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Last year, when Apple introduced the original iPhone and the latest generation of iPods, another new product came out of Cupertino, Calif., but this one received little fanfare. It was a proprietary authentication chip. The chip works like a silicon key that unlocks streaming video functionality on iPhones and iPods and generally authorizes the devices to work with approved accessories. The advent of the “auth chip” made it impossible for any third-party company to produce iPod-compatible gadgets without dealing first with Apple—the only company selling the chip. Previous-generation iPods could output video over a generic $2 iPod video cable, but new phones and iPods require officially licensed Apple cables—and these can cost up to $50.
The chip has become a headache for many accessory manufacturers, who complain that they sometimes have to compromise on quality to pay for the chip and other Apple licensing fees, while still maintaining price points consumers can afford. “If we didn’t have to pay Apple for the dock and auth chip, we could have made a much better speaker for the same price,” said an official at a major electronics maker, who, like several sources for this story, requested anonymity because of fears that speaking with the press could jeopardize his company’s relationship with Apple.
And that relationship can be a profitable one. The iPod accessory market is formidable, with Apple selling over 22 million iPods in the first quarter of 2008—each one representing a new customer for accessory makers. Analysts estimate that the accessories market is worth $1.8 billion per year, so the dock and cable makers of the world are understandably cautious about rocking the business boat—especially with the new, highly anticipated iPhone 3G hitting stores tomorrow.
The authentication chip isn’t the only cost that manufacturers incur by building iPod and iPhone accessories. In fact, licensing fees, such as the one for the ubiquitous “Made for iPod” sticker, account for the bulk of the so-called “Apple tax.” While revealing exact costs for the exclusive connector and chip would violate nondisclosure agreements, a product decision maker at a global consumer electronics company was willing to list the standard licensing fees paid to Apple, insisting that they had become common knowledge within circles of the industry: “Small accessories like battery-pack adapters, that’s 10 percent the cost of the item, and the other items like desktop audio are $4 per unit.”
A representative from Apple declined to comment for this story or confirm details provided by manufacturers, stating that Apple “does not discuss the Made for iPod program.”
Stephen Baker, who monitors the electronics accessory market as vice president of industry analysis for the NPD Group, was quick to note that there would be no market for iPod and iPhone accessories if Apple had not invented the breakthrough products. “They own the intellectual property,” he says. “They have an opportunity, without hurting their business, to extract some money from these companies who are making money off that business. Are they actively dissuading people? Probably not. Are they encouraging people? Well, a lot of people aren’t encouraged by the idea that they have to pay some kind of tithe to Apple.”
The authorization chip is not an issue for more generic accessories, such as USB connection cables—and prices tend to reflect that. Data-only USB connectors for iPod and iPhone can be easily replicated by third-party manufacturers, and sell for as low as $2 online.
After the quiet introduction of the authentication chip, several manufacturers said they found that their products—already in stores—wouldn’t work with newer Apple hardware, causing a desperate scramble to re-engineer accessory product lines. As one official who oversees a line of iPod speakers explained, “Last year’s announcement of the new iPods and the new iPhone obsoleted a lot of the products that were on the market. [Apple] changed a number of things that caused a lot of manufacturers to have product on the shelf that was just dead product.” Older gadgets without the new chips wound up staying on the shelf for some time: Apple hadn’t informed manufacturers of the new specs, the third-party companies tell PM, until it announced the new security hardware to the general public. This led to a period from June 2007 to January 2008 when manufacturers struggled to update their equipment to work with Apple’s new line.
The added cost of the Apple chip and license fees also increases retail prices for accessories. Basic products such as cabling can now cost up to 10 times their original amount.
Apple’s control over the accessories market extends to bookkeeping as well. “Apple has a carrot-and-stick approach to dealing with developers,” says Jeremy Horwitz, editor-in-chief of iLounge.com. “It’s had auditors go through licensees’ books to make sure it gets paid for every unit sold, in addition to the connector and chip fees. As a carrot, it holds out the prospect of shelf space in its Apple Stores.”
The same decision maker who outlined Apple’s licensing fees has been through this audit process, and explained why it’s simple for Apple to detect any wrongdoing: “You do royalty payments and quarterly reports to Apple. Also, they have a sole distributor that you have to purchase the connectors from. So in both ways, they can find out whether you’re doing things right.”
Most manufacturers who spoke to PopularMechanics.com estimated that up to $20 of the retail cost of iPod and iPhone speakers can be directly attributable to the fees levied by Apple.
There are upsides to Apple’s hold on the accessories market, said the source with firsthand knowledge of the audit process: “It’s trying to control that environment so it can control the level of the quality of the piece.” So while Apple has a vested interest in high-end accessories reflecting its much-revered product line, the same source still insisted that Apple’s royalties seemed designed to drive out “cheap items.” Consequently, “With the royalty fees so high, when manufacturers like ourselves are considering [selling a new] product, we have to think beyond just entry level, because the cost of business is high.” The source estimated that $50 retail values had become the new low end—far more expensive than many consumer audio accessory products for non-iPod devices.
Regardless of how Apple changes its hardware in the future, it is almost guaranteed to maintain its control over the accessories market. Many in the consumer electronics industry have already wondered about Apple’s reluctance to adopt the Bluetooth standard for data and stereo audio streaming, and now the introduction of its authentication chip makes streaming media on any open standard appear unlikely.
The companies that work with Apple seem to have accepted this. “Are we at the mercy of Apple because we’re trying to bank on the marketability of their iPods? Of course! That’s the name of the game,” said the product decision maker at a global consumer electronics company.
The same official who was concerned with speaker quality explained that “Apple sales are predictable,” making the market for third-party products equally simple to measure. Apple works closely with the companies to provide forecasting and stock availability numbers once CEO Steve Jobs has unveiled a product. “It’s an expensive relationship,” said the company’s product manager, “but a profitable one.”