Several Advantages To Apple's iPhone Price Cut

Here are several of Apple (AAPL)'s advantages for pricing the iPhone high initially, and the benefits to later cutting price:

1) Attract more non-AT&T (T) customers to switch carriers. Apple receives bonus revenue for new subscribers. Eventually, Apple will have to offer the iPhone to other carriers, but while it’s exclusive to AT&T Apple can capture high margin revenue. Service revenues fall straight to the bottom line, thus it makes sense for Apple to ramp up adoption as much as possible before their exclusive carrier agreement expires.

2) A high initial price meant that the early adopters would be mostly “die-hard Apple loyalists.” This consumer segment has significant Apple bias, thus those users will talk very positive about the product, hence generating significant buzz. In addition, loyalists won’t focus on any drawbacks, for they focus on all the strong points of the device. Thus, Apple is less likely to receive negative word of mouth from the product release.

3) The initial high selling price means fat margins that can be allocated toward the recapture of up-front development costs. The sooner these development costs are recovered, future margins will expand at a faster pace.

4) The new iPod Touch is essentially an iPhone, without the phone capabilities. Thus, both the new iPod and iPhone will share the same components which will drive scale efficiencies. The shared costs between the two products will aid in offsetting the margin decline stemming from the lowered selling price. Increase in volume spreads fixed costs over more units, which improves the incremental profit margin per unit.

5) The lower price point of the iPhone should dramatically boost adoption. According to a ChangeWave Alliance survey of 3,000 non-owners, one-third stated “high price” as the reason for not buying an iPhone. Roughly 25% of those respondents indicated they would “likely” purchase an iPhone in the future, which one-third said they were waiting for the price to come down.

6) Apple is switching from a price-skimming strategy to a market penetration strategy. Apple will be able to expand market share quicker; this will strengthen competitive barriers.

A skimming strategy is defined by an initial high selling price followed by gradual decreases. The concept is to capture all the demand at the highest price point, and when that demand is exhausted, the price is reduced slightly to capture demand at the lower price point. This continues until no additional demand can be generated at a lower price point.

A penetration strategy, on the other hand, is setting price lower than product costs or competitors’ price. The objective is to drive volume rapidly which will enhance economies of scale and reduce unit cost. If there are high switching costs involved, then a penetration strategy is most appropriate. An excessively high selling price just invites competitors to offer similar devices at the lower prices consumers are willing to pay.

After a consumer buys an iPhone, it’s likely they will not be looking to buy a phone for two years. Additionally, given Apple's strong brand and customer loyalty, once a consumer gets his hands on an iPhone it will be very difficult for a competitor to pull them away. Apple can repel competition with the adoption of more users since it’s doubtful that other firms will want to spend the effort in pursuing satisfied iPhone users. It hasn't worked for those firms seeking to convert iPod users.

I don’t think the move by Apple is a suggestion that iPhone sales were soft. Analysts closely following iPhone sales had been reporting that sales were tracking as expected. There was a disconnect between expected sales and consumer interest.

Customer satisfaction is extremely high, yet given the underlying positive perception, adoption hasn’t seemed to develop as sentiment would suggest. The high price is certainly a barrier. Surveys and polls indicated there is significant demand potential, but the steep cost has been a formidable barrier. Lowering the price will have an immediate impact on sales, immediate.

In my social circle, the majority of my friends say they are waiting for the price to drop. Or, they were waiting for the second generation (and a cheaper price tag). I got the impression that it’s a widely-held belief that Apple would release something better and cheaper soon which made folks hesitant to take the plunge. It was bound to happen. But, no one expected it would come this soon and the price reduction would be so great.

I wonder if this price reduction isn’t preparation for a future model with enhanced functionality. An improved camera function would seem most logical. The current camera is pretty sweet for a phone device, yet it’s still far from a digital camera. Apple already has incredible software applications- iPhoto and iMovie, which can sync with the iPhone, thus improving this feature would really make the iPhone a slam dunk.

Apple’s iPhone revenue will certainly be lower than previous forecasts since projections were assuming $550-600 average selling price. Unit volume will be much higher, it’s doubtful that volume will be great enough to completely offset the decrease in price. Service revenues should be significantly higher, and margins should recover modestly from increasing economies of scale.

