Is Android Google's Achilles' heel?

Despite this, Google really entered a new area with Android – one that could easily fail. We spoke to Allen Nogee, Research Director of In-Stat's Wireless Technology Group, to ask why Google chose to create Android.

"In the last few years, Apple, Microsoft, Google and Intel have all tried to get heavily into the phone business," he explained, "and if you dig a bit deeper, their motives are all different. So Google is a company that makes its money from advertising, currently mainly from advertising to those that use a desktop or laptop computer.

This is how Google financed the projects that it gives away for free – its revenue from advertising. On a PC, the browser is the gateway to the web, which is why Google, Apple and Microsoft all make browsers and give them away for free.

"Since 2007, with the introduction of the iPhone, the balance of power has started to shift to mobile and Google, like others, is well aware of that. If people no longer use a PC to get to the web and instead use a phone, then Google could be shut out of advertising revenue. It doesn't want that to happen, so this is why Google created Android.

"Even if it gave it to phone manufacturers for free, it would pay for itself in mobile advertising revenue, or so Google hopes. Whether mobile advertising revenue will ever match that of a PC is not yet known, but Google knows that if a phone isn't running its software then it has no control of sending advertising across it, so it had to have a phone plan."

We also put this question to Tim Shepherd, Senior Analyst for technology analysis firm Canalys. He told us:

"Google's activities in the mobile space in general, and with the creation of Android, I believe, need to be understood in the context of its wider business model. It is still a company driven primarily by advertising revenues and as mobile devices bring countless millions more consumers around the world to the web, and as connected services on mobile devices become more a part of our day-to-day lives, Google cannot afford to be anywhere but at the forefront of that trend.

"Android gives Google the opportunity to be relevant and a force on mobile, and to get its services and experiences in front of more consumers who will become increasingly dependent on them. This presents a host of advertising opportunities, with the added benefits mobility brings around contextual relevance to consumers, as well as the potential to diversify into monetising cloud services on mobile. This is a lucrative area, and Google sees it as essential to be more than just present here."

With this long term-strategy in mind, we asked Nogee if he thought Google was hoping to make any money from Android at the start. "Google realises that the path from point A to point B isn't always obvious. When it designed its search engine, Google likely never anticipated how much advertising revenue it would get, but 10 years later it looks obvious. It's the same with mobile. Not all the plans are known, but Google knows that if only Microsoft and Apple make phones, it will have little chance of making money.

"Mobile advertising is going to take longer to produce results than PC advertising did," he explained. "I don't think Google planned to make much money on it right away, and it doesn't have to, PC advertising is still paying the bills and will for many years to come.

"The question is after that, can mobile advertising replace all PC advertising? Well, it's likely the amount per phone will be less than per PC that Google will receive. But while there are 1 billion PCs, there are 6 billion phones, and unlike PCs, where many of them never have a human using them directly, every phone is used directly, although not all mobile phones are smartphones."

Hidden expense

So there seems to be a necessity for Google to get into the phone market and to control at least a part of it, but how much has it cost it to get this far? What have been the costs of setting up Android in terms of development and advertising? No one knows for sure, except for Google's finance department of course, but everyone agrees that it must be a lot.

Nogee didn't even like to guess: "I'm not sure of the total development costs for Android, but it's considerable." Shepherd had a ballpark figure: "Android development, marketing and related activities have cost tens of billions of dollars, but it is a crucial strategic investment from Google's standpoint."

For any normal company this is an insane amount of money to pay out for something that is hardly bringing in any revenue seven years after it was introduced. Apple, meanwhile, by creating its own ecosystem of tested apps, is bringing in a substantial profit from its operating system, receiving money from each phone and a 30 per cent cut of each app sale.

We asked Allan Nogee of In-Stat why Google seems to be increasing its market share at a very high rate but showing very little return for it, while Apple is raking in the profits.

"There are very different business models going on here," he points out. "Apple makes its money from selling hardware. In fact, Apple makes more profit from each iPhone then almost all other manufacturers. Sell more phones and make lots of money. It's easy to see how the money is rolling in at Apple. With Google, mobile advertising revenue is going to take time to build. Since Google makes money on advertising, just getting a phone in a user's hands doesn't give it any money, but Google hopes to make its money over the long haul with advertising.

"Unfortunately for Google, mobile advertising is a bit immature, so it may take years before large amounts of mobile advertising occur. In fact, since users only keep their smartphones for two years, at least in the US and Europe, Google may not even make its money back on some phones, but longer term, it hopes to.

"It's much like the model for cellular operators," he adds. "It loses money on each phone, with subsidies, but makes the money back in service revenue."

However, Google has been clever in its implementation of Android: it has side-stepped a large cost by leasing out the technology to any mobile phone companies who want to get involved. The cost of creating a handset, publicising it and even distributing it to the public was never borne by Google.

Instead, the phone manufacturers would carry the cost as part of their usual handset release cycle. Google merely provided the operating system. If the phone failed, it wouldn't harm Google financially – unless that manufacturer was so put off by the handset's failure that it turned its back on the Android OS in favour of something else.

Stifling innovation

This seems like a very clever practice, but it does mean you need to keep the handset manufacturers on your side by remaining an attractive proposition. Android's major competitors seem to have recognised this fact and are starting to pull out the big guns to try to prevent Android's continued market takeover.

However, they aren't training them on Google, but on the suppliers of the handsets. Costly patent cases are cropping up all the time from the likes of Microsoft and Apple against the likes of HTC, Barnes and Noble, Viewsonic and Acer. Each case hinges on the fact that the Android phones issued by these companies are in violation of patents held by Microsoft, Oracle and Apple.

In fact, HTC, Samsung, Viewsonic and Acer have already all agreed to pay Microsoft licences to pay for patent infringements on their Android handsets. This means that while Google gives Android out free to phone manufacturers, they in turn need to pay Microsoft for each Android handset they produce.

HTC reportedly pays Microsoft $5 for each Android device while Acer and Viewsonic are being asked for between $7.50 and $12.50 per device. Amazingly, this means Android is making money for Microsoft each time a phone running the OS is sold, while Google makes nothing.

It's very rare that you get a situation where a direct competitor makes more than you when your product is used. Google's impressive free-to-use OS is suddenly not as attractive once there are costs attached to it.

Google, which isn't actually involved in the patent cases (except when it hands patents over to help it counter-sue those suing it, as it did with HTC against Apple in September), isn't happy about it. In August David Drummond, Google's Chief Legal Officer, described the patent cases as "a hostile, organised campaign against Android by Microsoft, Oracle, Apple and other companies, waged through bogus patents."

Drummond also said, "Patents were meant to encourage innovation, but lately they are being used as a weapon to stop it."

Microsoft, of course, disagrees. Brad Smith, Microsoft's General Counsel, told the New York Times in October that, "Patent-licensing regimes allow companies to build on the shoulders of others. They allow companies to use technology and ideas, after paying reasonable fees. They can spend resources on new ideas instead of trying to figure out ways to invent around the work done by others. In that way, patent-licensing is pro-innovation."

Patent licensing isn't new; in fact, most handset manufacturers have to pay fees to other companies already. The first licences to be paid are for the radio technology for cellular communications. Here, companies like Qualcomm, leaders in these technology fields, can receive up to $20 for each smartphone produced.

Then there are the patent licences for media systems, which allow handsets to use the technologies for playing video and music. These cost between $3 and $5 a smartphone. Add the cost of an unexpected $5 to $12.50 patent licensing fee and handset manufacturers' profit margins can be cut considerably.