Tuesday, February 22, 2011

Why iPad Can Sell at $500

On Wired's website, Brian Chen writes about how the iPad can possibly sell at $500, when many competing tablets coming to market are more expensive. He begins by citing Jason Hiner of Tech Republic, who focuses on the fact that Apple has its own retail stores. Hiner argues that Apple "saves" the usual retailer margin paid to other chains by competing tablets. Chen rightfully refutes this argument, which is often incorrectly cited to justify vertical integration. As Chen writes, "The retail advantage is a reasonable theory, but Hiner neglects to mention the high overhead costs that Apple must pay handsomely for each of its 300 stores."

If forward integration's benefits were as simple as "cutting out the margin made by retailers," then we would see many more firms owning their own stores. Naturally, we do not because firms don't eliminate that margin "for free" - they must invest a ton of capital. The shareholders expect a return on that investment. They will only tolerate a forward integration strategy if the return on capital invested makes sense.

What does explain Apple's ability to sell the iPad at such a competitive price? Chen argues that one has to look at Apple's vertical integration strategy in its entirety to understand its advantage. Moreover, one has to look at the money it can make off of its "ecosystem" - i.e. all the apps, music, etc.

However, I would go one step further. To understand Apple's advantage, you also must look at its HORIZONTAL integration. In other words, Apple has an advantage from the fact that it competes in multiple product markets - phones, MP3 players, personal computers, tablets, etc. Why is that? Well, Apple can share and leverage resources and capabilities across these product categories. As a simple example, consider the operating system that drives Apple products. An Apple computer operating system costs more than $1 billion to develop. If Apple only competed in personal computers, it would face a steep hill to climb to break even on that investment. However, Apple leverages those R&D expenses across all of its products. The basic elements of the Apple operating system underpin everything from its laptops to its phones and the iPad. That ability to spread its R&D investment and capability across so many categories provides a powerful competitive advantage.


Jagadeesh Venugopal said...

However, if one were to go with your argument regarding horizontal integration, then Microsoft ought to have come up with even better products priced even cheaper, considering the amount of sales they have to amortize their R&D over. Furthermore, Android tablets must have been cheap, because they get their (software) R&D for free from Google.

As a different explanation... how about penetration pricing? Apple priced it very low to begin with to ward off competition. And when sales took off, economies of scale kicked in and helped them make money off the low price even.

Another explanation that's possible... Apple gets a huge cut of pretty much anything that's put on the iPad/iPhone. Hardware sales can be run at lower margins because they have a content revenue stream.

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