Estimating the Impact of Tiered Pricing on iTunes Store Profits

It was good news when Apple announced the end of DRM on iTunes Store music. And variable pricing sounds like a good opportunity for consumers, but is it? The problem with business deals is that most of the details are hidden from the public. To find out the truth, we have to ask a few questions about motivation, limits, and trends.

I see a few facts in the deal worth pursuing. How much more are the parties expecting to earn? What are the limits on the profitability? Who is stuck with the costs? What changes will increase a company's profits?

Estimating Costs

Since no one is talking, we'll use some old facts and basic assumptions to piece things together. My first assumption is that the recording industry will maintain its licensing fee as a fixed percentage regardless of price structure. It will continue to make 70% of the selling price. This leaves it free from all the operating costs (network connection, servers, customer complaints, credit card charges, etc.); Apple has to carry all of these costs.

While it gives the recording industry freedom from operational expenses, it allows Apple to increase its profits as it reduces these expenses. This is a fair tradeoff in risks between the two parties.

The next assumption is that if the recording bit rate is the same and the song length is similar, then operating cost is constant for any of the three tiers of song prices. I'm guessing this at 13¢ per track.

The unknown variable cost is the promotions/advertising costs. Some of this may be paid by the industry out of its licensing fees. I will assume Apple will spend its own chunk of money as it chooses to promote sales and/or artists. Apple has the additional benefit of promoting its iPods at the same time. Apple will control this spending to increase the store's profitability, but at the end of the day an average amount will be spent.

Breakdown of Expenses

Old One Tier Pricing Model

The remaining money is profit. The recording industry will make more on $1.29 songs, and so will Apple. They will both have a financial incentive to increase the sale of these songs more than the lower priced songs. for this reason, I am going to assume that Apple will spend more on advertising the 99¢ and $1.29 songs and less on the 69¢ tracks.

The next claim by Apple is that more songs are going to be sold at 69¢ than at $1.29. That is great - with a large back catalog there are probably tons of songs that can be discounted. People have burned many of these songs from their old CDs, but now they can be lazy and buy them again for a reduced price. Don't you just love a free market?

Just because more songs are available for 69¢ doesn't mean they are the most popular. Apple has been tracking purchases for the last 6 years. A few days searching through its database will tell you what songs to sell at a given price to maximize revenues. Once Apple starts tiered pricing, it will gain additional buying habit information on consumer preferences. forget everything else going on; this database alone will be worth millions of dollars once it is compiled. (I can envision Apple selling access to this database as part of future negotiations.)

Guesstimated Breakdown if More 69¢ Songs Sold than $1.29 Songs

To me it's clear that the harder to sell songs will be discounted, while the moderately popular ones will be priced higher. The most popular will be priced at the two highest levels depending on the maximum overall profitability, e.g., some will sell significantly better even if priced lower, thereby making the discount worthwhile. I assume discounts will be used to spike demand for particular artists.

Guesstimated Breakdown if More $1.29 Songs Sold than 69¢ Songs

The variable pricing works better today because the sales model has been proven, consumer buying habit data has been collected, and the size of the back collection is large enough that differentiation is meaningful. If you pick the wrong songs to price at 69¢, you could potentially loose money relative to the flat 99¢ pricing.

Apple has been disciplined in its business dealings to grow from 100 million song per year to 2 billion (a 20x increase) in six years. That consistency in focus says a lot about its business skill in negotiations. It also shows that the record industry has a larger interest in variable pricing to inflate its profits.

At the end of the day one thing is clear: every penny counts. In fact, I would gladly take just one cent on every song sold for one year. The extra $20,000,000 would look great sitting in my bank account. With huge earnings possible over every single penny, it's easy to see why the change in pricing structure was not done quickly. These were serious negotiations that no one could afford to walk away from without fighting for every advantage possible.

The breakdown of the NBC and UMG negotiations in 2007-08 showed that it was much better to drop iTunes than risk establishing precedence that could cost them billions later as the iTunes power continues to grow.

Make no mistake about it, iTunes will continue to grow. It has weathered competition from satellite radio, subscription services, other proprietary formats, file sharing, and DRM-free sales from other large distributors. NBC didn't come back because it likes Apple, but since no other solution has proven as effective, it had to get back in the game in order to play.

The question now is how will the recording industry continue justifying its 70% cut? It is producing fewer records and CDs to supply the retail stores. Apple is doing a lot of work with promotion, and it can see that the best way to expand profits is to leave the recording industry out. Why not sign more independent artists and pay them twice their usual royalty? Apple would still more than double its profits in the deal. I think recording executives are going to have to start working harder for their pay in order to stay relevant in the new marketplace.

While I admit that my numbers are mostly guesswork, they have a good feel to them. We know that Apple spends millions on advertising both iTunes and iPods, so 5¢ per download may be high at $100 million, but that's within a total advertising budget of $486 million. Profitability of the iTunes Store was originally estimated to be around 10% back in 2003. I'm sure Apple has figured out how to reduce its expenses, so this number has probably grown over time. Still, Apple does say that the iTunes Store affects its margins, so that means profits are well below 30%.

As a basic overview of the whole market, I am confident that the scale of these numbers is reasonable. What I am missing is the very complicated business arrangements that make it happen, what penalties, how songs are picked for the different tiers, when promotions can start and end, etc. There are plenty of inside details that would be fun to hear about to see how these high stakes gamblers have played their cards. Until I get promoted to the boardroom, I'll just have to satisfy myself with dreams of earning one penny off every song sold.