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What’s the value of all the upgraded features in the third-generation iPad? $100. I’ll show my work later in this article, but it’s an important number. Apple is consistently criticized by pundits, bloggers, other firms, and market analysts for either innovating too much with initial releases (the MacBook Air, the iPhone, and the iPad, notably) or too little in subsequent product revisions. There’s a reason for that. I want to defend Apple’s incremental improvements as the basis of its success in the market, something its competitors seem baffled by, because they apparently don’t understand the difference between revenue and profit, and between delighting customers with products that can be used for several years and those that are obsolete before they’re even sold.

Apple isn’t selling the third-generation iPad to those who bought an iPad 2. Rather, Apple is targeting both new customers and owners of the first-generation iPad. That’s a key differentiation between Apple and most other hardware companies. Apple has managed to maintain high profit margins on all its products and to couple that with recurring revenue from its application and media ecosystems on all those devices.

Apple makes its money over the long term not just by introducing disruption, which would mean flash-in-the-pan products that spark and then fizzle, but by seeing disruption through into stable releases, each with significant improvements that appear to be incremental to a product’s design and capabilities.

The value of incremental improvements is key to Apple’s success, and is one of the key reasons that even its most capable competitors seem unable to duplicate more than a fraction of what Apple does.

The Low Margin/High Margin Battle — Firms like Dell, Lenovo, Motorola (clearing regulatory approval to be acquired by Google), Nokia, and Samsung, to name just a few, typically make very little money on each device sold, whether a desktop, laptop, smartphone, or tablet. This low-margin approach requires that they restrict expensive innovation on the devices that make up the bulk of their sales, or they might end up losing money on each unit sold. Because these firms have locked themselves into a race to produce the cheapest product (whether sold directly or via a cell carrier), their products are rarely future-proofed with sufficient RAM, storage, processor speed, graphical processing, and displays. You can of course find exceptions — and they cost more than the majority of the products that these companies sell.

(Research in Motion was, for a long time, an outlier. It could charge carriers a premium, as BlackBerry phones brought in high-spending corporate customers. RIM also sells business applications and receives some portion of service fees for handling messaging and other features. Its failure wasn’t because of its revenue model as such, but in understanding the sea change wrought by the iPhone. It hasn’t been able to keep up in hardware and operating system design.)

These low-margin companies either need to develop a constant interest among new audiences for their products (which means high marketing and customer acquisition expenses) or convince existing buyers to upgrade frequently. Because their products tend to under-deliver as operating system upgrades appear, or, as in the case of many Android smartphones and tablets, lack the specs to accept the upgrades, a performance or upgrade gap is supposed to propel irritated users to purchase the latest and greatest, even if it has been only a year or so since they bought the previous latest and greatest. Without those regular upgrades, these companies can’t make their razor-thin profit margins work.

Put bluntly, Apple will sell you a mobile phone model today that’s more than two years old (the iPhone 3GS) and capable of running the latest version of iOS, while Google allows its ostensibly independent handset-making partners to release new models today that run two- and even three-year-old versions of Android. (It’s not all about currency, but newer operating systems tend to be more refined, have more useful features, sport fewer bugs, and be better optimized, especially for multi-core CPUs in newer devices.)

Because Apple stays generally near the top of the hardware feature curve, front-loads future headroom for upgrades, and charges more for its goods, it doesn’t need to push existing users to purchase each model upgrade. The company certainly doesn’t stint on marketing and hyperbole, but it never, ever tells existing customers that the hardware they own is now so much old trash. (Although, that’s sometimes implicit in requirements for new services — the Mac OS X and iOS requirements for iCloud still rankle.)

Regular Buyers Aren’t Fanboys — This is where most of the non-Apple punditry gets it wrong, labeling all Apple product buyers “fanboys” and talking about how the legions of Mac zealots tromp out to buy the latest iteration of whatever Apple releases. It is, in fact, exactly the opposite, excluding a very small core of early adopters and enthusiasts. (That group must be well under a fraction of a percent of Apple’s current buying population. It’s simply not large, and never was.)

