The iPhone and Apple's Margins

As the following graph shows Apple gross margins and its operating margins have both been on a consistent upward slope since early 2006.

The reason is that the company has moved to more mobile devices as a percent of products shipped. Whereas Macs have had decent margins by the standard of the PC industry, they are not as profitable on a unit basis as iPods, iPhones or iPads. As portable or mobile products grow rapidly, it would follow that margins would as well.

However, the growth is not monotonic. There are occasional dips in gross margins. The cause is the launch of new device versions. On the following graph I show the launch times for the iPhone versions and the company’s gross margin as well as my estimates for iPhone and other product line margins.

The general pattern is clear: each new version of the iPhone causes a dip in gross margins. This is not surprising as the company forewarns of this (in a decidedly exaggerated manner.) But why does it happen?

The iPhone is a profit monster, but when it launches there are many costs associated with it: components tend to be more expensive, there are more warranty returns, there are higher shipping costs are units are shipped in smaller lots to more points of sale. Tim Cook explains as “In terms of costs, with each new product we see learning curves associated with ramping production.”

Every launch causes an amplification of these learning effects. With each dip in margins however, comes another surge as the learning is complete and the volumes of the new generation product begin to dwarf the previous. And so the process continues.

There is an asymptotic limit to margins as they cannot grow higher than whatever the iPhone yields but that’s not yet in sight. The upper bound is probably in the 50% range.

  • Re – the second graph. It’s interesting to note that when new iPhone versions don’t change the form factor (3GS & 4S). there is little or no dip in the iPhone gross margin (down arrows #3 & #5).

    • Lauching a new “form factor” product involves rebuilding the full production lines.
      This should include rearranging (almost) everything and re-training employees.
      This cost may be distributed for a short period of time.

      • Tatil_S

        AFAIK, the machinery used in production is accounted for under capex, not part of “cost of goods sold”. The employees on the manufacturing line work for Foxconn etc, so I’d think they would charge for the training costs as part of their “per handset” prices, distributing such expenses across a year of production.

      • Over how many years do they depreciate this type of equipment?

        Doesn’t the output ramp up so the costs are spread over more units?
        I.e. margin may be lower in this qtr but better in two qtrs as output goes up significantly?

      • Tatil_S

        Ideally, companies depreciate the machinery over the actual lifetime of the equipment. If the CNC machinery wears out over sculpting Macbook bodies out of bricks of aluminum in two years, then it should be depreciated over 2 years. There are more pre-defined depreciation schedules for tax reasons, but companies keep two different “books” for tax and reporting purposes. For example, during the recessions, government sometimes let companies depreciate equipment in the year they get purchased to reduce their taxes, as an incentive to invest. However, for shareholders, that would not reflect the reality on the ground, so they can and should account for it differently.

        Output ramp-ups may indeed reduce costs in a logical sense, but it is not easy to reflect that on the books clearly. This is more like return on capital rather than margins. The cost of goods normally include the “raw materials” such as the aluminum for the body or the chips inside. If the machinery is purchased, that is not really a variable cost, it is an investment, so it does not show up as part of gross margins on the books. Parts of the machinery that wears out fairly regularly based on the number of products manufactured (rather than just losing value as time passes whether used or idled) can be called variable costs, but those kinds of costs do not really improve over time. If you are making fewer gadgets early on, those parts are wearing out more slowly as well.

        One way for margins to improve after the initial ramp-up is by improving yields. Early on, some finished goods will not pass final tests and those gadgets cannot be sold, wasting materials put in them. As time passes, company tweaks its production methods or its intermediate testing, so that almost all of the gadgets exiting the production line will be good enough. That reduces the wasted materials, hence the cost of goods sold, increasing margins.

  • Horace:
    You write and talk (your last podcast) in depth about capital expenditures; cap-ex is normally depreciated over some time period- meaning the cash is out (balance sheet) but from an income statement perspective it can be “booked” is various ways. Some companies can put this in cost of goods- do you know how apple handles the “expense” side of its cap ex?

