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Microsoft Blew It on the Price of Xbox One

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Microsoft Blew It on the Price of Xbox One

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UPDATE: On June 19, 2013, Microsoft announced that it would reverse its highly restrictive digital rights management policies on the Xbox One. That being said, the author still stands by his argument that the price is too high.
At last week's Electronic Entertainment Expo (E3) conference and show, both Microsoft and Sony unveiled their new gaming consoles which will be released this holiday season. While both systems support a wide variety of games, they each have unique differentiating features. Microsoft's Xbox One, for instance, provides strong integration with television, Internet, and Skype. Sony's PlayStation 4 (PS4) is less restrictive in its digital rights management, which makes sharing games easier and renting games possible.

The most striking difference, however, is their prices. Perhaps feeling cocky because its sales consistently trump those of the PlayStation, Microsoft set the Xbox One's price at a 25% premium over the PS4. The Xbox will sell for $499, while the PS4 has a retail price of $399.

Now for the folks at Microsoft, here's a brief pricing history refresher:

King C. Gillette started selling razors and razor blades in the early 1900's. To get razors in the hands of consumers, Gillette set prices low and made his profit from the ensuing sales of high priced blades. This pricing strategy has been successful and emulated by many other products (printers and cartridges, for instance).

Facebook is the indisputable champion of social networking. How did it gain over a billion members to use its site monthly? It made the price of entry cheap - in this case, free.

Why remind Microsoft of these strategies? Like the Pledge of Allegiance, these two stories should have been recited before every meeting that discussed the price of the Xbox One. The foundation for the battle of the next generation of console-based gaming will be set by this holiday season's sales, and lessons from each example above reveal the importance of setting a relatively low price for the system in order to maximize overall profits.

Due to the make-or-break importance of these head-to-head initial sales, there are two key reasons why Microsoft should lower its Xbox price, matching or even beating the price of the PS4:

The Razor/Razor-Blade Pricing Strategy. Game console manufacturers have long followed King Gillette's pricing strategy: They create game customers by selling consoles as cheaply as possible and then profit from game sales. In fact, consoles are often sold at a loss on the faith that manufacturers will reap hefty profits from the licensing fees they charge game manufacturers to run games on their hardware. On a game created by an outside developer that retails for $60, for instance, it is estimated that the console manufacturer receives a $7 platform licensing fee. Since the profit comes from games and ancillary sales, the pricing strategy is straightforward: Set prices low to get consoles in the hands of gamers. The more consoles purchased, the higher the potential profit upside.

Role of Price in Creating a Network. A growingly important decision factor in selecting a console is the breadth of its associated online community. Both Xbox and PlayStation have closed networks - meaning that if you own an Xbox One, you won't be able to play online against others (friends, expert players, etc.) who have a PS4, and vice versa. In these types of closed networks, the more people who join, the more valuable the network becomes. At a 25% price premium, Xbox is not doing itself any favors in terms of growing its gaming network.

Console prices will drop over time. It's standard practice for new technology to start prices high and then discount in the ensuing months and years. But this strategy may not work for the Xbox. Its premium price is receiving so much publicity that the notion of "it's too expensive" is becoming embedded in consumers' minds.

I get that Microsoft believes its new Xbox provides more value, and hence deserves a higher price. But historically, consumers haven't been willing to pay a premium for the "razor," even if it ultimately provides higher value. In 2007, for instance, Kodak bet the company on a new printer pricing strategy. While Kodak charged a premium for its laser printers, the upside for consumers was that ink cartridge refills were priced at $9.99. While a seemingly attractive value proposition, the strategy did not catch on with consumers; in 2012 Kodak filed for Chapter 11 bankruptcy.

The Xbox One is already starting at a disadvantage: A recent poll by Amazon.com found that over 94% of respondents favored the PS4 over Microsoft's gaming console. This sentiment, coupled with the backlash from its premium price, has created a pall of gloom that Microsoft needs to overcome. The good news is there is still plenty of time to gracefully lower price (or offer a discounted version with less functionality) before consoles go on sale.

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Microsoft Blew It on the Price of Xbox One

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UPDATE: On June 19, 2013, Microsoft announced that it would reverse its highly restrictive digital rights management policies on the Xbox One. That being said, the author still stands by his argument that the price is too high.

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PS4 versus Xbox One: A cost to market story

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Using data from Video Game Sales with Ratings

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The combined hardware and manufacturing cost of Microsoft Corp.'s new Xbox One amounts to $471, suggesting that Microsoft is subsidizing the cost of the video game console at the time of launch.

The Xbox One carries a bill of materials (BOM) of $457, according to preliminary results from the Teardown Analysis Service at IHS Inc. (NYSE: IHS). Manufacturing is estimated at $14, which means the console's total cost of $471 is only $28 less than the retail price of $499.

This is very similar to the new PlayStation 4 from Sony Corp., which carries a hardware and manufacturing cost of only $18 lower than its retail price, according to the preliminary IHS teardown information released last week. And just like the PlayStation 4, Microsoft initially will take a loss on each Xbox One sold when other expenses are added into the equation.