Most Apple users expect that they will be able to use a newly purchased Mac for at least three to five years (see “Apple’s Planned Obsolescence Schedule,” 2 November 2011). AppleCare extends the warranty on computers for three years for a reason: that’s the longest Apple expects to turn a profit by promising to fix service defects and unexpected wear and tear on products. But that three-year assumption also reflects Apple’s view of its customers’ typical ownership lifecycle. (We know that many TidBITS readers have machines that are far older than five years, and still perfectly useful to them, too.) Mobile devices like the iPad, iPhone, and iPod touch are both cheaper and suffer the indignities of portable use, so AppleCare lasts only two years there. Plus, a two-year and every-other-model upgrade cycle fits well with the standard two-year cell phone contract, but even more so than computers, iOS devices tend to become technology hand-me-downs.

This has been by and large true for me, despite my occupation and my predilection for the new and shiny. I tend to own desktop Macs for five years and laptops, which get harder wear, for four. I expect to keep my current MacBook Air for three or four years. I use a shorter cycle for iOS devices, partly because I need to own the latest model to write about new hardware features (especially networking capabilities). But even so, I kept the original iPhone for two years until the 3GS came out; I went to a 4 as a business necessity (yeah, right), and then a 4S for the same reason (uh huh). (My wife got my 3GS and then 4. My dad used my original iPhone sans cell service as an iPod touch for some years, another we donated to charity, and the remaining 3GS our kids use around the house, again without cell service.)

This loyalty is hard for people who don’t own recent Apple products to understand. It’s just not that Apple’s designs are cool, and slick, and seamless, and oh-so-fashionable. That is often the case, but it’s not the point. Rather, the reason for staying with Apple gear is that the company’s integrated manufacturing, upgrade cycle, and warranty philosophy is structured around long-term ownership by both the original purchaser and that person’s extended network.

Low Margins Require Faster Upgrades — Those competing with Apple have to advertise every new device and computer as being substantially different enough to justify a quicker upgrade cycle. If Apple makes $400 from a low-end MacBook Air that might be in use for five years, and Dell makes $50 (after paying Microsoft for Windows) for a low-end laptop, how quickly does Dell need to sell that person another device? During those five years, Apple might get $29 two or three times for updates to Mac OS X; Dell gets nothing from any Windows upgrades. Apple may also now reap additional dollars from Mac App Store purchases, too. Dell? Nothing.

The Android ecosystem has the same trouble as desktop and laptop computers. Google gives away the operating system, so no phone maker can earn anything from upgrades. Plus, several major phone makers now must pay Microsoft about $15 per phone for patent licenses. The handset manufacturers have to convince carriers to buy the phones, and outside of the flagship models, like Verizon’s Droids from Motorola and certain high-end Samsung models, carriers reportedly negotiate extremely low prices.

Handset makers are still shipping versions of Android that are as much as 3 years old, and six months after the launch of Android 4, it’s in less than 2 percent of currently active devices. (That will change rapidly later this year.) That’s partly because carriers’ cheapness and manufacturers’ low margins force a very large percentage of Android phones to have insufficient CPU power and/or RAM to handle the latest updates. Google sells apps to end-users in the newly christened Google Play (née Android Marketplace), but sales are relatively low compared to the iOS App Store, and Google splits its share among carriers and handset makers, spreading the already low revenue even more thinly.

There’s also a tension between phone makers and cellular carriers, who don’t want customers to update very often. Carriers have to buy phones from handset makers and recover the difference between their cost and what the user pays over the life of the contract. Carriers make their money in recurring fees, and want upgrades just often enough to keep customers happy. If you keep a phone past the two-year contract, the carrier still charges you the same rate, thus collecting $10 or $20 per month in pure gravy (not to mention the gold-plated profit of text-messaging plans, which cost nearly nothing in per-message expense). That said, carriers don’t want to prevent you from getting a new phone, even though that hurts their profits, because of the risk that you might jump ship to another carrier and a snazzier subsidized handset. (This situation is different in countries in which it’s easy to buy an unsubsidized phone; there the carrier just wants your recurring fees; it doesn’t care when you upgrade.)

