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The pricing strategy for the Apple Watch is insanely smart

Apple Watch vs Swiss WatchStefano Pozzebon/Business Insider, Shutterstock

How do you price a new type of smart watch at $US600 (£410), or more, when the market price is below $US300 (£205)? That’s the problem Apple faced when the time came to devise a pricing strategy for the Apple Watch.

The following chart shows that Apple has successfully managed to maintain the average selling price (ASP) of the iPhone — the company’s most valuable product — at above the $US600 (£410) level for the last six years. The reason why the average selling price (ASP) of the iPad had dropped is due to the introduction of the iPad mini, and the introduction of lower-price iPod models also explains why the ASP of the iPod has dropped over time.

Apple Watch Gen Research3Generator Research

Here are a couple of insights we can glean from this:

  • Don’t place an upper limit on the price at the point of launch: You would not want to set up the Apple Watch product strategy in such a way that the entry price represented a price ceiling. If you did that then you’d know that you may eventually be forced to introduce lower-price models that would then result in the same downwards trend that has affected the iPad and iPod;
  • Try to prevent rivals from developing lower-priced alternatives that will cannibalise sales: The iPhone had managed to avoid the fate of the iPad and iPod because it has not been feasible for rivals to develop a clearly distinct segment within the premium smartphone market at a lower price.

    The only way to reduce the ASP in the smartphone market was to either develop a physically smaller device (which would damage usability) or reduce the functionality. The market has taken the latter course which explains why we are seeing very low-price models being sold in price-sensitive markets – but these devices have not been affecting demand in the premium segment, which is where Apple and Samsung are competing.

The watch market has given Apple the perfect opportunity to execute what I think will be seen in years to come as an extremely astute pricing strategy — that will allow the company to effectively guarantee that the ASP will be well above the entry level of $US349 (£239), and probably some way above $US600 (£410).

It is clear to me that Apple has spent a lot of time studying the Swiss watch industry: in spite of manufacturing just 29 million finished watches in 2014, representing just 2.3% of worldwide industry production volume, Swiss watchmakers accounted for nearly 67% of retail expenditure.

This picture is even more distorted if you take a look at the top end of the Swiss watch market, which is defined as watches that retail for over $US10,000 (£6,800): this rarefied segment accounted for just 0.1% of worldwide production volume in 2014 — but 48.5% of retail expenditure.

This goes some way towards explaining what Apple is trying to achieve with its seemingly bizarre pricing strategy for the Apple Watch, where prices start at a reasonable $US349 (£239) but then go all the way up to $US15,000 (£10,200).

To understand what is going on here, I firstly divided Apple’s watch market into three broad price segments:

  • Entry: $US349 to $US1,000 (£239 to £680)
  • Mid: $US1,300 to $US5,000 (£880 to £3,500)
  • Luxury: $US5,500 to $US15,000 (£3,750 to £10,200)

I then needed to estimate the sales level for each of these segments.

The starting point for this is our projection that Apple will sell 20.5 million Apple Watch units this calendar year – if you’re interested in understanding where this figure comes from then you will find plenty of background in the 2015 edition of Generator Research’s Smart Watches report.

I then prepared three different uptake scenarios which were modelled on the reality of the Swiss watch industry, where shipment volumes are heavily skewed towards the lower price bands while value is heavily skewed towards the upper price bands.

The three uptake scenarios were:

  • Scenario A: Entry @ 95%; Mid @ 4%; Luxury @ 1%
  • Scenario B: Entry @ 90%; Mid @ 8%; Luxury @ 2%
  • Scenario C: Entry @ 85%; Mid @ 11%; Luxury @ 4%

This now gives us sales levels for each of the three price segments, for each of the three scenarios.

The next step is to estimate the revenues.

To do this I developed some plausible demand curves which were based on sub-dividing each of the three price segments into 14 sub-segments – with unit sales decreasing on a straight-line basis from the lowest price to the highest price. I adjusted the elasticity in each of the three segments to reflect the fact that people in the Luxury segment are clearly less price sensitive than those in the Entry segment.

The result was a set of demand curves that look like this:

Apple Watch Gen Research2Generator Research

We can now calculate the revenues for each of the sub-segments and therefore, each of the price segments for each of the three demand scenarios.

This results in the following table:

Apple Watch Gen Research1Generator Research

Here’s what we can say from this analysis:

  • The base case is where the Apple Watch is just one price ($US349, £239) which would mean that the revenues for 2015 would be $US7.2 billion (£4.9 billion). All of Apple’s rivals are operating a price model that either involves a single price or a number of closely-related prices (compared, that is, to the massive difference between the entry level and top end prices of the Apple Watch);
  • Basic economics tells us that a ‘flat rate’ pricing strategy is sub-optimal because it fails to extract the maximum revenue from every buyer. With the iPhone, Apple is stuck with a ‘flat rate’ pricing model because pricing in the premium segment of the smartphone market is quite concentrated. But that is not the case in the Swiss watch market, which provides Apple with a great opportunity to move to a revenue-maximising pricing strategy for the Apple Watch;
  • If 95% of unit sales of the Apple Watch were in the $US349 (£239) to $US1,000 (£680) segment, with just 1% in the $US5,500 to $US15,000 segment (£3,750 to £10,200, Scenario A) then this would have the effect of doubling the average selling price from $US349 (£239) to $US748 (£478) and doubling revenues from $US7.2 billion to $US15.2 billion (£4.9 billion to £10 billion);
  • In the most optimistic scenario (Scenario C), where 4% of unit sales of the Apple Watch are in the luxury segment, then the revenue earned by the luxury segment for calendar 2015 would be $US8 billion (or 33% of total revenues, £5.45 billion) while revenues for all three segments for 2015 would be $US24.1 billion (£16.40 billion) — or nearly 3x the base case.

To me the conclusion is that Apple has been very clever in how it has priced the Apple Watch — even more so when one realises that most sales in the $US5,500 to $US15,000 (£3,750 to £10,200) luxury segment will be incremental to sales of Swiss luxury watches: most buyers will see an Apple Watch as an additional device, not a substitutional device.

We already know that the high average selling price of the iPhone has allowed Apple to accumulate around 80% of smartphone industry device profits — and that was with an average selling price of about $US600 (£410).

In the long run, when manufacturing processes are mature, then because the Apple Watch has a lower mass and contains less electronics than an iPhone, it will actually cost less to produce. When combined with the higher ASP then the Apple Watch is set to be even more profitable for Apple than the iPhone.

Andrew Sheehy is chief analyst at Generator Research.

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