Handset subsidies largely are responsible for rapidly increasing smart phone penetration.

On the other hand, the subsidies put pressure on service provider profit margins. Assume a service provider subsidies a device at about 50 percent of its actual cost, in exchange for a two-year service contract.

A device that costs the service provider $400 might be sold for $200, with the subsidy value recouped over the life of the service contract. One might say handset subsidies are a necessary evil, allowing service providers to more easily acquire new customers, reduce churn and increase sales of smart phone data plans.

Typically, smart phone users commit to new multi-year-term contracts and generate average revenue per unit nearly twice that of voice-only consumers. But there is a price: the subsidies are a real cost of acquiring customers and reduce both cash flow and operating margins.

In Canada, operators are seeing the benefits of higher sales and upgrade volumes largely wiped out by the impact of discounted handset pricing,” says Joss Gillet, Wireless Intelligence senior analyst.

‘The handset subsidies represent something in the range of $350 to $400 per new subscriber in Canada, and about the same amount in the U.S. market.

Nevertheless, Canadian operators value these costs as positive investments since they help to acquire and retain higher ARPU, lower-churning customers on longer-term contracts.

In markets that are saturated, there now are pressures to reduce subsidies. But nobody really can predict what will happen if service providers do so.

One has to think (economics suggests higher prices for any product people want will lead to lower demand; while lower prices lead to higher consumption) much-higher handset prices will reduce purchases of new handsets.

At the very least, that will reduce the rate of innovation in devices, as users will refresh their devices at a slower rate, and it is device innovation that drives change in the mobile business. Lower subsidies also will drive consumers to buy less-expensive devices, as well.

On the other hand, at least some might argue that service providers should “double down” by extending contracts and refresh cycles, essentially gaining longer contract terms at the price of more-rapid refresh rates.

Some might say the solution is simply to provide more prepaid options for consumers. A key objection so far has been that service providers differentiate postpaid service from prepaid by the selection of devices.

Typically, the hot new devices only are available on postpaid plans. It seems unlikely service providers will want to give up that advantage, suggesting that a rival tactic, namely making less costly phones available, will be preferred.

In Australia, for example, Vodafone Hutchison says smart phones are growing as a share of the prepaid base with devices available from just US $123.

It’s a conundrum, to be sure. In a device-driven business, few service providers will want to risk losing customers who want a hot device. Carrier experience with the Apple iPhone should have demonstrated the issue clearly enough.

Given margin pressure on one hand or customer acquisition and retention on the other, subsidies might be the lesser of two evils.

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