Point/Counterpoint: On the iPhone 5 replacing the iPod touch

A reader wrote in to us surmising that the iPod touch is on its way out, to be replaced by a lower-cost iPhone 5. It sounded ridiculous at first, but the evidence he gave sounds pretty compelling when it's all put together.

1. According to iSuppli, "The components that make up the 16 GB iPhone 4 cost just under $188." That of course should be taken with a grain of salt.
2. Production of the iPhone 5 allegedly begins in July, with a launch in September -- traditionally the time Apple unveils new iPod hardware.
3. iOS 5 will debut in the fall, and major iOS releases tend to come alongside new iPhone hardware.
4. Thus far, there is no mention of new iPod touch hardware in the iOS 5 betas.
5. The next-gen iPhone has reached final testing stage, destined for a September launch. With the exception of an A5 processor and possibly a universal GSM/CDMA design for its 3G hardware, it is expected to be substantially similar to the iPhone 4.
6. Unlocked iPhones are finally available in the US.
7. Recently unearthed evidence in the iOS 5 beta suggests the iPhone 5 will use the same 5 megapixel camera as the current iPhone 4 rather than the 8 megapixel camera suggested by rumors earlier this year, suggesting Apple is focused on cutting production costs.
8. This year, Apple's Back-to-School promotion will offer a $100 iTunes gift card instead of a free iPod touch as in previous years.

Taken together, this does seem to paint a pretty stark picture for the iPod touch's future. It also sparked off an intercontinental debate between fellow TUAW writer Richard Gaywood and myself on whether Apple is likely to lower costs on the iPhone 5 enough to make it a viable replacement for the current iPod touch lineup.

CR: I'll say this: if the unlocked 32 GB iPhone dropped to US$299 and a 64 GB model was available at $399, the iPod touch would pretty much have no further reason to exist. Odds of that happening? Who knows.

RG: That's a huge "if" there. The iPod touch has to be cheaper to make than the iPhone, so Apple would have to slash its own margins to cut the price of the latter to meet the former. $299 is less than half the price the 16 GB iPhone 4 is selling for today. Why would Apple do that? I don't see much upside.

The iPod touch is also lighter and much thinner. Or, if it was as thick as the iPhone 4, it could offer much better battery life.

CR: Aside from the rear-facing camera, the GPS/3G antenna/chipset, and the case design, where's the extra cost for the iPhone 4 versus the iPod touch? They have the same SOC, the same display, the same front-facing camera. Apple's estimated cost to manufacture the 16 GB iPhone 4 is less than US$200. If the iPhone 5 is going to be essentially an iPhone 4S, the production cost isn't likely to be terribly higher than the iPhone 4's is now.

The upside to discontinuing the iPod touch line and replacing it with a lower-cost, contract-free iPhone is twofold. First, that's one less piece of hardware Apple has to manufacture. The iPod line would be returned to music-only devices (the shuffle and nano), with only two multi-use, touch-based devices to manufacture: the iPhone and iPad. The upshot from a sales POV is that all the users who might have bought the iPod touch will buy the contract-free iPhone instead, which would go a loooong way to making up for the reduced per-device margins.

RG: According to Anandtech, "The pricing guarantees Apple is going to continue to have incredible quarters going forward. Apple found sneaky ways to reduce the total BOM (bill of materials) cost on the new iPod touch. A cheaper chassis compared to the iPhone 4, no GPS, less DRAM on package (256 MB vs. 512 MB), a cheaper screen and a worse imaging sensor."

That's in addition to the UMTS chip itself, the antenna for it, and (easy to overlook on a BoM listing), the considerable hardware engineering effort and testing that goes into making the cell phone part of the device work properly. They also use cheaper lower-density flash (the iPod touch has two chips, not one, so a 32 GB model of either handset is a single 32 GB chip in the iPhone and 2x16 GBs in the iPod touch).

Note that the parts Apple skimps on -- the baseband, the display, the DRAM, the flash, the rear-facing autofocus camera -- are some of the most expensive parts in the iPhone 4 to start with.

CR: The engineering and testing costs will likely be more than offset if the iPhone 5 has essentially the same exterior design as the iPhone 4, as virtually everyone expects it will.

