Why Don't Carriers Push Unsubsidized Phones?

Once upon a time it was possible to find a cheaper data plan if you brought your own phone to a carrier in the United States, but those days are over. Whether you buy your phone subsidized or not, you pay the same rate for data.

That fact got me thinking: why don't carriers push unsubsidized phones more?

Costs of an Unsubsidized Phone

Of course, it is a considerable expense for the customer to purchase an unsubsidized phone, especially for smartphones in particular. Verizon is the one carrier that makes it easy to see what it costs to purchase a no-contract phone on its website, so for all of the examples here, I'm going to use Big Red.

According to VZW's website right now, the unsubsidized price for the Galaxy Nexus is $649.99. That's also what a 16GB iPhone 4S costs, and the price goes up in $100 increments as you add storage to 32GB and 64GB. An unsubsidized Droid RAZR goes for that same $649.99, a Droid Bionic sets you back $589.99, and the new Blackberry Torch 9850 goes for $459.99.

Subsidized smartphones all require data plans, so it follows that the carriers probably make up for the subsidies with those data plans. When you subtract the subsidized price from the unsubsidized price, you find out how much each phone is subsidized. Divide that subsidy by 24, and you find out how much each month the carrier charges you per month to make up for the lower up-front price. Here are the subsidies for those phones:

• iPhone (all varieties): $450 subsidy; $18.75 per month
• Droid Bionic: $390 subsidy; $16.25 per month
• Galaxy Nexus, Droid RAZR: $350 subsidy; 14.58 per month
• Blackberry Torch: $280 subsidy; $11.67 per month

In all of these cases, the amount of revenue Verizon effectively brings in for the data plan falls by more than $10 per month thanks to the subsidies. The two lowest (and therefore likely the most popular) data plans Verizon offers are $20 per month for 300MB and $30 per month for either 2GB or 4GB of data (depending on its promotions). That means Verizon is collecting at most $8.33/month purely for data at the lower level and $18.33/month for data at the higher level on the subsidized Torch. It is collecting at the lowest $1.25/month for the lower level and $11.25 for the higher level with the iPhones.

Verizon's Profitable Zones

Verizon's early termination fee (ETF) for smartphones is $350 minus $10 per month of paid service. So, if you cancel after one complete month, your fee is $340. If you cancel after one complete year, your fee is $230.

ETFs basically exist to recoup the subsidies on phones. This must be the case because they are comically small compared to the lifetime value of the contract.

The least expensive smartphone plan on Verizon for an individual is $40 for voice and $20 for data for a total of $60 per month. That works out to $1,440 over the lifetime of the contract. The only point at which Verizon's ETF entirely covers the lost money of the plan is in the final three months, but that doesn't include any subsidy that is still being paid off. Include that factor, and it's likely to only completely cover the losses in the final one or two months.

Therefore, it's safe to say that lost value from the monthly payments on service is not a factor in the ETF. The question then becomes: when are subsidized phones more profitable than unsubsidized phones for Verizon?

The ETF plays heavily in here because someone without a two-year contract can walk without paying that fee. For the unsubsidized phone to be more profitable, the extra amount the company would have made on data versus a subsidized phone at the time must be greater than the ETF at the time minus the amount of the subsidy the customer wouldn't have paid back at the time they terminate. In formula form:

Extra data money to date > ETF - (subsidy - subsidy payments to date)

Here is a chart showing the amount by which Verizon benefits from having an unsubsidized phone at the various subsidy levels I described above. The values charted are for if a customer leaves after the number of months on the x-axis.

As it turns out, it's a very simple relationship. The amount of extra money Verizon makes per month in data with an unsubsidized phone is exactly the same as the amount of the subsidy that gets paid down every month. Therefore for any given month, it's just a matter of taking the value of the initial subsidy and subtracting the ETF for that month.

The only time Verizon doesn't come out ahead when a customer with an unsubsidized phone leaves is for the first few months with a model that normally has a subsidy less than the initial $350 ETF like with the Blackberry Torch. On all the rest of the phones, Verizon would have made more money with an unsubsidized phone no matter when the customer decides to leave.

And of course if the customer with an unsubsidized phone stays through the entire two-year contract, the amount Verizon ends up ahead on the deal is the value of the subsidy it would have offered on that model.

The Customer's Perspective

Before talking more about the carrier, let's talk about the customer.

Buying an unsubsidized phone is much more expensive than buying a subsidized one. The primary value proposition for the customer in foregoing the initial discount is the ability to take that phone to another carrier without having to pay a penalty. Well, sort of.

Thanks to the dueling GSM and CDMA standards, you can only take a standard 3G phone to one other major carrier in the US. Even world phones with both GSM and CDMA capabilities might not be transferable from one to the other thanks to carrier and device restrictions. For instance, the unlocked and unsubsidized iPhone 4S cannot be used on Verizon or Sprint.

