Fixed Costs Are a Two-Edged Sword
When people think about large corporations, they think that everything must be easier when you have all that volume. Big companies get better prices on raw materials, and they can spread their fixed costs over greater volume. But leveraging your fixed costs is a two-edged sword that can swing back and cut you just as fast as it can help. No one realizes this part.
Leveraging your fixed costs means you are increasing your sales volume while your machinery and equipment costs stay the same. But here’s the problem: your fixed costs stay fixed whether your volume goes up or down. And the more you have invested in machinery and equipment and other fixed costs, the more you are at risk.
When Apple is about to launch a new iPhone, they have two opposing forces that they must manage:
The only way to get all those iPhones into all those hands within days or weeks of launch is to invest in many redundant manufacturing lines. Each line may cost many millions of dollars. Then when the sales peak is over, Apple carries excess capacity. But the cost of those manufacturing lines doesn’t go anywhere. It continues to get charged to the income statement every month. It’s the same as if you bought a new car but never drove it. That payment still needs to be paid every month.
Now for Apple, this hasn’t been too much of a problem since they could always count on rising unit sales. They could plan on purchasing equipment to meet their peak demand, and there wasn’t too much risk because ever more iPhone buyers would help pick up the slack after the launch frenzy was over.
Apple’s profitability was down this quarter compared to last year. I assume fixed costs will be a big reason why. The decision on how much to spend on capital equipment was made long before the iPhone 7 was launched. So this latest sales decrease still had more to do with the 6s than it did with the 7. They didn’t know if the iPhone 6 phenomenon was a real surge in demand that they should plan on continuing or not.
The question now is what did Apple plan for the iPhone 7? Remember Tim Cook’s comment about why they wouldn’t release launch-week sales? Tim knew right off the bat that the iPhone was going to be supply constrained. How did he know that? Was he so sure that iPhone 7 demand was going to be out of this world right after a significant decrease? If there was ever a time that Apple couldn’t predict demand, it would be now. I don’t think it was confidence in his sales forecast that made Tim utter that statement.
It was the other side of that equation, capacity, which Tim knew was going to be the limiting factor. If there is one thing that Apple can predict with great precision, it’s capacity. If Apple were to play it safe with how many manufacturing lines to fire up, this would help Apple’s gross margins, as long as the iPhone 7’s volume doesn’t rise significantly from iPhone 6s levels. But this could be a risky proposition if the iPhone 7 demand continues strong into 2017. Longer wait times and availability issues could be a problem all year long as Apple brings the iPhone 7 to each new market.
Apple had a great Q4, and even though it was a decrease from 2015, it was their second best year of all time. Now they’re predicting that 2017 will be a return to growth. How does this jive with a capacity cut? Easy—you extend lead times. They could still manufacture as many iPhones as they need to. They just might not have them available up front.
With the market for mobile devices maturing over the last year, the job of Apple’s COO, Jeff Williams, has just gotten a whole lot harder. Apple’s efforts to streamline their manufacturing and logistics and forecast their demand are all going to be front and center. We’re all going to see just how good Apple’s operations are. Or aren’t.
When Apple is about to launch a new iPhone, they have two opposing forces that they must manage:
- Customers want their new iPhones ASAP.
- If they over-invest in capital equipment, they will doom themselves to lower gross margins for the life of the product.
The only way to get all those iPhones into all those hands within days or weeks of launch is to invest in many redundant manufacturing lines. Each line may cost many millions of dollars. Then when the sales peak is over, Apple carries excess capacity. But the cost of those manufacturing lines doesn’t go anywhere. It continues to get charged to the income statement every month. It’s the same as if you bought a new car but never drove it. That payment still needs to be paid every month.
Now for Apple, this hasn’t been too much of a problem since they could always count on rising unit sales. They could plan on purchasing equipment to meet their peak demand, and there wasn’t too much risk because ever more iPhone buyers would help pick up the slack after the launch frenzy was over.
Apple’s profitability was down this quarter compared to last year. I assume fixed costs will be a big reason why. The decision on how much to spend on capital equipment was made long before the iPhone 7 was launched. So this latest sales decrease still had more to do with the 6s than it did with the 7. They didn’t know if the iPhone 6 phenomenon was a real surge in demand that they should plan on continuing or not.
The question now is what did Apple plan for the iPhone 7? Remember Tim Cook’s comment about why they wouldn’t release launch-week sales? Tim knew right off the bat that the iPhone was going to be supply constrained. How did he know that? Was he so sure that iPhone 7 demand was going to be out of this world right after a significant decrease? If there was ever a time that Apple couldn’t predict demand, it would be now. I don’t think it was confidence in his sales forecast that made Tim utter that statement.
It was the other side of that equation, capacity, which Tim knew was going to be the limiting factor. If there is one thing that Apple can predict with great precision, it’s capacity. If Apple were to play it safe with how many manufacturing lines to fire up, this would help Apple’s gross margins, as long as the iPhone 7’s volume doesn’t rise significantly from iPhone 6s levels. But this could be a risky proposition if the iPhone 7 demand continues strong into 2017. Longer wait times and availability issues could be a problem all year long as Apple brings the iPhone 7 to each new market.
Apple had a great Q4, and even though it was a decrease from 2015, it was their second best year of all time. Now they’re predicting that 2017 will be a return to growth. How does this jive with a capacity cut? Easy—you extend lead times. They could still manufacture as many iPhones as they need to. They just might not have them available up front.
With the market for mobile devices maturing over the last year, the job of Apple’s COO, Jeff Williams, has just gotten a whole lot harder. Apple’s efforts to streamline their manufacturing and logistics and forecast their demand are all going to be front and center. We’re all going to see just how good Apple’s operations are. Or aren’t.
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