Explaining Apple economics for math-challenged reporters

Once more – Apple iTunes economics 101: I’m not going to point to the stories that caused me to draft a version of this rant last night, but lets just say they are long explanations about the amount of revenues generated by music and video downloads on iTunes and how much Apple is or is not making on such downloads. These reports and “analyses” seem to marvel that “content creators” can make lots of money distributing their “content” through iTunes with Apple taking just a small cut. Why do these analyses bother me? They ignore the obvious — or as we business people like to buzzword it: they ignore the elephant in the room.

So, one more time, here it is: Apple’s business model is driven by selling $400 iPods that play video files, not by selling the videos that play on them. The thin profit it makes (if any) from the margin it clears on 55¢ of revenue (which, I’ll go slowly, is different than earnings) is a knot on a gnat’s ass compared to revenue represented in the margin Apple enjoys on the sale of hardware. Remember, Apple makes $0 from facilitating the distribution of podcasts, but it generates $100 – $400 each from selling iPods that play those podcasts. In the business model of Apple, the thin margin it clears on video and audio downloads, even if that margin represents profits that reach into the tens of millions of dollars (which is doubtful due to the costs incurred in generating those revenues), is mere icing on the cake of the revenues those downloads represent in the corresponding sale of iPods those downloads drive. Because Google and Yahoo and other music and video download channels have no corresponding hardware sales revenue, it’s harder to make their math work. It also explains why Microsoft is going to sell its own “digital player” in order to generate a hardware revenue stream in this category. (My prediction: more likely to be an X-Box branded PSP competitor than an iPod threat.)

Where Apple finds itself in the digital download “space” is much like the position RCA enjoyed in the early days of broadcasting in America. Back then, RCA manufactured most of the radios and controlled the distribution channels (two NBC radio networks) of programming. (In RCA’s case, it also created the programming — the records and radio shows . Apple doesn’t do that — although other holdings of Steve Jobs are involved in that enterprise.) I feel certain, despite the dominance of the radio networks it owned (and which the government broke up), RCA’s most significant revenue stream came from the hardware it produced and sold using the advertising mascot Nipper, the little dog listening to “his master’s voice.” (For the record, I wasn’t around back then. I was born the same month and year the first color TV was manufactured by RCA, however.)

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  • Terry Heaton

    Excellent observations, Rex. This is why I preach to clients the value of getting into aggregators and other models that push business opportunities away from the old core of content creation. I think you can still make a ton of money as a content creator, but the smart media people are looking beyond that. Cheers.

  • Jackson

    Didn’t MicroSoft actually pioneer this strategy with selling Xboxes at a loss?

  • rex

    Actually, a Microsoft strategy to lose money on the hardware (and make money on selling games) would be the “opposite” strategy — but one that works (think Gillette razors, for example) if you have a proprietary platform and a closed software (or razor blade) environment. In the example of Apple (and perhaps RCA), the strategy is to make lots of money on the hardware and less money on the “software.”

  • Shawn Lea

    Good work, Rex. Next I want you to tackle the second business question I am getting tired of hearing about with Apple/iTunes: Why do they allow no pricing differentiation?

    All songs are $.99, whether they are by B.B. King or Kevin Federline, they scream. Not fair, they scream. Almost all business models have price differentiation for products, they scream.

    And I’m too lazy to research it right now, so if you’re bored, tackle that one next, please. 😉

  • rex

    Okay, Shawn. Rather than the elephant in the room buzzword, this is the 800 lb. gorilla buzzword. I think the economic principle at work can be boiled down to the three words: “because they can.”

  • lcreekmo

    Oh here’s my favorite iTunes note of the week. I don’t know how many of you rexblog readers have 6-year-olds, so you all may not have a clue about the album that’s been #1 on iTunes for a week now — and as of 7 p.m. Saturday night, still has half the songs in the Top 10.

    It’s “High School Musical,” an original Disney Channel special that aired last weekend three times and has continued in rotation throughout this past week. It was a cute movie aimed at the preteen set about — you guessed it — a high school musical. Halfway thru watching it with my six-year-old (we watched it twice), I thought, “You know, if they were REALLY smart, they put these songs on iTunes. She is already singing along.” And there they were. Sheer genius.

    Now I will say that “Breaking Free,” the one that’s been at No. 1 all week, is a nice song that I’ll even put on my iPod. I would recommend it to any rexblog reader. The rest of the songs on the album were very nice and well-written for the program but I’m going to leave them to the 6yo for her own player.