Does It Pay For Firms To Innovate?

The answer is a clear “yes”—at least for Apple and the iPod—according to a study underway by Ken Kraemer and Jason Dedrick, along with Greg Linden from UC Berkeley. As part of a project being conducted by the Personal Computing Industry Center, an Alfred P. Sloan Foundation Industry Center, these researchers are examining who captures the value from innovation. Specifically, they are asking which companies and countries benefit from innovation in their new research project The Value from Innovation: Where the Value-add and jobs end up for the iPod and notebook PC.

While innovation is held to be the key to U.S. competitiveness, there is little understanding of the “value from innovation” in the sense of where the value-add from innovation ends up with respect to companies and countries. In addition, currently there is little understanding of how the distribution of value might vary between new innovative products like the iPod and more mature ones like notebook computers.

Given that the iPod is a relatively new innovative product, it is an excellent case to analyze for a better understanding of value-add for an individual product and for a product family over time. In contrast, the notebook PC, once itself a new innovative product like the iPod, is now a mature one with a different distribution of value. Thus, in this research the iPod as a new innovation will be compared with the notebook PC as a mature innovation in order to highlight important similarities and differences in the payoffs from such products.

Claims that value mainly accrues to China and other countries in the Asia-Pacific are ever-present in the media and policy circles, because manufacturing and product development are often outsourced offshore to Asia. Additionally, most components, including high value components, are sourced from Asia. These include the small HDD in the iPod from Toshiba, flash memory from Samsung, and DRAM, other chips and most components in the notebooks.

Do these products also create value for the U.S.? Although it is hypothesized that the value and jobs accrue mainly to China and Asia more generally, significant value-add may also accrue in the U.S. For example, the intellectual property and some high salary jobs associated with innovation (R&D, design, product and brand management, and supply chain management) are in the U.S., and core technologies such as software and microprocessors come from U.S. companies. Thus, the researchers expect that considerable value will accrue to Apple in the iPod and to Intel and Microsoft in notebook PCs. The research team will develop estimates of these values in order to better establish where the value is created and captured.

The research project is being conducted in two stages. During this first phase, the researchers are focusing only on the iPod. They are currently developing an analytical paper with a clear set of questions regarding the value add associated with innovation and a methodology to address them. They also are developing a first estimate of the value add for the original iPod, followed by an estimate of profit margins for products. Using that data, they will make some estimates of the value-add of different components that contribute to an iPod. Then the team will apply the same methodology to the notebook PC in the second phase.

Preliminary results from the first phase indicate the following for the 30GB Apple video iPod:

• Apple doesn’t actually make the iPod. It outsources the entire manufacture of the device to a number of Taiwanese firms, including Foxconn (Hon Hai), Asustek, and Inventec—all of whom actually produce it in China.
  
• Of the $299 retail price of the 30GB video iPod, 50% is the cost of materials, 25% is for distribution and retail, and 25% is Apple’s gross margin. So, Apple is the single biggest winner in the iPod sweepstakes.

• But there are other winners too. The most expensive component in the iPod is the hard drive ($73), which is made by Toshiba but actually manufactured in the Philippines. The next most costly components were the display ($20) made by Toshiba-Matsushita, the video processor ($8) made by Broadcom and the controller chip ($5) made by PortalPlayer.
  
• Looking at the value add by country, $163 of the iPod’s $299 retail value was created in the U.S., breaking it down to $75 for distribution and retail, $80 to Apple and $8 to various domestically manufactured components. Japan contributed about $26 of the value added (mostly via the Toshiba disk drive), Korea contributed about $1, and China contributed about $2 in labor for assembly and test. Other lower-cost parts come from Europe, Taiwan and possibly elsewhere, but the value added is very small and does not affect the broader pattern above. In this country analysis, therefore, the U.S. is clearly the biggest winner.

So what does this all say about the payoffs from innovation? First is that the biggest winner is Apple. For iPods sold in the U.S., retailers and distributors also are winners.

Second, the producers of high value, critical components also capture a large share of the value. In the case of the iPod, it is Japanese firms (Toshiba and Matsushita) and to a lesser extent U.S. firms (Broadcom and PortalPlayer).

Third, the real value of the iPod doesn’t lay in its parts or even in putting those parts together. The bulk of the iPod’s value is its conception and design. While Apple may not make the iPod, they created it and that’s what really matters in determining who gets the value from innovation.

Fourth is that when American companies create innovative products, most of the benefit comes back to the U.S. But, if Apple was a French company, 25% of the product’s value would have gone to France, not the U.S.

Thus, so long as the U.S. remains dynamic, with innovative firms and risk-taking entrepreneurs, global innovation should continue to create value for American investors and well-paid jobs for technical and professional workers. But if those companies get complacent or lose focus, there are plenty of foreign competitors ready to take their places. If this happens, the benefits from the global innovation system could shift quickly away from the U.S.

For a more complete discussion of the preliminary findings from this study, please see http://pcic.merage.uci.edu/papers/2007/AppleiPod.pdf.