Looking through Blurry Specs — This battle over pushing for upgrades more frequently also leads to some computer and smartphone makers awkwardly larding their hardware with features that aren’t ready for prime time or that are overhyped. For instance, smartphones with 4G LTE radios were available a year ago but were roundly panned in the marketplace because of their short battery life. Several smartphone makers offer screens much larger than the iPhone’s, but a bigger screen means a bigger, heavier battery or a shorter, more frustrating battery life. Competing with Apple products purely on specs, as the latest craze of quad-core tablets attempt to do, is a sure sign that the device’s user experience won’t stand out on its own.

Because the iPhone is such a plain phone in some ways, and because Apple hasn’t competed purely on technical specs with it, competitors seem determined to use hardware specs as a way to stand out. This approach doesn’t seem to work, based on sales, even when many Android smartphones are free with a two-year contract. Apple released the original EDGE-only iPhone when 3G phones were on the market, included a low-resolution camera when higher-resolution ones were available, and avoided adding 4G LTE to the iPhone 4S despite competing 4G LTE phones.

The key exception appears to be, of course, the iPad. At first glance, its first through third-generation models violate a number of rules: it’s cheaper than many competing tablets, it’s ahead on many features (like the Retina display), and it’s not sold under subsidy by carriers, forcing customers to bear the full cost of purchase. (Some competing tablets are sold only with two-year contracts for data service.)

Despite these facts, the iPad still fits into Apple’s incremental product advance approach. You remember I said I’d explain why the third-generation iPad features that differentiate it from the iPad 2 — the Retina display, 4G LTE, improved camera, and voice dictation — cost $100. How do I know this? Because Apple discounted the iPad 2 by exactly $100 compared to the new 16 GB iPad. (All credit goes to Adam Engst for this insight.)

That means Apple values all the new features at $100, since they didn’t raise the third-generation iPad’s price relative to the iPad 2. Somehow, in the space of a year, Apple managed to use its vaunted sourcing, one of the keys of its success since Tim Cook joined the company more than a decade ago, to purchase a display with four times the number of pixels while keeping the profit margin on the third-generation iPad at roughly the same point as it was a year ago with the iPad 2 and a less-dense screen. (This also means that the iPad 2 likely costs Apple at least $70 less now than it did at its year-ago introduction, if we assume Apple is still making money on each sale.)

The “modest” or “incremental” improvements in the third-generation iPad aren’t intended to persuade owners of iPad 2 models to upgrade. Nearly every one of the early reviews of the latest iPad mentions that fact. Everyone loves the Retina display and talks about how marvelous it is. But the reviewers note that the display and the potential for faster networking in parts of the United States don’t provide enough of an advantage to run out and replace an iPad 2. (And we certainly agree.)

But the third-generation iPad has established the new baseline. The Retina display’s resolution is higher than any tablet on the market. The LTE support is as good as any tablet’s or phone’s. The battery life is phenomenal because Apple was able to engineer enough additional space without increasing the weight proportionately to power the bigger, brighter screen while maintaining the same 9–10 hour battery life. That’s all before we get to the virtues of iOS 5 and available apps.

Thanks to its sourcing prowess, Apple was able to keep the iPad’s price points the same and still make a whopping profit because of the higher margins on 32 GB and 64 GB units. (Memory is cheap.) This fits the Apple pattern. The improvements are incremental, but in this case, keep the product at the front of the market (with the exception of the cameras). The iPad 2, still for sale, will likely be upgradable through iOS 7 two years hence. But those waiting to buy an iPad or looking to upgrade a poky first-generation iPad that can’t even run iPhoto are now primed to see the advances as significant enough to push them over the edge.

Little by Little, Apple Products Just Get Better — The advantage of incrementalism seems clear if you can make products that are outstanding enough to cut through the clutter of the marketplace. Rather than focusing at any point in the last decade on a cheap item that could outsell PC and then handset competitors, Apple has largely focused on releasing hardware that costs more in order to buy more of the future for its purchasers. The iPad is unusual, in that it marks the first time that Apple can be both ridiculously ahead on price relative to features and have such an extreme lead over competitors that it can maintain its position, all while making only incremental improvements.

I can’t say whether any competitor could have done the same without the kind of design eye that guided Apple: a combination of Steve Jobs, Jonathan Ive, and untold others. But it’s clear that no other firms have learned a thing from a decade of competition in which Apple has made hundreds of billions while introducing truly new products only occasionally and updating them regularly.