Image source: Tesla.

We aren't used to thinking of products this way.

This is largely why Tesla Motors(NASDAQ:TSLA) pricing model around battery capacity is so controversial in the first place. We're accustomed to the idea that you purchase a product for a specific price, and once the product is yours, you have full functionality in almost every way. Meanwhile, Tesla continues to explore unorthodox pricing strategies in which you purchase a product for a specific price, but the functionality that you receive is commensurate with the price that you pay.

Controversy aside, there is a clear benefit to the consumer: flexibility.

Would you rather buy a new one?

Consider other products and devices that you own. If you want to upgrade a basic specification about the product at a later time, most of the time you can't without having to buy another one. Want more storage capacity on your smartphone or a faster processor on your laptop? Oftentimes (particularly with highly integrated products), you'll need to buy another one with the higher specifications that you're looking for, and then probably sell your old one in an attempt to recoup some of the cost.

As daunting as that process sounds for a $600 smartphone or a $2,000 laptop, imagine the exponential difference when you're talking about a $60,000-plus vehicle. Of all the assets that you own, few have longer useful lives than a car. Depreciation is brutal, and transaction costs associated with trading up are extremely high, so ideally you keep it for as long as possible.

The optional upgrade increases the range of the base 60 battery by nearly 20%, and costs $9,000 if purchased after the fact. On average, Tesla vehicles lose 43% of their value over the first three years. Let's say you purchased a base 60 for $66,000 with no options, but then changed your mind after three years and decided you needed more range. That would theoretically translate into depreciation of almost $28,400. And then you'd have to go purchase a new Model S with the higher capacity that you need, which would then cost well over the base $66,000 price. You'd then be starting at the top of a brand-new depreciation curve too, by the way.

Wouldn't it just be easier to keep the same car but modify it in some way? Traditional vehicle modifications include adding new components or hardware to the vehicle, but the process becomes vastly easier if the hardware is already there -- unlockable with software.


Image source: Tesla.

Tesla is implementing a model that is strategically simpler in many ways. If you want additional functionality, you simply pay more. If you don't want additional functionality, you simply pay less. Tesla is even willing to absorb lower margins for those who only purchase the base capacities with no intention of ever upgrading, purely for the sake of offering that flexibility and affordability to the customer.

But at what cost?

The pricing strategy does not change the underlying cost structure that Tesla faces, so the company is very much putting profitability at risk in order to make its vehicles more affordable.

Note that Tesla does not use this pricing model for Model X. It's only used for Model S, which also makes sense since the overall cost curve has likely fallen in the four years since the sedan's launch. I would expect Tesla to bring the pricing structure to Model X over time once costs come down.

To be sure, Tesla does benefit in terms of manufacturing efficiency, since it doesn't need to make as many different battery configurations or capacities. But again, that benefit still comes at a very real cost to the company in the form of margin dilution for customers that never upgrade. Maybe one of these days we'll get used to it.

Evan Niu, CFA owns shares of Tesla Motors, and has the following options: long January 2018 $180 calls on Tesla Motors. The Motley Fool owns shares of and recommends Tesla Motors. 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.