"For both Microsoft and Sony, their latest-generation video game console hardware is unprofitable at the time of release, requiring the companies to subsidize it initially," said Steve Mather, senior principal analyst for IHS. "However, these companies easily can largely compensate for their losses though sales of highly lucrative game titles. Meanwhile, as the cost to produce the consoles decreases according to the normal learning-curve dynamics in the electronics industry, the companies can cut their retail pricing-or pad their profits. Over time, Microsoft is likely to reduce the retail price of the Xbox One in order to maintain sales momentum."

Microsoft may also be more willing to take a loss on hardware sales with the Xbox One than it has for its previous-generation products.

"The Xbox One is designed to serve as a beachhead in the home for Microsoft, with the console's capability to interact with-and interface to-other devices, such as televisions, set-top boxes, smartphones and tablets," Mather noted. "Gaining such a strategic advantage in the battle to control the connected home and Internet-enabled living room is well worth having the Xbox One act as a loss leader for Microsoft."

Table 1 attached presents the preliminary BOM and manufacturing cost estimate of the Xbox One and the PlayStation 4. Note that these teardown assessments are preliminary in nature, account only for hardware and manufacturing costs, and do not include other expenses such as software, licensing, royalties or additional expenditures.

AMD takes the lead in gaming

The Xbox One's core architecture is very similar to the PlayStation 4, with most of the functionality of the two systems residing in highly integrated system-on-chip (SOC) devices supplied by Advanced Micro Devices Inc.

"It's interesting that AMD has taken over the core central processing unit (CPU) and graphic processing unit (GPU) in both the Xbox One and PlayStation 4," said Andrew Rassweiler, senior director, IHS teardown service. "This is a very different landscape from the hardware of just a few years ago, when IBM was dominating the core CPU slot in both the Xbox 360 and PlayStation 3 consoles."

"Although the AMD chips are unique in the two consoles, they appear very similar in many ways. Both chips are built in 28-nanometer-process geometry, have the same number of CPU cores, and possess similar silicon die surface area between the two, suggesting similar amounts of functionality and processing power. Even the net power requirements for the two consoles are very much alike, which further underscores functional similarity. The two consoles are not clones, but are definitely related."

Kinect: the Xbox One's not-so-secret sauce

The biggest factor increasing the hardware cost of the Xbox One compared to the PlayStation 4 is Microsoft's inclusion of the new-generation Kinect system as a standard feature of its console. The Kinect adds $75 to the Xbox One's BOM and manufacturing cost.

IHS has determined that Microsoft has made significant advancements in the Kinect hardware since the first version of the device examined by the Teardown Analysis Service in 2010.

In the intervening years, Microsoft has added new features, including new optics for the system's two cameras that are larger and more sophisticated than for the previous generation. The more advanced optics should provide better images to the sensor, but are more expensive. The three infrared emitters in the new version of the Kinect also contain some elaborate optics that IHS is still analyzing.

Because of the increased sophistication, the new generation of the Kinect is estimated to be $75, which is more expensive than the older version, which carried a $64 BOM and manufacturing cost.

AMD inside

Like the PlayStation 4, the Xbox One is based on a highly integrated SoC processor from AMD that performs the vast majority of the functions in the console. In each system, the AMD processor is essentially a "console-on-a-chip," combining the CPU and GPU into a single device, as well as integrating other functions.

And just as the Xbox One and PlayStation 4 are related but aren't clones, the two chips in the two consoles are not exactly alike.

Preliminary modeling from IHS suggests that the AMD chip in the Xbox One should cost about 10 percent more than the device it sells to Sony for the PS4. The AMD process in the Xbox One costs $110, compared to $100 for the PlayStation 4.

Cost accounting

One other major cost driver of the Xbox One compared to the PlayStation 4 is the optical drive. Microsoft uses a Blu-ray drive made by Lite-On, compared to what IHS believes to be an in-house, Sony-made device in the PlayStation 4. The Lite-On drive accounts for $32 of the Xbox One BOM.

The power supply on the Xbox One also represents a $25 cost for the Xbox One. Unlike the PlayStation 4 which featured an internal power supply, Microsoft adds bulk and cost by employing an external power supply for the Xbox One.

Table 2 attached presents major suppliers and components in the Xbox One.

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microsoft xbox one hardware cost comes in below retail price

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Microsoft Xbox One Hardware Cost Comes in Below Retail Price, IHS Teardown Reveals - IHS Technology

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The combined hardware and manufacturing cost of Microsoft Corp.'s new Xbox One amounts to $471, suggesting that Microsoft is subsidizing the cost of the video game console at the time of launch. The Xbox One carries a bill of materials (BOM) of $457, according to preliminary results from the Teardown Analysis Service at IHS Inc.

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Edgar Company Research Financial Statements

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Edgar Company Research Financial Statements

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