Section 5.2. Integrating Ecosystems: Apple's iPod

5.2. Integrating Ecosystems: Apple's iPod

Apple's iPod is not precisely a web application. At its heart, it combines iPod hardware for playing music (and pictures and video), iTunes software for managing that content (shown in Figure 5-4), and an iTunes store that runs over the Web (shown in Figure 5-5). The iPod exemplifies the integration of new technology with existing systems, and its continuing growth into new areas (such as the web-capable iPhone) demonstrates how different technological ecosystems can coexist. Physical hardware can both benefit from network effects and create surrounding businesses based on those effects.

Figure 5-4. iTunes software with a user's music library

Figure 5-5. Apple's music store running inside of iTunes

However, the iPod combines much more than just components made and controlled by Apple. The first four ecosystems we'll discuss are illustrative examples of platform innovation, and they demonstrate how Apple has captured value from its ecosystems and expanded and widely distributed this value to its partners. You'll see the overall increased returns from collaborative innovation.

In this example, a lead company—here, Apple—conceives, designs, and orchestrates the external innovation and creativity of many other outside participants, users, suppliers, creators, affiliates, partners, and complementors to support an innovative product, service, or system. The final (and fifth) ecosystem—the iTunes and major record label partnerships—is used as a contrasting example of recombinant innovation and will be discussed later.

5.2.1. Platform Innovation Ecosystem #1: Production

To create the iPod, Apple first assembled a production ecosystem—a group of companies all over the world that contributed to circuit design, chipsets, the hard drive, screens, the plastic shell, and other technologies, as well as assembly of the final device.

Although many people still think of the manufacturing process as the key place to capture added value, the iPod demonstrates that Apple—the creator, brand name, and orchestrator—has actually figured out how to capture the lion's share of the value: 30%. The rest of the value is spread across a myriad of different contributions within the network of component providers and assemblers, none of them larger than 15%. Researchers, sponsored by the Sloan Foundation, developed an analytical framework for quantitatively calculating who captures the value from a successful global outsourced innovation like Apple's iPod.

Their study (http://pcic.merage.uci.edu/papers/2007/AppleiPod.pdf) traced the 451 parts that go into the iPod. Attributing cost and value-capture to different companies and their home countries is relatively complex, as the iPod and its components—like many other products—are made in several countries by dozens of companies, with each stage of production contributing a different amount to the final value.

It turns out that $163 of the iPod's $299 retail value is captured by American companies and workers, with $75 to distribution and retail, $80 to Apple, and $8 to various domestic component makers. Japan contributes about $26 of value added, Korea less than $1, and the final assembly in China adds somewhat less than $4 a unit. (The study's purpose was to demonstrate that trade statistics can be misleading, as the U.S.-China trade deficit increases by $150—the factory cost—for every 30 GB video iPod unit, although the actual value added by assembly in China is a few dollars at most.)

Suppliers throughout the manufacturing chain benefit from sales of the product and may thrive as a result, but the main value of the iPod goes to its creator, Apple. As Hal Varian commented in the New York Times:^[32]

^[32] Hal R. Varian, "An iPod Has Global Value. Ask the (Many) Countries That Make It," New York Times, June 28, 2007, http://people.ischool.berkeley.edu/~hal/people/hal/NYTimes/2007-06-28.html.

The real value of the iPod doesn't lie in its parts or even in putting those parts together. The bulk of the iPod's value is in the conception and design of the iPod. That is why Apple gets $80 for each of these video iPods it sells, which is by far the largest piece of value added in the entire supply chain.

Those clever folks at Apple figured out how to combine 451 mostly generic parts into a valuable product. They may not make the iPod, but they created it. In the end, that's what really matters.

5.2.2. Platform Innovation Ecosystem #2: Creative and Media

The iPod is also part of an ecosystem and contributes to the indirect network effects of Apple's other key product: Macintosh computers. Even though iPods, and the iTunes software that supports them, were originally compatible with Macs only, the cachet of the iPod has continued to help sell Macs even after the iPod developed Windows support.

Beyond the iPod and iTunes, Apple's creative and media ecosystem includes software such as iMovie, iDVD, Aperture, Final Cut, GarageBand, and QuickTime (a key technology for the video iPods). These are all Apple products, but many other companies also provide software and hardware for this space, notably Adobe and Quark.

5.2.3. Platform Innovation Ecosystem #3: Accessories

As any visit to the local electronics (or even office supply) store will show, the iPod has inspired a blizzard of accessories. Bose, Monster Cable, Griffin Technologies, Belkin, and a wide variety of technology and audio companies provide iPod-specific devices, from chargers to speakers. Similarly, iPod fashion has brought designers, such as Kate Spade, into the market for iPod cases, along with an army of lesser-known contributors. Also, automobile companies and car audio system makers are adding iPod connectors, simplifying the task of connecting iPods to car stereo systems.

iPod accessories are a $1 billion business. In 2005, Apple sold 32 million iPods, or one every second. And for every $3 spent on an iPod, at least $1 is spent on an accessory, estimates NPD Group analyst Steve Baker. That means customers make three or four additional purchases per iPod.

