Why This Apple Inc. Watch Cost Estimate Is Dead Wrong

By Markets Fool.com

According to IHS, the Apple Watch costs just $83.70 to make. This is based on the breakdown and estimate of the component costs found inside the device, the contents of the box, and so on. However, in light of the comments that Apple made with respect to Apple Watch gross profit margins on its most recent call, I would say that this number significantly misses the mark.

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Apple Watch gross profit margins said to be below corporate average
Apple guided to 38.5% to 39.5% gross profit margins for its upcoming quarter. Apple executives also said on its most recent earnings call that the average gross profit margin for the Apple Watch in the coming quarter will be belowthat corporateaverage.

If we assume margins come in at 39%, this implies that the gross profit margin percentage for the Apple Watch Sport is below that level, say 35%.

If the Apple Watch Sport sells for $349, and the company is making 35% gross profit margin on the device, then that would imply a manufacturing cost of $226.85, or nearly triple what IHS says the device costs to make.

What is driving that cost?
Generally speaking, when we talk about the "manufacturing cost" of a product, it is not enough to simply sum up the costs of the individual components to reach a total.

There are costs associated with assembling the devices. High-tech equipment is not cheap, and the depreciation of that equipment should flow to cost of goods sold.

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I am not sure how Apple does the accounting here, but I would guess that manufacturing labor costs for Apple would fall under cost of goods sold rather than operating expense, since Apple uses contract manufacturers to build its products. The contract manufacturers also need to earn a profit, which adds overhead for Apple.

Also keep in mind that not every Apple Watch that runs through the assembly lines actually "makes it" as a final product. Some Apple Watches will inevitably be defective (the defect rates tend to get better with time, though), and that might mean throwing away or recycling almost-but-not-quite-there Apple Watches.

This, in effect, raises the average cost of the devices that make it to store shelves.

To illustrate this phenomenon, assume that the IHS estimate is correct that the materials that go into the Apple Watch Sport cost just $83.70. Let's then suppose Apple builds a batch of 1,000 Apple Watch Sport models, but only 70% of them actually pass inspection.

This means Apple paid $83,700 for the materials to build 1,000 units. However, if only 700 units hit store shelves, then the average raw materials cost per device is $83,700 divided by 700, or $120.

See how nuanced this can get?

Remember what Tim Cook said . . .
During the most recent earnings call, Tim Cook made it quite clear that the manufacturing cost estimates of Apple products that wind up getting published are often very far from accurate. The IHS estimate of $83.70, when Apple is seeing average gross profit margin percentages on these devices under 39%, just does not pass the common sense test.

Furthermore, while some people will say that the cost estimate is off because Apple has to market these products, design them, and so on, I would say that is incorrect.

Costs such as marketing, research and development, and so on are lumped into operating expenses. These obviously affect overall project and corporate profitability, but they do not affect gross profit margins.

The IHS teardown does not seem incorrect because it "only" takes into account component and manufacturing costs -- it looks incorrect because the actual manufacturing cost implied by the gross margin profile of the products is substantially higher than what the IHS cost estimate implies.

The article Why This Apple Inc. Watch Cost Estimate Is Dead Wrong originally appeared on Fool.com.

Ashraf Eassa has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.