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Taranis
05-21-2002, 07:58 AM
Here's an interesting article on the economics of the "lose money on hardware, make it up on software" model that Microsoft seems to be employing.

http://red-mercury.com/mmceo/mmceo_current.html

Kind of a downer for us fans, but like everything on the web, take these "facts" with a grain of salt.

Text of article, for those too lazy to click a link:
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'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

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

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.



YOYODLR

(You Own Your Own Damn Living Room)

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 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.

Send comments, criticism, and corrections to mmceo@red-mercury.com

Hugh_Jass
05-21-2002, 11:06 PM
That's a good read, but I don't think MS only makes $5-$10 per software title sold. That might be true for third party titles, but for first party I think it's more like $30.

Dre
05-21-2002, 11:17 PM
The website is also a slashdot favorite. Anyone who reads slashdot regularly, such as I, has come to realize (in around 10 seconds) that anything Microsoft related posted on that site is always against them. I believe they all have alias slashdot="I H8 M$" in their .bashrc files ;)

The article is a pretty good read, but I still believe the writer makes a few too many anti-ms assumptions that are favorable to his argument.

RadRider
05-21-2002, 11:21 PM
Every hardware manufaturer loses money (even Nintendo now that they had to drop it by $50, although I assume they were before also.) I think that all console companies have been employing this model since the Sega Master System.

and I also agree with Dre here.

X-Ray
05-22-2002, 12:02 AM
Originally posted by Hugh_Jass
That's a good read, but I don't think MS only makes $5-$10 per software title sold. That might be true for third party titles, but for first party I think it's more like $30.


Yep you're probably right.


P.S. I wrote a hella long reply to this about 9 hours ago but It was too long so I tried splitting it into two posts and then I realized I wasn't signed in. No biggie I thought. So I clicked the post button thinking Id enter X-Ray and my password and then my first installment would be posted (installment 2 was on my clipboard). I lost my entire first reply! And since part II makes little sense w/o part I, about a half-hour of typing, research, and carefull though went to waste!

Marc
05-22-2002, 12:22 AM
Don't worry X-ray, I can attempt to give a summary of all your hard work. The guy is full of *****.

X-Ray
05-22-2002, 12:35 AM
Originally posted by Marc
Don't worry X-ray, I can attempt to give a summary of all your hard work. The guy is full of *****.

I tried to orchestrate in terms of his misinterpretation of data that is sometimes pretty sketchy, committing logical fallacies and so forth. But you do have a nice summary.

P.S. note that of the 10 consoles that the SOB worked on only 2 were successful...hmmm...So what does he know?

OZXboxAddict
05-22-2002, 01:35 AM
IMHO the economic priciples mentioned in the article ring true in many ways but the author makes too many assumptions that are not favourable to the Xbox as well as leaving out some important variables that will affect the console war which is and always will be consumer driven.

He makes the assumption that Nintendo and Sony are not really selling for a loss even though they tell us they are?

Microsoft are already becoming more cost effective and will continue to become more so (new locations for productions, pressuring chip makers like NVIDIA to pass on their cost reductions etc) The author assumes again that Sony will do this with a combined chip and nintendo was do something of that ilk . . but that M$ won't? We already seeing evidence of M$ doing this (remember media rumours of Xbox2 which was really a more cost effective Xbox!?)

He states the console war going on for 6 or 7 years and then supposes only a minumum of 7 titles over the life of the console, perhaps this 'conservative' estimate is a lil tooo conservative @ one title per year. As I earlier said consumers will drive the wars and thus so will the games. Maybe platforms such as PS2 and GC only have that many decent titles in their lifetime but I definitely wouldn't make that assumption of the Xbox!

A major variable overlooked is online strategies, again driven by content and consumers. In a five year strategy the emphasis for online gaming will gain momentum and really change the playing field of the scenario set by the article's 6 to 7 year time frame. Consumers are always demanding more and the other platforms cannot provide this without significant purchases from consumers (who as a general rule of thumb want everything for nothing). Even the models put in place for online strategies offer the consumer more bang for buck with MS because of the out of box capability and one network (thus one subscription for basic services) while developers (well some), have more freedom to develop online without infrastructure cost whilst still receiving subscription/download fees and MS with continual cash flow because it's subscription based + royalties + peripheral business from online cosolidation.

Its all about the games and I make the assumption that consumers will always want more . . no other platform besides Xbox can provide the evolutionary curve needed to keep up with consumers over the next '6 to 7' years!

Fixxer
05-22-2002, 04:11 AM
1 title a year.... heh, I've had the Xbox a little over a month and already have 4 games. This thing is gonna break me.

UltraMuffin
05-22-2002, 06:21 AM
Whether MS pulls through or not in the long run...
them losing money = us saving money!

Dre
05-22-2002, 09:06 AM
Originally posted by Dre
The website is also a slashdot favorite. Anyone who reads slashdot regularly, such as I, has come to realize (in around 10 seconds) that anything Microsoft related posted on that site is always against them. I believe they all have alias slashdot="I H8 M$" in their .bashrc files ;)

The article is a pretty good read, but I still believe the writer makes a few too many anti-ms assumptions that are favorable to his argument.

So to prove this point (as if it needed proving though...), here's another slashdot article. I don't want to start another thread just on this because seriously, I find the guys opinions are a joke. Anti-ms at every turn.. oh well.. He raises a couple of interesting issues, but all in all, I'd have to say its not really worth my time.

Here's the article:
http://www.theregister.co.uk/content/4/25367.html