The price of the unlocked iPhone must eventually come down. The unlocked 32 GB iPhone 4 is actually more expensive than a 32 GB iPad 2 Wi-Fi + 3G. I don't see that situation persisting for very long. I also don't see that as a matter of offsetting component/production costs; I see it as a high price intended to mollify the carriers. The price disparity between a 32 GB iPod touch and a 32 GB unlocked iPhone 4 is $450, too, and I find it incredibly unlikely that the iPhone 4 costs THAT much more to produce than the iPod touch.

I mean, come on. The improved camera and flash, better quality display, extra RAM, GPS/UMTS, and chassis add up to an extra $450 -- or even $300? Not a chance. Even if the $130 price disparity between the 3G and non-3G iPads truly represents the cost of the 3G hardware (it doesn't), that's still $320 for a slightly higher-quality display, an extra 256 MB of RAM, a 5 megapixel camera, three pieces of precision-cut stainless steel, and a piece of glass.

With a BOM of $188 for a 16 GB iPhone 4, Apple's margin for the device amounts to $461. That's high even by Apple's standards. No, that calculation doesn't include R&D or shipping, etc., but if the iPhone 5 is going to be substantially similar to the iPhone 4, most of that is going to be offset anyway.

RG: BoM isn't the whole story, though. A common rule of thumb for a R&D-heavy devices like the iPhone is 1/3 materials, 1/3 cost, 1/3 profit. If you just compare how much it costs to assemble with how much Apple sell it for, it looks like a huge margin -- but all those smart guys in Cupertino don't come cheap, nor do their swanky digs. You're not making an Apples-to-apples comparison, because we don't have a comparable BoM cost for the iPod touch.

CR: You're right, BoM is only part of the tale. So let's look at profit margins instead. It turns out Apple's profit margin on the entry-level $499 iPad 2 is 25 percent. That's a healthy, respectable profit margin for a consumer electronics product -- but it's far lower than Apple's average profit margin across all products, which is a much higher 38.5 percent.

Apple's profit margin for the iPhone? An astonishing 50 to 60 percent. For every 16 GB iPhone 4 sold, then, Apple makes about $324.50 in profit at the lower end of the scale. We can therefore assume that the break-even price for an entry-level iPhone 5 would be around $330; the A5 processor is slightly more expensive than the A4, but the iPhone 5 is expected to have mostly the same components as the iPhone 4.

RG: Bottom line for me is this: replacing the iPod touch with an iPhone at the same selling price would inevitably require Apple to sacrifice considerable profit margin, would face carrier hostility (which might be so severe as to make them refuse to issue data plans for it), would be of marginal benefit to many consumers (customers who cared about having cell data for an iPod touch already own iPhones, I'd wager), and would cannibalize sales of the more lucrative iPhone (particularly the pre-pay models, which America might get now it has unlocked iPhones). Never say never and all that, but it doesn't feel very likely to me at this point in time.

CR: After running through the numbers a bit more closely, selling the iPhone 5 for $299 looks like a net loss for Apple (which ain't gonna happen), but selling it at $399 would yield a profit of about 17 percent. That's far lower than the margins Apple currently enjoys on the iPhone, but Apple's financial guidance for the past couple quarters has warned investors to expect overall profit margins to decline. There's certainly room enough for the iPhone's margins to thin a bit but still make Apple tons of money.

I'm not saying Apple will do any of this, but I will not be at all shocked if it chooses to. The iPod touch has always been a sort of an "also-ran" in the iDevice line, an iPhone-lite for people who don't want to be tied down to a contract. If the iPhone becomes available contract-free everywhere, and at a price comparable to what the iPod touch sells for today, I still believe the iPod touch would have no reason to exist anymore.

Conclusion

It turned out to be a lively debate, and we'll see who's right in a couple months. In the meantime, there are a couple of other things to keep in mind. First, Apple has removed the "iPod" branding from iOS 5. In iOS 4 and earlier, both the iPhone and iPad handle music playback via an "iPod" app, but in iOS 5 these two devices instead have a "Music" app just like the iPod touch. It may mean nothing, but it's still an interesting move considering the iPod was Apple's top-selling product for so many years.

The other thing to keep in mind is a recent quote from Instapaper developer Marco Arment, who sums up my side of this argument perfectly: "When speculating on what Apple will or won't do, a change that gets them more iPhone customers is probably worth considering even if you think they'd 'never' do it. iPhone customer acquisition is a higher priority than almost everything else."