The exact magnitude the price reduction has on demand will be an important indicator. If demand reacts sluggishly then Apple has a serious problem. Thus, it will be important to pay close attention to how Apple’s new move plays out in the consumer market.

Comments

[samij:]

It might be indeed that Apple reached the expected sales levels, however the price drop indicates a problem in the sales: either it was slowing down significantly after the Apple fans had theirs or Apple had no problem of selling them, but instead had a problem of making the buyers to keep their iphones.

Supporting the second theory is the fact that there is (and has been for a long while) a large number of refurb iphones available on Apple store. The refurb availabilty of those seems to be much better than other Apple products: either iphones have a much larger % of defective units than other Apple products, or customers are returning their iphones after testing them out for the 14 days.

Supporting the first theory is the fact that there is still good availability of $299 left-over 4gb iphones, if there was a strong demand on iphones at lower price, those would have already been sold out.

2007 Sep 10 04:44 PM

[davesmall:]

I have an iPhone and I love it. Do wish it was on faster 3G networking though, and wish I didn't have to deal with AT&T and their onerous contract. A flat monthly charge for unlimited everything is really what I want and expect from a cell phone service provider. If I can't have that then I want prepaid minutes and unlimited data networking. I don't want to deal with a phone company that has the word "roaming" anywhere in their contrract.

My guess is that Apple really cranked up production when they saw the initial burst of sales and customer acceptance. They didn't want to run short so they authorized maximum production. Now sales have slowed a bit, which is to be expected, and they've found themselves accumulating inventory. With the rumored iPhone version 2.0 with 3G networking just a few months away they need to clear inventory. Don't be surprised if we see the same $600 price tag returning when the 3G phones are released.

2007 Sep 11 09:57 AM

[User 107661:]

It may be that Apple chose to pursue a low volume/ high margin strategy during the initial marketing phase, while testing market reaction and ramping up manufacturing. Their exclusivity deal with ATT and other EU carriers, which includes additional subscription revenues for Apple, is in line with strategy. This allows Apple to make high profits while being able to focus on a limited market and quickly solve initial mishaps such as activation issues, potential design flaws, etc...

A high volume / lower margin strategy requires scale efficiencies, large manufacturing capabilities, and a general expertise in this entirely new new business for Apple. It seems logical for Apple to initially adopt a cautious strategy, and to switch gears only once the market has responded favorably, manufacturing is in place, and Apple is confident it can globally manage a larger cell phone business. Future steps include worldwide expansion, non-exclusive deals with multiple carriers, a broader phone offering, and potentially a more proprietary network possibly in partnership with Google.

2007 Sep 19 04:09 AM

[turleymuller:]

User107661-
I totally agree with your comment. The low volume-high margin (high price) strategy, or skimming, allowed Apple to test their new product among the most loyal Apple consumers. This way, any flaws etc. would be downplayed by this consumer segment because they are biased due to their love of the Apple brand.

The limited market allows Apple to test and confirm their product quality before rolling out to the mass market, If Apple had initially used a low price/high volume strategy, and there were flaws, then the bad reputation would haunt Apple on their subsequent iPhone releases. Even if they had cured any issues, the bad word of mouth may linger and impede sales.

Also, just as you said, and as I alluded to in my article, when Apple is confident that there is sufficient demand, then a lower price (margin) strategy to drive volume will result in scale benefits. Scale and learning curves allow Apple's cost to fall thus recapturing some of the lost margin from the selling price reduction.

Additionally, the lower price drives adoption and subscription fees and revenue that Apple receives from AT&T. This further offsets the margin decline from a lower selling price.

2007 Sep 19 05:07 PM

[Ryan Thomson:]

Hi Turley,

Interesting article. I am MBA student at Griffith University currently working on a strategic analysis of the iPhone. When you consider the low industry attractiveness as a whole (not segmenting the 'feature phone market') it appears Apple's decision to enter the cell phone industry was driven by the threat from convergence devices (mp3/phone) and the prospect to further strengthen its position as the dominant PMP with the iPod/iPhone through a product development strategy. Therefore, certainly the AT&T contract's exclusivity does not act to promote growth for their ipod/iphone line (given the high switching costs consumers would incur with switching to the AT&T contract)? What are your thoughts Turley?

Regards,

Ryan Thomson

2007 Oct 19 12:10 AM