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Microsoft's Red-Ink Game

Microsoft's newest gaming console marks an improvement on the earlier version in some decisive ways. To name a few, the pricier Xbox 360 is sleeker and more powerful (see BW Online, 11/22/05, "Xbox: How It's Designed to Thrill"). And unlike its predecessor, the Xbox 360 is being released months ahead of the comparable next-generation console from Microsoft's chief gaming rival, Sony (SNE).

But when it comes to profitability, the new machine won't change anything. Microsoft (MSFT) will carry on its tradition of taking a loss on the console, according to a preliminary analysis by market researcher iSuppli.

BREAKING IT DOWN. An up-close look at the components and other materials used in the high-end version of the Xbox 360, which contains a hard drive, found that the materials inside the unit cost Microsoft $470 before assembly. The console sells at retail for $399, meaning a loss of $71 per unit -- and that is just the start.

Other items packaged with the console -- including the power supply, cables, and controllers -- add another $55 to Microsoft's cost, pushing the loss per unit to $126. These estimates include assumptions that Microsoft is getting a discount on many components.

That was the case with the first Xbox console, which contained about $323 worth of parts and materials when released, but sold at retail for $299. It's certainly not going to help Microsoft reverse the trend of losses in its home-entertainment segment. In the fiscal year ended June 30, that unit lost $391 million on sales just shy of $3.25 billion. That's a little more than 8% of Microsoft's total sales of $39.8 billion.

A Microsoft spokeswoman said that the company's plan calls for a "gross margin neutral" strategy through 2006, meaning that between the sales of consoles, game software, and accessories, it expects to essentially break even. Profits should follow in 2007.

PLAYING TO WIN. Microsoft's strategy with the Xbox family has always been one of taking a loss on the hardware in hopes of cutting a profit on game-software sales. Redmond would like nothing more than to narrow Sony's lead in computer games (see BW, 11/28/05, "Robbie Bach Is Ready to Rumble").

The Xbox 360 was released widely on Nov. 22 with 18 game titles from companies such as Electronic Arts (ERTS), Activision (ATVI) and Microsoft's own game unit. It hit store shelves in the U.S. and Canada at the stroke of midnight, with consumers lining up outside stores from San Mateo, Calif. to New York hours before the official launch. Chairman Bill Gates showed up for a sales event at a Best Buy (BBY) store in Bellevue, Wash., and Microsoft held a launch party that drew hardcore game enthusiasts to California's Mojave Desert (see BW Online, 11/22/05,

"Hardcore Offer Mixed Verdict at Zero Hour").

Semiconductors alone account for $340, -- more than 72% of the materials cost -- iSuppli estimates. One key component, the IBM-designed microprocessor chip at the center of the console (see BW Online, 10/25/05, "Inside IBM's Xbox Chip") costs about $106. Both IBM and Chartered Semiconductor (CHRT) of Singapore are building the chip for Microsoft.

ROOM FOR IMPROVEMENT. Analyst Chris Crotty with iSuppli says that as both companies improve their manufacturing efficiency and production yields, they will likely reduce the chip's cost by 20% to 25%. The same will likely apply to ATI (ATYT), which is building the graphics-processing unit, or GPU, for the Xbox. iSuppli estimates that the chip is the most expensive component in the system at $141.

The graphics chip also includes embedded memory from NEC (NIPNY). "There's room to improve the yields on both chips," says Crotty. "We expect that could cut the materials cost by as much as $50." That would bring the materials cost down to $420 and total expense to $475 -- within $76 of break-even. Costs of other components could come down over time as well, further narrowing Microsoft's loss on the product.

Other components in the system include a hard drive from Seagate (STX), which costs $53, and memory chips from Samsung at $65, iSuppli says.

EVERYBODY LOSES. IBM also has designed chips at the heart of the competing video-game systems -- the Playstation 3 from Sony and Nintendo's forthcoming Revolution system, both of which are due next year. Crotty expects that Sony's loss on the Playstation 3 may be even wider, as the cell processor that IBM, Toshiba, and Sony designed for the system is more complex.

Estimates vary as to how much the cell processor will cost. Richard Doherty of Envisioneering Group in Seaford, N.Y., expects the cell chip to cost about 50% more than the Microsoft chip. "Based on what we've seen so far, the Playstation 3 could cost as much as $600 to make in today's pricing," Doherty says.

And Crotty says that since it's a more complex chip, its price will fall more slowly than the price on the Xbox chip.

FIRST TO MARKET. "The cell processor is a great chip with a lot of power, but we're hearing that it's a little more difficult to develop games that take advantage of that power," Crotty says, adding that the cell chip and Blu-Ray DVD drive will also add to Sony's materials cost. The Xbox 360 uses a conventional DVD-ROM drive that costs $21.

Sony has yet to set final pricing for the Playstation 3 in North America, but the unit is expected to sell first in Japan for the equivalent of about $450. Microsoft beat Sony in timing, but Sony could get at least some of its thunder back by shaving about $51 off that price tag.


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