In any event, if you buy an unsubsidized phone, you're going to want to know how big a discount you'll need to get at each month over the next 24 months to come out ahead versus a subsidized phone. You need to know when the ETF plus the amount you would have paid back towards the subsidy is greater than the extra money you put up by not getting a subsidy plus any savings per month. In formula form:

ETF + amt. of subsidy paid back > subsidy + savings from new plan

Here are a few charts of the change in the total amount you pay over the course of 24 months by choosing an unsubsidized phone over a subsidized phone and by switching to a lower cost plan in a particular month. If a number for a month is negative, that means you save money by buying having bought an unsubsidized phone and switching that month. If a number for a month is positive, that means you save money by having bought a subsidized phone and switching that month.

This is the chart for switching to a plan that costs $10 less per month:

If you and your unsubsidized phone switch to a plan that costs $10 less per month, you must do it no later than 14 months after buying that phone to make it worth it if the subsidy would have been $280. As the subsidy goes up, you have more time to wait and still come out ahead. Of course if your new carrier charges an activation fee (or more accurately, doesn't waive it), you will have to switch a month or two sooner depending on the phone.

This is the chart for switching to a plan that costs $20 less per month:

You have much longer to wait if you can swing a $20 discount, which makes sense.

The trick is that you won't be able to pull this kind of money saving switch too many times. The other way you can come out ahead with an unsubsidized phone is if you use it on a carrier that doesn't require a data plan for all smartphones regardless like Verizon does. It will take you anywhere from going 14 months without data (for an otherwise $280 subsidized phone like the Torch) up to 23 months without data (for an otherwise $450 subsidized phone like the iPhone).

Why Don't Carriers Push Unsubsidized Phones?

Subsidies are tremendously useful for the carriers. Many people who are unable or unwilling to pay the higher up front price of an unsubsidized smartphone will go for the reduced initial cost of a subsidized one. That then puts them in data plans that more than make up for that initial subsidy. Plus, advertising fancy phones for low prices, or even "free", gets people's attention.

There's no reason why carriers should get rid of subsidies. However, they can have material effect on a carrier's margins if a big selling new phone has a large subsidy. Unsubsidized phones are more profitable for them, so why doesn't every carrier do as Verizon does and make it easy to browse them as options?

Primarily, it's probably because the main advantage for the customer of getting an unsubsidized phone is being able to walk away from the carrier without paying a fee. "If you buy this, you can leave whenever you want with no penalty!" is an awkward pitch for an industry that has been built around the two-year contract. Early termination fees probably also create a mental block in people's minds that prevents them from thinking about leaving even if they can come out ahead after paying it. Plus, a customer leaving early is most often costlier than the subsidy is.

The example of a plan that costs $60 per month is possible but probably not common. Let's imagine a smartphone user who opts for a plan of $90 per month with Verizon. Let's also imagine this person bought an unsubsidized Android phone (that normally has a $350 subsidy) that can be taken to Sprint to take advantage of one of its $80 per month plans.

Let's say this person is considering switching after 12 months. Based on the math from the previous section, this will allow the person to save either $30 total or $65 if Sprint waives the activation fee. It would be worth it financially to switch.

Verizon will have collected $1,080 total from this customer at the time of this decision. If the person stays for another 12 months, Verizon will have collected $2,160 in total. If the person had bought a subsidized phone and stayed the entirety of the two-year contract, Verizon would have collected $1,810 in total (net of the subsidy). In this particular scenario, by giving the option of the unsubsidized phone the carrier is looking at an upside of $350 and a downside of $730. It had better hope its network is much better in the customer's region than Sprint's is.

As the numbers and considerations change, the upsides and downsides do too. However for almost all of the subsidies I looked at here, the carrier takes in more revenue from a full term contract than it does from an unsubsidized, no-contract customer at the points where it makes financial sense for that customer to switch carriers. Only with the iPhone's $450 subsidy versus an unsubsidized customer who switches after 19 months does the carrier no longer care (it brings in $1,710 either way).

Verizon must worry less about bleeding customers than the others because it makes it the easiest of all to shop for unsubsidized phones. I find that interesting because Verizon itself is not the low cost carrier. Big Red should be more vulnerable to being undercut on price and therefore to seeing unsubsidized customers walk away early, but it must feel confident that its network quality, amenities, and packaging deals will insulate it from mere price sensitivity.

Sprint and T-Mobile, as the low cost carriers, would seem to benefit from a proliferation of unsubsidized phones. However, they are having issues with customer loss. Pushing options that let customers leave without having to think about a termination fee might be a bad idea.

As for AT&T, your guess is as good as mine.