Since I’ve been talking to a few journalists about Samsung’s fairly dismal Q3 earnings forecast, and pointing people back to my previous pieces on Samsung, one thing that’s been coming up a lot is profitability and margins in smartphones. I thought I’d quickly jot down a couple of thoughts on this point in particular, as there seems to be a poor understanding of this topic in general.

The key here is that there are at least two components to profitability in smartphones, though they’re often conflated or one ignored entirely:

• Gross margin, i.e. the difference between the cost of manufacturing a device (cost of sales or cost of goods sold) and its selling price.
• Operating margins, i.e. gross margins minus all the shared costs of running the business that sells the smartphones, including all non-manufacturing employees, advertising, general and administrative costs, depreciation and amortization and so on.

It is entirely possible for a company to make a positive gross margin on each phone sold (even a significant one) and yet be hideously loss-making because its advertising, general and other costs are greater than the gross margin on the device. Motorola, for example, claims that it makes money on each device it sells, but that’s a reference to gross margins, and the business unit itself continues to be unprofitable as part of Google, because the other costs are greater than the modest gross margin it makes on its device sales.

This is important in the context of Samsung’s earnings forecast for a couple of specific reasons. Firstly, Samsung’s overall margins have benefited from two key factors:

• Firstly, it has achieved significant share of the premium smartphone market, and an extremely high share of the premium Android market. Gross margins are much higher at the premium end than at the low end, and this is a major component of Samsung’s overall high margins relative to every competitor except Apple.
• Secondly, it has massive scale, as easily the largest smartphone vendor in the world over the last couple of years. Scale is important because it spreads shared costs such as advertising, general employee costs and so on over a much greater number of devices. In other words, if Samsung spent a billion dollars on advertising and sold a hundred million phones, advertising costs per device would be $10, but if it sold two hundred million phones, advertising costs per device would be $5. The more devices over which you can spread these shared costs, the bigger the impact on operating margins. There are also some scale benefits to gross margins, of course.

Both this quarter and in previous quarters, Samsung’s earnings have taken a hit because of reduced scale (affecting mostly operating costs per device) and reduced prices (affecting gross margins), so both parts of the profitability equation are suffering at once. Some have suggested that Samsung should go harder after the low end of the market, while others have said that would be stupid because there are no margins there. This is where the above understanding of profitability becomes relevant: yes, the gross margins are lower at the low end, but there’s massively more scale there, which can help operating margins. So it’s not as simple as saying that Samsung should steer clear of the low end because the margins are poor.

Having said that, Samsung does face increasing pressure at the high end, especially since Apple has closed a major competitive window with the new iPhones launched a few weeks ago. So it may be increasingly important for Samsung to focus on the low end. However, that’s easier said than done too: the low end is arguably the main focus of many of the most aggressive moves in the industry at present, with Microsoft providing reference designs for cheap Windows Phones and Google launching the Android One initiative, along with the Moto G and other low-cost smartphones. It’s not necessarily going to be any easier for Samsung to compete at the low end than at the high end, especially if it wants to generate the kinds of margins it has in the past in smartphones. But there’s not really anywhere else to go: the mid-market is rapidly disappearing as the market bifurcates between premium and low-cost, with very little in-between.

Hence, perhaps, Samsung’s renewed investment in the chip business, as a potential supplier to other players. There’s far less competition in that business than in smartphones, and Samsung already has a very strong role in this business as a supplier to Apple and itself. Even as Apple’s reliance on Samsung chips wanes, there are plenty of other opportunities for Samsung to go after here. But of course the average selling price of a chip is far lower than the average selling price of smartphones. Even if the margins are good, it’s extremely unlikely that Samsung will be able to make up the difference on chips alone. Which means it has to continue to go after the smartphone market aggressively too, even though it faces falling margins and shipments going forward.