Google’s New Hardware Strategy: Actually Make Money

Technology companies like to cite computer scientist Alan Kay’s famous quote that “People who are really serious about software should make their own hardware.”

These days, Google’s motto could be, “People who are really serious about AI should make their own hardware—and sell it at a premium.”

That appears to be the strategy behind the Pixel, the first Google-designed smartphone, which was released on October 20. Prior to the Pixel, Google offered a series of Nexus-branded smartphones that it developed with smartphone makers and sold online, at prices that essentially covered its costs. But while the Nexus phones supported the company’s primary business of online advertising by getting more people to use Google services, the Pixel seems to be geared toward monetizing Google’s AI initiatives, specifically its efforts to build a virtual assistant that will act as a user’s “own personal Google” and provide a consistent experience across an entire line of Google-designed gadgets.

The move prepares Google for a world of conversational interfaces in which consumers will acquire information by speaking to virtual assistants embedded in a range of electronic devices. As such, the Pixel is a test of Google’s technological bets on these interfaces and the AI that powers them, as well as the company’s ability to deeply integrate its services into hardware, create a family of gadgets that will form a complementary ecosystem, and make money off something other than online ads. Its outcome will show whether Google can evolve and continue its domination in search.

In the hypercompetitive smartphone market, the only way to reap significant profits is to create a premium phone and sell it at a premium price. So Google selected top-of-the-line parts for the Pixel and is selling the device for $649, the same starting price as Apple’s iPhone 7 and Samsung’s Galaxy S7. (A 5.5-inch version of the Pixel, called the Pixel XL, costs $769, which is the same as the iPhone 7 Plus.)

Third-party analyses indicate that Google is making a generous margin on the phone. IHS Markit, a London-based market research firm, estimates that the Pixel XL’s material and manufacturing cost is $285.75, based on an examination of its internal components. Chipworks, a division of the technical analysis firm TechInsights, gives an estimate of around $220, but it didn’t include as many components or manufacturing costs in its evaluation as IHS did, according to analyst Dick James.

These figures are speculative and don’t reflect major expenses such as R&D, patent licensing, and marketing. But they are the most accurate data available in the absence of official information from Google. And they suggest that the Pixel has a gross profit margin only slightly smaller than that of the iPhone 7, which is the world’s most profitable smartphone (along with the iPhone 7 Plus).

Another way to gauge how much Google is making off the Pixel is to compare the phone—and its retail price—to a phone with similar hardware. James, the Chipworks analyst, has identified at least twelve common components between the Pixel XL and the Mi 5s from the Chinese startup Xiaomi, ranging from their Qualcomm processor to their primary camera (a 12 megapixel model from Sony). Yet the international version of the Mi 5s costs $250 less than the Pixel XL.

The Pixel's profit margin is a big jump up from what Google made on its Nexus phones and will help the company pursue high-end hardware seriously, which is the only sustainable business model in this tough market, says IHS Markit analyst Wayne Lam. Google is differentiating the Pixel with its virtual helper and virtual reality software, which require significant investments in AI and machine learning.

Indeed, burgeoning consumer interest in virtual assistants and VR is one reason why Google is revamping its smartphone strategy. The maturation of the smartphone industry is another. Microsoft and BlackBerry’s slumping smartphone businesses have pitted Google and Apple against each other for market dominance. As a result, Google believes it needs a single Android phone that can truly take on the iPhone, and matching the Pixel’s price with the iPhone’s is the company’s way of telling consumers the devices are comparable.

The other relevant change in the smartphone market is that Samsung is the only company that currently manages to make money selling premium Android phones (in spite of its Galaxy Note 7 debacle). Several years ago, Google would have hesitated to release a pricy smartphone under its own brand for fear of alienating its many Android partners. But Samsung’s control of the high-end Android phone market has concerned Google for some time and it likely hopes that the Pixel will diminish this dominance.

So far, the Pixel is selling more briskly than Google expected. It’s too early to gauge whether it will be a success, but it does show how Google intends to compete in an AI-first world.