The reason iPad rivals can't compete on price

The mass invasion of Apple iPad competitors has begun. But, what was expected to be a ferocious battle is starting to look like it could turn into a lopsided rout, at least during 2011. The reason: price.

While many of the top tech vendors have trotted out impressive-looking tablets, the problem with virtually all of them is that they look great until you see the price tag. It's developed into a sad little ritual in the tech industry in recent months where a company announces a very promising tablet and gets people excited and then the price of that tablet leaks out and people gasp in confusion and disappointment.

The Motorola Xoom - the flagship Android tablet - will cost $800 ($600 for the Wi-Fi model). The HTC Flyer will reportedly cost around $700 and it's only a 7-inch tablet (compared to the 10-inch iPad). Another attractive 7-incher is the BlackBerry PlayBook, but it's likely to cost about the same as the iPad while offering very few advantages. The Hewlett-Packard TouchPad based on Palm's webOS looks like an excellent alternative, but will reportedly cost $700.

The iPad starts at $500 for the 16GB Wi-Fi model. That's the magic number.

So why is that these highly disciplined, very experienced hardware makers cannot match -- let alone beat -- the price of the iPad?

I've heard a lot of reasons thrown around, from buying flash memory in bulk to Apple's strength in supply chain management to the fact that Apple now has its own line of CPUs. However, nearly everyone seems to be missing the biggest and most obvious reason: The Apple Store.

Line for the iPad wraps around the Apple Store in Shanghai, China. Photo credit: Apple

More specifically, the combination of Apple's 300+ retail stores and its online Apple Store means that the company sells a huge chunk of its iPads directly to its customers.  While Apple has cut distribution deals with Best Buy, Target, Wal-Mart, Amazon, and a few others, those are mostly market-share grabs and ways to help spread the iPad's marketing message.

Apple appears to carefully control the inventory it sends to these retail partners. Even during the holidays, there weren't typically huge stacks of iPads on a pallet in the aisle at Best Buy or Wal-Mart like other popular consumer electronics such as the Nintendo Wii or the Xbox 360. The iPads seemed to be sprinkled among the various retailers throughout the holidays. Meanwhile, the Apple retail stores were loaded with an almost unlimited supply of iPads, so if you wanted to make sure you got one your best bet was to go there (or order one from Apple's Web store). One estimate was that Apple sold 8.8 iPads per hour per retail store on Black Friday.

While Apple hasn't released statistics on the percentage of iPads that it sells directly to customers versus the number it sells through its retail partners, I wouldn't be surprised if the number of direct sales was as high as 50%.

That means that Apple can set the retail price of the iPad at a precipitously low number. The company can swallow the bitter pill of hardly making any money from iPad sales through its retail partners because it can feast off the fat profits it makes when customers buy directly through its retail outlets and the Web store. However, companies like Motorola, HP, and Samsung have to make all of their profit by selling their tablets wholesale to retailer partners.

For example, iSuppli estimates that the total production cost of the 16GB iPad Wi-Fi is $229.35, so when Apple sells it directly to customers for the retail price of $499 the company makes a whopping $270 of "profit" on each unit. This isn't pure profit, obviously, since the company has additional overhead, but we'll use the term profit for the purpose of this discussion.

However, when Apple company sells the iPad wholesale to retailers, it's a different story. The wholesale price is traditionally half of the retail price (although this sometimes varies in high volume consumer electronics and PCs where manufacturers and/or retailers take less profit in order to get the price down and ultimately make more money by selling in larger volumes). We don't know the wholesale price of the iPad, but since the iPad launched as an untried experiment in computing, it's likely that Apple and its retail partners have a more traditional arrangement. In other words, Apple probably sells the iPad to retailers for around $250, which means it makes about $20 profit on each unit -- respectable, but certainly not a number Apple would live with if it didn't have the big profits of its direct sales to balance it out.

Conversely, iSuppli estimates that the Samsung Galaxy Tab has a total product cost of $214.57. Verizon Wireless was selling the Galaxy Tab for $600 with no contract (and thus, no subsidy) when the product was first launched last fall, which means Samsung was likely wholesaling it for around $300. So, Samsung was making about $85 per unit on the Galaxy Tab -- much better than the 20 bucks Apple makes from retailers on its lowest priced iPad, but a far cry from the more healthy $270 Apple makes when it sells the iPad itself.

So, when pundits like me were saying that the Samsung Galaxy Tab would have been a much more popular product if it cost $300 (and I stand by that), you can see where that price was utterly impossible for Samsung to hit -- unless it was selling the tablet directly to consumers.

The math here is estimated and imperfect, but it gives us a general picture of the situation. From this perspective, it's easy to see why the tablet economics are not adding up for everyone else outside of Cupertino, California. This is a massive advantage that Apple has over its tablet competitors, and the fact is, none of them are going to be able to change the reality of the situation any time soon.

UPDATE, Feb. 20, 2011, 5:59PM EST: Since first publishing this article, I've received multiple reports from people in the retail sector saying that the wholesale price Apple sells the iPad to its retail partners is significantly higher than the traditional 50%-of-retail that I suggested (remember when I stated that some OEMs and retailers occasionally take lower margins?). In fact, one individual who didn't want to be identified because of being under NDA stated unequivocally that Apple sells the iPad to retailers at a meager 3% discount off of the retail price (in other words, $485 for the $500 iPad). I'm attempting to get confirmation on this from Apple and its retailers, but have not received a response. If true, this raises a number of additional questions and issues. Are retailers willing to sell the iPad for virtually no profit just to bring customers into the store? Would they be willing to take the same low profit margin in order to carry the Motorola Xoom or the BlackBerry PlayBook or HP TouchPad? (TechRepublic member donb says they might) If not, then this gives Apple even more room to wiggle on price than its tablet rivals.

UPDATE, Mar. 11, 1:00PM EST: I have followed up this article with another piece called Advantage Apple: Retailers only get a 3% discount on iPad. It basically comes to the conclusion that there are three reasons why Apple can price the iPad so competitively. It also includes a quote from Steve Jobs that confirms that the Apple retail stores were an important part of the iPad's success.

This article was originally published on TechRepublic.