Microsoft Surface Sales - Reading the Tea Leaves

There's a lot of rumour and click-bait on this subject. Recently an analyst at Goldman estimated 260k surface sales, other analysts have said 1m. This is an attempt to estimate the sales based on information released in Microsoft's SEC 10-Q filing. This is going to be very dry and technical, prepare to be bored.

Cost of Revenues

There are many kinds of expense, but the one we're interested in is cost of revenues. Cost of revenues are the variable costs of making the stuff that you're selling. For the surface, that means the cost of the component, assembly and shipping. It excludes the software R&D, the marketing, the fixed costs and any other costs which would be incurred even if not a single unit was ever sold.

Windows Division operating income decreased, due mainly to lower revenue and higher sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $368 million or 24%, reflecting advertising costs associated with the launch of Windows 8 and Surface. Cost of revenue increased $292 million or 30%, including product costs associated with Surface and Windows 8 and Windows 8 upgrade support costs.

As we can see Cost of Revenues jumped by $292 mil, and this was attributable mostly to Surface, (for comparison the cost of revenues only rose $85 mil when Windows 7 was launched).

Given that BoM estimates for the Surface are in the region of $280-$290 this would indicate that somewhere between 700k and 1mil units. For reasons that will become clear the upper end of that is more likely.

The Matching Principle

So does that mean Microsoft build 1mil units or that they sold 1mil units? It turns out it means sold. There's an accounting principle known as the Matching Principle, which requires Microsoft to recognise cost-of-revenue at the same time as it recognises the revenue that gave rise to it. When Microsoft buys 1 surface from its supplier, $300 of cash becomes $300 of inventory. When it sells it, $300 of inventory turns into $700 of cash, along with $700 of revenue and $300 of cost-of-revenue.

For the same reason we can expect that Win-8 is a smaller contributor to cost-of-revenues than Win-7 was. Win-8 has not been such a big seller, and fewer people than ever are buying physical copies (or getting official install disks from OEMs). Win-8's loss is Surface's gain - hence the assumption that Surface sold closer to the 1mil upper end.

Inventories

We can also apply the same logic to the change in inventories. Inventories unfortunately aren't reported at the division level, but only across Microsoft as a whole. They have however risen by $530million - and the raw materials component has tripled.

Although they don't provide any insight into the rise, we can safely assume that it's mostly down to Surface. Software inventories are insignificant since inventory must be valued at the lower of cost or value. XBox inventories would presumably drop over the holiday quarter. So conservatively we have an additional 1.8 million units in the pipeline, about 600k of which are ready to ship.

Conclusion

Microsoft can't possibly have sold only 260k Surfaces, it would require us to believe that Win-8 has shipped more boxed units than Win-7 did to put the number anywhere below 700k. It's likely close to 1mil. Microsoft has probably built another 600k and is committed to another 1.2mil,