Accessory makers are happy to sell their products, of course, but this ecosystem also supports retailers, which get a higher profit margin on the accessories than on the iPod (50% rather than 25%). It also reinforces the value of the iPod itself because the 2,000 different add-ons made exclusively for the iPod motivate customers to personalize their iPods. This sends a strong signal that the iPod is "way cooler" than other players offered by Creative and Toshiba, for which there are fewer accessories. The number of accessories is doubling each year, and that's not including the docking stations that are available in a growing number of cars.

Most industry participants were surprised by the strength and growth of the accessory market. Although earlier products such as Disney's Mickey Mouse or Mattel's Barbie supported their own huge market for accessories, those were made by the company that created the original product or by its licensors. Apple has taken a very different path, encouraging a free-for-all; it accepts that its own share of the accessories market is small, knowing that the iPod market is growing.

5.2.4. Platform Innovation Ecosystem #4: User-Provided Metadata

Even before the iTunes music store opened, users who ripped their CDs to digital files in iTunes got more than just the contents of the CD. Most CDs contain only the music data, not information like song titles. Entering titles for a large library of music can be an enormous task, and users shouldn't have to do it for every album.

This problem had been solved earlier by Gracenote, which is best known for its CDDB (CD database) technology. Every album has slightly different track lengths, and the set of lengths on a particular album is almost always unique. So, by combining that identification information with song titles entered by users only when they encountered a previously unknown CD, Gracenote made it much easier for users to digitize their library of CDs.

Rather than reinventing the wheel, Apple simply connected iTunes to CDDB, incorporating the same key feature that made CDDB work in the first place: user input. Whenever a user put in a CD that hadn't previously been cataloged, iTunes would ask that user if he wanted to share the catalog.

Apple has no exclusive rights to CDDB, but it benefits from its existence nonetheless. Users get a much simpler process for moving their library to digital format, and contributing to CDDB requires only a decision, not any extra work.

5.2.5. Recombinant Innovation

The music industry is perhaps the most difficult ecosystem the iPod has to deal with—and the most frequently discussed. The music industry has dealt with the Web and the Internet broadly as a threat rather than an opportunity, as it saw its profits disappearing when the transaction costs of sharing music dropped precipitously. So, how did Steve Jobs get the record labels—which had been suing Napster and Kazaa—to sign up for the iTunes store to offer online, downloaded music?

Apple presented its proposal to the big four music companies—Universal, Sony BMG, EMI, and Warner—as a manageable risk. Apple's control of the iPod gave it the tools it needed to create enough digital rights management (DRM)—limiting music to five computers—to convince the companies that this was a brighter opportunity for them than the completely open MP3 files that users created when they imported music from CDs. Jobs was actually able to leverage Apple's small market share into a promising position:^[33]

^[33] Steven Levy, "Q&A: Jobs on iPod's Cultural Impact," Newsweek, Oct. 16, 2006, http://www.msnbc.msn.com/id/15262121/site/newsweek/print/1/displaymode/1098/.

Now, remember, it was initially just on the Mac, so one of the arguments that we used was, "If we're completely wrong and you completely screw up the entire music market for Mac owners, the sandbox is small enough that you really won't damage the overall music industry very much." That was one instance where Macintosh's [small] market share helped us.

Apple also played a key role in coordinating the pricing of songs among the big four music companies—99 cents a tune. This was a major step in weaning the music companies away from their high-priced retail distribution of prepackaged bundled digital goods— CDs—toward a digital distribution channel with a per-user/per-song revenue structure and potentially strong social-network effects. Downloads were also carefully priced to incentivize users who preferred having legal downloads and who trusted Apple and Steve Jobs to keep the price at that level despite the protests of the music labels.

After 18 months of negotiations, Apple was able to get started on its own platform, and later carry the DRM strategy to Windows. (One pleasant side effect for Apple of the DRM deal with the music companies is that it is difficult for Apple to license that DRM technology, preserving Apple's monopoly there.)

Apple provided the music companies with a revenue stream built on an approach that would let them compete with pirated music, although the companies aren't entirely excited about adapting to song-by-song models and the new distribution channels. However, EMI's decision in April 2007 to start selling premium versions of its music without DRM—still through the iTunes store but also through other sellers—suggests that there is more to come in this developing relationship. Ecosystems evolve, and business ecosystems often evolve beyond their creators' vision.