Microsoft's Red-Ink Game

Business Week is reporting that Microsoft could be losing up to $125 per Xbox 360 sold. I had heard originally that it was a loss of between $70-75 per unit, but Business Week's analysis is fairly sound, and I can't find any particular figure that I would argue with, though some of the numbers still seem a little high to me. My guess would be that the $70-75 figure is still accurate, but that additional costs have been borne by the fast ramp-up for launch.

It's sort of understood that the Video Game Industry runs on a "razor and blade" model. Sell the hardware as cheap as possible (razor), and make up the difference on the games (blades). There are all sorts of facets to the strategy, and it's different for a distributor/manufacturer than it is in retail, namely, the margins are very different. Microsoft's royalties from game software are not on a per-game-sold basis, but come when the disc is pressed. Initial pre-orders and buzz will drive this number up, but it really doesn't matter if that initial run really sells at all. Microsoft gets their money regardless. Unsold games imapct retail, however, who are not making any money on the console, and need the game sales to make up for that. It's part of the reason why a game store may only order enough of a marginal title to cover any possible pre-orders; they don't want to be left with stock that they can't sell, because purchasing one extra game that you can't sell will eat the profits of around five games that you did sell. This is where that difference between the number of games "sold" versus the number of games "sold through" comes into play.

Part of how a console manufacturer will make up for this is by flipping the model slightly, and offering discounts on accessories, so that the profit margins are higher. This is also why when a console launches, you'll see stores refusing to sell units unless you buy a bundle, which normally includes a game or two, but will always include extra hardware. Costco and Sam's Club are selling bundles that include another controller, and other accessories, and may or may not include a game. Profit margins are highest on the accessories, which is why you'll sometimes see the games taking a backseat at retail. It's interesting to note that Microsoft has turned this part of the industry on it's head this console generation, and is charging royalties for third-party accessories as well, looking to get a cut from all around.

So the question becomes, why would you risk selling hardware at a loss? Well, it's certainly a risk, but the idea is that you want to increase your installed base as quickly as possible. Remember, you need to make up your money on games and accessories, and you can only do that when people have the main hardware. Game publishers understand that they will never sell to every potential customer, so that installed base needs to be as large as possible when you're only going to sell around 20% of that number in software. The risk comes from trying to ramp up that number too fast, and ending up with more red ink than you can make up in games. (You might have heard, but Microsoft manufactured Perfect Dark Zero at a 1:1 ratio, basically assuming that every Xbox 360 owner at launch would buy it. That's crazy.) Microsoft lost money right up until the fourth year of the Xbox. They're on record now saying that they plan to be "gross margin neutral" through 2006, then profitable after that. It's quite ambitious.

There's a balance to be had here. The more consoles you make at the beginning of a generation, the more they will cost you. Economies of scale have yet to kick in, and won't be fully realized for years. There is a balancing act to be maintained ... get enough hardware into the channel to boast a large installed base and to get orders for software, but try to stretch it out so that you can start to benefit from optimizations and cost-cutting measures in manufacturing. Inciting demand through a publicized shortage is one way to do that. Nintendo was famous for this particular tactic, though the rumor at the time was that Nintendo actually had the consoles stashed away, which would have defeated the purpose if the goal was to keep demand inflated over time ... Nintendo was looking for a larger initial spike in sales.

It's interesting to note that Nintendo doesn't follow this razor-blade model. Nintendo rarely loses much (if any) money on the consoles, and usually turns a profit by the second quarter. Nintendo creates incredibly efficient and cost-effective hardware, has a higher royalty structure, and keeps it's budgets in check. It just goes to show that there is more than one way to play the game.

I'll talk more on this subject after the holidays as we start to see how Sony plans to deal with being caught between Microsoft and Nintendo.