    • This is a very good question. It’s my next area of inquiry. I have new data to confirm that the capex is spent on process equipment by about a ratio of 5:1 vs. server infrastructure. As far as how it’s allocated I need to bone up on some accounting sleuthing methods.

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  • I suspect the guys in Cupertino “hate”you for giving away their secrets.
    If you we’re the next CEO of Microsoft, we would see a spike in their p/e.

  • abhibeckert

    At what point do they cross from healthy profit margins to being too greedy? Didn’t steve jobs say that was their biggest mistake with the Mac, and almost sent Apple bankrupt?

    I don’t like it, 40-50% seems unreasonable. I’d be happier if they dropped back down to around 30%, either by lowering prices or spending more on the actual product R&D/manufacturing.

    • Sacto_Joe

      Not to put too fine a point on it, but Apple should charge the maximum that the market will bear, so long as its production is outstripped by demand. That’s not greed, that’s just good business. You are bringing an issue of morality into the picture that is both highly subjective and, in my opinion, irrational.

      • Pricing is more complex than that (I don’t disagree with the basic argument). Consumers expect prices for objects to behave in certain ways — e.g. Apple products are supposed to stay the same price or drop very slightly and then be switched out. Apple needs to gauge prices based on the volumes they expect to sell once production ramps up or they will need to cut prices and annoy early customers. When they have severely miscalculated in the past, they have tried to male good with customers who paid the higher price.

    • You can think of this 40 to 40% margin as a downpayment on future research.
      It could change but, so far at least, this is how things have turned out.

      Driving down to commodity profits is great for the consumer at first, but then it results in stagnation. Large profits are necessary somewhere to pay for R&D. Historically this has shifted from one company to another over time (ATT at one point, IBM at one point, Intel for some time now), but the pattern is constant.

      I’d say these types of profits in a company in a stagnant field (eg making movies or packaged food) would be depressing and worth complaining about. But in a dynamic field, coming from a company that is clearly advancing the state of the art, I think it’s best just to accept the situation as the way the world advances.

      You can pay an “Apple Tax” and be happy that your tax dollars are going to something more constructive than blowing up the Middle East; or can refuse to pay the tax and even so still benefit (with lags of a year or two) from the miscellaneous R&D Apple is doing with the money.

  • mieswall

    I guess the GM will be directly related to the number of iphones sold in the Q. The larger the number, the better the GM. It would be interesting to have the correlation of these two figures. Also, a little more indirectly, the shrink of GM can be seen as a consequence of the supply issues.

    Ive design is much praised, with good reasons. But also a measure of good industrial design is its economic feasibility of its production. In this matter, may be ip5 design could be a little more questionable.

    Another issue here may be that ip5 was untimely released, not giving the production enough time to tune up supply with demand, given the fact that it will be restricted, and GM shrinked, exactly at the best Q.

    I have the feeling that Cook has overextended the just-in-time supply policy. A much larger stock facing the ip5 release would have made both sales and GM figures radically different, specially for this holidays Q.

    • jawbroken

      The only way to build up a larger stock before release would be to start earlier or go on sale later. Which are you suggesting?

      • mieswall

        start earlier. Use more capex to build plants, prepare staff, diversify production.

  • What caused the huge ~65% margin on the original iPhone in 2008, before the iPhone 3G shipped? It seems odd that margins would be highest on the very first version of the iPhone, when Apple had no prior experience building such a device.

    • GeorgeS

      Perhaps it reflects Apple’s first deal with AT&T. As I remember, AT&T paid Apple part of the subscription fees and there was no carrier subsidy–the iPhone cost about $600. That wouldn’t make much difference to AT&T–it would have been about the same as the amortization of the subsidy, but it would be more money to Apple. (It was also more from the buyer.)

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