The Installed Base

I used to work for a major consumer electronics retailer. Our employee discount was a smaller markup from cost than the regular price. To be specific, it was set up such that the price the employee paid produced 40% of the profit that the current selling price would produce. It was once what is called “landed cost” which was essentially what the current cost of goods was for the product, it was raised to mine some margin from employees, but that’s a story for a different day.

One day I wanted to a new PlayStation 2. I think the new thinner one had come out, and I wanted to replace my old brick. I picked on up, turned on employee sale, and scanned it. The discount was 74 cents.

I was floored by this. How could a top selling entertainment product have such little margin? Surely the manufacturer is making a tidy profit by marking it up before letting it hit the retail channel, right? In fact, no. They are likely losing money. In the case of the PlayStation 3, the production cost at launch was over $800, and yet it was sold for $499. The same situation holds true for the two generations of Xbox consoles from Microsoft.

June of last year John Walkenbach posted on his blog an interesting observation regarding Amazon’s Kindle: The price has been decreasing at a linear rate. And at that rate, it would be free by November of 2011. Let’s actually assume for a minute that this is an accurate prediction. Why would Amazon want to simply give away the Kindle?
Chart: Courtesy of J-Walk Blog

Wireless carriers are willing to offer ever larger subsidies on more feature rich smartphones. Carriers are purchasing equipment presumably above the price they are selling it for, contract included of course. While I’m not entirely sure how this is accounted for, I would imagine it is either considered a selling expense or cost of goods which would be an expense. Again, why would they do this?

There is a common thread here: All of these devices require the consumption of some other product. In the case of video game consoles it’s game software, the Kindle has digital books and other content, and wireless devices have service plans, fees, and overages. By building a large installed base, a company is better positioned to generate higher lifetime revenues. Once a customer is locked in to a particular device, or ecosystem, they are more likely to stick with it and continue purchasing from that same ecosystem. A one time investment can lead to hundreds or thousands of dollars in additional revenue over the lifetime of the device. It may, in fact, even lead to the purchase of another device from the same manufacturer as they already have content which only works with that line of devices.

Let’s perform a little thought experiment. Let’s assume that the iPad was not supply constrained. What if Apple were to give the iPad away for free? It’s crazy, I know. What if Apple were to give away a $100 or $200 App Store gift card (not iTunes, just App Store) with each iPad purchase? Or Sell the iPad at or near cost? First, competitors would probably accuse Apple of dumping (which is not technically the correct application of the term, but I feel it to be correct in spirit) and go crying to the Department of Justice and Federal Trade Commission. Second, Apple’s gross profit margin would plummet. Third, iTunes revenue would presumably sky rocket. While iTunes revenue is not anywhere near a majority of Apple’s revenue, it is fairly significant at around 8% for 2010 (although it could be argued that App Store sales are not being counted in the iTunes number, but in the ‘Software, service and other sales’ line, as it is not clearly stated in their 2010 10-K). In addition to being a source of revenue, it is also a source of stickiness. Customers who become heavily invested in the iTunes-based ecosystem are much more likely to purchase another iOS device. This increases the lifetime value of a customer, which is a key metric that many people overlook.

Getting back to the Kindle, the idea of it being free at some point shouldn’t seem so crazy. The logistical complexities of delivering a physical book to a customer add expense that simply isn’t there with an ebook. Additionally, ebooks are DRMed to the Kindle creating that essential stickiness. Even if Amazon operations at a lower gross profit on these products, the savings from the reduced logistical complexity and the increased customer lifetime value should offset the expense of equipping every eligible customer with a free Kindle.

I find it fascinating that this strategy that is all but institutionalized in the video game industry is becoming more pervasive within other areas of the CE sector. Less frequently are people asking “What can this device do?” and instead are asking “What can I do with this device?” This shift in consumer perception of technology is driving some very interesting innovation in the pricing models used by these companies. As we continue to move focus away from the hardware and toward the platform, we’ll continue to see company’s looking for ways to grow their installed base, which will likely be a major win for consumers.