Apple's $199 iPhone: How can it be so cheap?

Apple's announcement of a next-generation 3G iPhone wasn't a big surprise for most people at Monday's World Wide Developers Conference.

Apple's announcement of a next-generation 3G iPhone wasn't a big surprise for most people at Monday's World Wide Developers Conference. But the low prices at which the new models will debut — US$199 with 8GB of memory and US$299 with 16GB — certainly surprised me.

How could a phone with more memory, more radios (3G/GPS technology), and better battery life go for, essentially, a third of what the original cost a year ago? Sure, tech prices go down, but usually vendors hold the line on prices when they add new performance-improving features.

I surveyed a handful of experts to see what they had to say.

Price and Quality Tina Teng of iSuppli agreed that the 3G and GPS radios in the new models probably did add cost, but pointed out that other components (most notably memory) are indeed going down in price.

Gartner vice president Ken Dulaney said even the 3G radio technology probably didn't add as much cost as it might have a year ago, since most companies that make chips for cell phones are transitioning to the faster technology anyway. Increased supply means lower prices.

And Apple has also made some cost-cutting design changes, using plastic instead of metal on the new iPhone's case. Will that significantly degrade the quality? Teng wouldn't say that. "For users, what matters [are] the durability and the functionality... I'm sure they did a lot of stress tests to make sure the materials they are using now are still going to be durable."

More Than Just Hardware Sales

But Dulaney said there may be more to the price cut than manufacturing math. "There are probably subsidization issues going on here," he said. In fact, AT&T in a news release issued today hinted that it would be taking a hit on revenues from device sales in hopes of increased profits down the line from data services to what's anticipated to be a huge customer base.

"In the near term, AT&T anticipates that the new agreement will likely result in some pressure on margins and earnings, reflecting the costs of subsidized device pricing, which, in turn, is expected to drive increased subscriber volumes," the news release states. It also points out that AT&T will no longer share revenue on iPhone services with Apple, and that the cost of an unlimited data plan for consumers will rise from the current US$20 a month to US$30 a month (on top of a voice plan available for $40 or more).

Shiv Bakhshi, director of mobility research for IDC, says Apple will recoup any decline on its own margins for device sales "(a), through volume, and (b), through services I think iTunes will offer."

This business model would not have been possible a year ago, he notes. "When the iPhone was launched, it was with one operator in one country. Now it's launching in 22 countries as a 3G phone, going to 70 countries by the end of the year."

"They also have that thing called the apps store," notes Mike McGuire, research VP at Gartner. Apple CEO Steve Jobs has said developers of iPhone apps will retain 70 percent of sales revenue, which leaves 30 percent "for someone else," McGuire said.

"It's not just a hardware sale anymore — it's an ecosystem," McGuire added. "They're not just making money on the hardware."

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