Coevolving Innovations

With the primaries in the United States making headlines, Americans have been making noises about revisiting NAFTA. Michael Hart and William Dymond provided a Canadian perspective¹, with a global perspective on the larger trends.

If our neighbours elect a Democratic president, Senate and House on Nov. 4, things could get ugly, as a falling U.S. dollar, the credit crunch and serious troubles in the housing market add to recession anxieties.

The target for much of that ugliness will be China and other low-cost suppliers to the U.S. consumer market. Most Americans do not have much understanding of the role of these suppliers in maintaining U.S. economic activity. Both politicians and the public fail to realize the benefit of Chinese manufacturing goods produced to U.S. design and using U.S. technology. A recent University of California study found that, of an Apple iPod sold in the U.S. for $299, $160 goes to American companies that design, transport and retail iPods. Only $4 stays in China with the firms that assemble the devices.

I was curious about that $4, and tracked down the report to the Personal Computer Industry Center (PCIC), part of the Alfred P. Sloan Foundation. The paper by Dedrick, Kramer and Linden² has some interesting tables. Here’s a breakdown from the $299 retail price of the iPod.

Table 5. Derivation of Apple’s Gross Margin on 30GB Video iPod

Retail Price	$299
Distributor Discount (10%)	($30)
Retailer Discount (15%)	($45)
Sub-Total (estimated wholesale price)		$224
Factory Cost	($148)
Remaining Balance (estimated Apple gross margin)		$76

Source: Authors’ calculations; see text

From the above table, follow the $76 estimated gross margin for Apple. The $190 of captured value (profit margin by various participants in the value network) is constructed from the bottom, up.

Table 7. The Distribution of $190 of Captured Value in a Single 30GB Video iPod

	Sales in the U.S		Sales outside U.S.
Value Chain Segment	Apple	All other firms	Apple	All other firms
Apple Gross Margin (development, software, marketing	$76		$76
Parts Suppliers (key inputs only, Table A-2)		$35		$35
Manufacturing (assembly, test)		$4		$4
Distribution		$30		$30
Retail*	$23	$22	$11	$34
TOTAL VALUE CAPTURE	$99	$91	$87	$103

*”Retail is split between Apple and other firms based on our estimate that one-half of retail sales in the U.S. and one-quarter of retail sales outside the U.S. are by Apple through its stores and online website. Source: Author’s calculations, see text

The affordability of an iPod to middle class consumers is related to low manufacturing costs (i.e. $4). In the total price of $299, though, there’s a lot of profit that is captured.

For policy makers, here’s how the $190 of captured value breaks out by country of origin.

Table 8. The Geography of $190 of Captured Value in a 30GB Video iPod for a Unit Sold in the U.S.

	U.S.	Japan	Korea	Taiwan	Total
Apple Gross Margin (development, software, marketing	$76				$76
Parts Suppliers (key inputs only, Table A-2)	$7	$27	$1		$35
Manufacturing (assembly, test)				$4	$4
Distribution	$30				$30
Retail	$45				$45
TOTAL VALUE CAPTURE	$158	$27	$1	$4	$190

Note: for this table it is assumed that the unit is sold in the U.S. Source: Authors’ calculations.

Of the $299 price of the iPod, Apple (and the United States) gets $76 as the lead firm in the value chain, plus a potential $45 if the unit is sold directly through its retail channel. Value capture for parts gives $7 to the U.S. (e.g. video/multimedia processor, controller chip), and $27 to Japan (e.g. hard drive, display). Manufacturing (as assembly and test of the unit) results only in $4 of value capture for Taiwan.

This analysis supports advocates of investments in human capital for design and engineering expertise — i.e. university level skills — as opposed to lower-cost manufacturing facilities and roles. Given a choice between value capture in services (i.e. $30 for distribution, $45 for retailing) and manufacturing(i.e. $4), services win. In the global economy, it’s the investment using brainpower, not manual labour, that provides the larger and enduring value capture.

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¹Michael Hart and William Dymond, “The sabre-rattling on NAFTA is worrying, but take it as an opportunity”, Globe & Mail, March 15, 2008, accessed online at globeandmail.com.²Jason Dedrick, Kenneth L. Kraemer and Greg Linden, “Capturing Value in a Global Innovation Network: A Comparison of Radical and Incremental Innovation”, Personal Computing Industry Center (University of California, Irvine), Paper 407, 2077, accessed online at pcic.merage.uci.edu. There’s a contradiction with the September 2007 “draft” advising not to cite or distribute, while the document has officially been published on the PCIC web site.