Last week, research firm IHS published an estimate of the amount Apple (NASDAQ:AAPL) spends on the components and manufacturing of the entry-level Apple Watch Sport. It found that the materials totaled $81.20 and estimated manufacturing costs at $2.50 per unit, for a grand total of $83.70 per Apple Watch.
Remember, the Apple Watch Sport is priced at $349, nearly four times IHS's estimate. For comparison, IHS says the ratio of cost to price for the Apple Watch is lower than its estimate for the iPhone 6 Plus and other Apple devices.
But investors shouldn't get too excited. IHS doesn't account for a lot of costs that go into gross margin, and with the manufacturing problems Apple has had with Apple Watch so far, its costs are significantly higher.
Accounting for the Apple Watch
Apple doesn't seem to expect the Apple Watch to be its most profitable product. In fact, it believes its profitability will be below average compared with the rest of its business. In the company's most recent earnings call, CFO Luca Maestri noted, "Apple Watch margins will be lower than company average" for next quarter.
With guidance for gross margin between 38.5% and 39.5%, it implies that the real cost of an Apple Watch Sport unit is probably above $215 -- way more than IHS's estimate. That's not to say IHS's estimates are completely wrong; it's just that the research firm doesn't account for all of the costs of producing the Apple Watch.
Those costs might involve new equipment Apple purchased to help its suppliers assemble the Apple Watch. The depreciation expense associated with that equipment probably ends up in Apple's cost of goods sold. Additionally, there may be other fixed costs associated with manufacturing the Apple Watch.
And while IHS estimates that it costs only $2.50 to assemble the Apple Watch, it's not taking into account that Apple doesn't assemble its devices itself. It hires contractors, which typically take a profit.
Finally, and most importantly in the first iteration of the Apple Watch, IHS doesn't account for defective units. The Wall Street Journal reported last week that faulty "Taptic Engines" were responsible for the short supply of Apple Watches at launch. Each faulty unit increases the average cost of units that make it onto consumers' wrists.
The potential of Apple Watch
IHS's estimate might give investors the wrong impression about how profitable the Apple Watch currently is for Apple. However, it points to the huge profit potential Apple has with the device.
As Apple's suppliers and contract manufacturers work out the kinks with their processes, the number of defective units per batch will decrease. Additionally, as Apple scales the production of Apple Watch and demand increases -- as many analysts believe it will -- the fixed costs associated with production will be spread out among more units. Both of these will decrease the average cost per Apple Watch and increase Apple's gross margin.
It also points to the potential for Apple to improve the Apple Watch significantly with its next iteration. While most consumer-tech reviewers agree that the Apple Watch is the best smartwatch yet, Apple will have room to add features and functionality in the next iteration without sacrificing profitability. That will help it stay ahead of the competition.
Although Apple says it doesn't think about pricing when it makes devices, it does when it iterates on existing ones. The newest iPhone always costs $649 and the newest iPad is $499. So it is price constrained when it comes to developing future Apple Watches, because consumers will be expecting to pay $349 for the base model.
All this means that Apple has the potential to sell a lot of Apple Watches at a higher gross margin next year. Even though the Apple Watch isn't Apple's most profitable device this year, it could provide a boost to gross margin in the future.