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May 20, 2002

XBox Economics

Look at the price of Microsoft's XBox and you'll probably chant the magical phrase: "give away the razors and sell the hell out of blades!" We all want to believe that the Microsoft XBox, Sony Playstation 2, and Nintendo GameCube are $1,000 machines practically given away for $199. We are told that the hardware companies lose money on the hardware sales and make up the difference in software sales. In reality, Microsoft is the only one that has bought in to this "lose money on the hardware" idea.

The XBox hardware has been estimated to cost Microsoft $320 to $400 to build in 2001. They have been selling the box for $299, and this month they have dropped the price to $199 to keep up with Nintendo and Sony. Even after six months of cost reduction, they may still be losing $100 on each XBox sale. Nobody knows how much Microsoft is really losing, but they have confirmed that they are selling the hardware at a loss. Will they really be able to make up all of these losses with software sales?

What Was Supposed To Happen

"Microsoft is the only one that has bought in to this 'lose money on the hardware' idea."

Microsoft's plan was supposed to work something like this. On Day 1, they sell the XBox for $389 or so to those one million "early adopters" that would frankly pay anything to get their hands on a new game console. They can only realistically manufacture 500,000 to 1,000,000 units for that first holiday shopping season anyway. Note that this $389 price would have allowed Microsoft to break even on those first million units of hardware, so this part of the plan looks great on paper.

After the early adopters are tapped out, the Console Hardware Playbook calls for a price drop to something that sounds more affordable, like $299. At this point, sales are supposed to really start to pick up steam, packing on another 10 to 20 million units. A gradual price war is expected throughout the years of the XBox life span. Everybody's game consoles then slowly drop to $249, then $199, then $149, and finally $99. Microsoft would hope that Sony and Nintendo hold out until year 6 or 7 before dropping to the $99 mark.

While the retail price of the XBox is dropping regularly over the years due to market forces, Microsoft has that old friend Moore's Law in their back pocket. Remember, that's the law that states that computer hardware will cost half as much and run twice as fast every time you click your heels. So by the end of 6 years, if everything is planned correctly, Microsoft will be shipping the same hardware for 1/8th the cost of the original units, after only dropping the price by a factor of 3. Now, they're making money on the razors!!!

What's Really Happening

"Microsoft would hope that Sony and Nintendo hold out until year 6 or 7 before dropping to the $99 mark."

So rewind to day 1. Unfortunately, Microsoft had to launch the XBox at $299 to compete with the Playstation 2, so they missed out on the early-adopter tax and started losing money right away. Because of this price pressure from the start, they also missed their chance to drop the price after the holidays to jumpstart that critical second wave of sales. Now, they are being forced to match the Playstation 2 and Gamecube with a mid-year price cut to $199, but not enough time has elapsed for Moore's Law to lower the cost of the XBox very much.

Microsoft makes $5 to $10 on each XBox software title sold, no matter who publishes it (the major publishers probably negotiate this down to $5, and for low-cost titles, the kickback could be lower). They are counting on this money from software sales to subsidize all of their extra costs. Microsoft really bought in to the idea that they can lose a lot of money up front and make up for it later with this software kickback.

For Microsoft's sake, let's debunk that mythical "sell the hell out of blades" (translated: "make up for extraordinary hardware and marketing costs with software sales") part of the equation. If, on average, every XBox owner buys 7 software titles over the life of the console (a reasonable estimate), that's $35 per console sold that the first party gets without investing a penny more in development, manufacturing, or marketing. That's nice to have, but in light of all of the costs involved, it's not going to pay for extra hardware expense and still turn a profit. That little $35 figure kind of blows a hole in the whole razors and blades thing, doesn't it? Even if Microsoft's kickback is closer to $10, Sony and Nintendo can bring that down by starting a software price war. Sony and Nintendo are perfectly happy to let you believe that they are selling their hardware at a big loss. They are even happier to let Microsoft believe that. Sony and Nintendo both know that software sales are for profits, not for hardware subsidies.

Nightmare Scenario

"Sony and Nintendo both know that software sales are for profits, not for hardware subsidies."

It appears that Microsoft is in a dangerous price war that it is losing. But what would happen if one of their competitors suddenly combined two of its major computer chips in to one chip, tripling the output of their manufacturing plant? That competitor's costs would fall dramatically, and they could drop the price of their console much faster and much lower than Microsoft could.

Sony has done exactly this with the Playstation 2. Two of their largest chips will now fit on to one chip. Sony invested $1 billion in their own chip fabrication facility. Now you know why. Microsoft, on the other hand, grabbed a bunch of off-the-shelf chips from a variety of vendors and shoved them together in an absolutely huge, expensive, heavy box that looks a lot like a PC and would probably maim a small child if it fell off the top of a TV. Even if Microsoft could combine the nVidia graphics chip with the Intel CPU, do you think nVidia and Intel would go for this? These chips are owned by different (competing) companies, and the chips are manufactured in different places. If this combination were even physically possible, it would never happen for obvious competitive business reasons that are completely out of Microsoft's hands. Microsoft's box is, and will continue to be, expensive to make, because they don't control the silicon. They will not catch up to Sony or Nintendo on manufacturing costs.

It seems that, while Microsoft was salivating over Moore's Law, Sony has been cheating and using "Moore's Law Plus". Nintendo is also clearly cheating with some enhanced Moore's Law variant in their calculations; if you've ever picked up a feather-light GameCube, you might wonder if there are any electronics inside the thing at all. The result is a price war between Nintendo and Sony that is just starting to get good. This month (May 2002), the Sony Playstation dropped to $199 and the Nintendo GameCube dropped to $149. The XBox dropped to $199 to stay competitive, but boy does it hurt to see that. The XBox has been out less than a year, while Sony has had 3 years to bring its hardware costs down (Playstation 2 launched in Japan in 1999). Nintendo and Sony are cutting each other's throats on retail price (as planned), and still making money on the hardware. Microsoft has to follow suit with the price cuts, causing them to lose even more money on relatively new hardware that is still expensive to build. Don't worry, Microsoft will make it up in software sales, if every customer buys 20 or 30 games.

(You Own Your Own Damn Living Room)

"Don't worry, Microsoft will make it up in software sales, if every customer buys 20 or 30 games."

Game consoles historically do one of two things. They live long, healthy lives with software support for many years (the original Playstation still does brisk business today, and just dropped to $49), or they die horrible, horrible deaths when the console sales stagnate and software publishers run screaming (Sega Dreamcast). If sales stagnate, a console will die.

Some seem to think that it doesn't matter if Microsoft loses millions or billions on the XBox, because they will just release the XBox 2, and everybody will buy that, according to some larger Microsoft "strategy" to "own the living room". Game consoles don't work that way, for some reason. If the XBox goes the way of the Dreamcast, nobody… NOBODY is going to be clamoring for the XBox 2 (how many millions of people are eagerly awaiting Dreamcast 2? That's right, zero million.)

The economics of the XBox don't add up now, and they get worse with time. Sony and Nintendo can kill the XBox on cost alone. The "software subsidies" that Microsoft expected are a myth. Game console prices will continue to drop, from $199 to $149, then on down to $99. Will Microsoft ever make it to the $99 level of this game? We'll see. According to XBox economics, it all depends on how much money they are willing to lose.

Entire contents Copyright © 2002-2005 by Red Mercury, LLC. All rights reserved.

About the Author:
Scott Corley started Red Mercury in 1999 to develop small games for mobile devices.
He worked in the console game industry from 1993 to 1999. During that time, no fewer than ten game consoles came and went. Of those ten, only two were considered a major success.

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