global smartphone market, Apple holds a 14.5% share, placing it second behind Samsung, which commands 20.8% share. Apple's share has been growing, however. The 14.5% figure covers all of 2016, but in Q4 of that year Apple held a 17.8% share — enough to lead the market — largely because of the Samsung Galaxy Note 7 recall scandal, which severely damaged Samsung's reputation and removed one of its flagship products from sale (Strategy Analytics, 2017).

The smartphone industry is fundamentally divided into high-end and low-end segments. High-end phones dominate in developed countries and among wealthy consumers worldwide, while less developed markets are served by cheaper devices for large middle-class populations. Last year, 44.9% of the global market was held by firms outside the top five. The presence of relatively unknown brands such as OPPO and Vivo in the top five underscores that at the high end, Apple and Samsung effectively operate as a duopoly, with all other firms competing in the undifferentiated, price-sensitive segment. Apple and Samsung together hold roughly 35% of unit sales but a significantly higher proportion of dollar sales. The duopoly dynamic was illustrated clearly when Samsung faltered: Samsung lost 3.1% market share, and Apple gained 3.3%.

References

Campbell, M. (2016). Apple R&D spending jumps to $2.5B in Q2, accounted for 5% of total revenue. Apple Insider. Retrieved April 9, 2017, from http://appleinsider.com/articles/16/04/27/apple-rd-spending-jumps-to-25b-in-q2-accounted-for-5-of-total-revenue

Mayo, B., & Mayo, B. (2017). $649 iPhone 7 estimated to cost Apple ~$220, here's the component breakdown. 9to5Mac. Retrieved April 9, 2017, from https://9to5mac.com/2016/09/20/649-iPhone-7-estimated-to-cost-apple-220-heres-the-component-breakdown

MSN Moneycentral. (2017). Apple. Retrieved April 9, 2017, from http://www.msn.com/en-us/money/stockdetails/financials/fi-AAPL?ocid=qbeb

Strategy Analytics. (2017). Global smartphone shipments hit a record 1.5 billion units in 2016. Business Wire. Retrieved April 9, 2017, from