Apple Inc. is working on the first of a new line of less-expensive iPhones and an overhaul of software services for the devices, people familiar with the matter said, moving to accelerate sales of its smartphones amid growing competition.

One of the people, who saw a prototype of the phone late last year, said it is intended for sale alongside Apple's existing line. The new device would be about half the size of the iPhone 4, which is the current model.

The...