EVOLUTION OF THE XBOX SUPPLY CHAIN

With the first generation of Xbox, our ambition was to change the way people think about video games. Starting today with Xbox 360, our ambition is to transform the way people play games and have fun.

óRobbie Bach, President of the Microsoft Entertainment and Devices Division1

In November 2005, Microsoft prepared to launch its next-generation video game console, the Xbox 360. A global release was scheduled, beginning on November 22 in North America, followed shortly by Europe (December 2), and Japan (December 10). It had been four years since Microsoft had introduced the original Xbox. The first Xbox had hit the U.S. market a year behind Sony ís PlayStation2, but this time Microsoft expected to beat Sony ís next-generation system to market by many months.

The Xbox 360 would provide a substantial increase in performance for gamers. Its processors were so powerful that graphics would appear virtually lifelike, and would run on high definition televisions. When used with Microsoft ís Xbox Live Web service, the Xbox 360 would enable gamers to play multi-player games online. The system could also be used as the base of a family ís home entertainment system, taking advantage of its high definition DVD player. Demand for the new system was expected to be heavy. The challenge would be for production to meet the demand.

THE VIDEOGAME MARKET

In 2005, the global market for video games was approximately $27 billion, consisting of $6.7 billion in console sales, and $20 billion of software (games) (Exhibit 1). Sony dominated the market, with cumulative sales through December 2004 of 102.5 million PlayStation 1 (PS1) consoles and 87.5 million PlayStation 2 (PS2) consoles. Microsoft had sold 19.9 million Xbox consoles, slightly more than Nintendo had sold of its GameCube (Exhibit 2). Of the current

Evolution of the Xbox Supply Chain GS-49 p. 2

generation systems, which used 128-bit technology, (PS2, Xbox, and GameCube), Sony had 67 percent share, Microsoft had 17 percent, and Nintendo 16 percent.2

Several factors contributed to Sonyís dominance in late 2005. By the time the first Xbox was released, Sony had gained a substantial head start. Not only was the PS2 available 12 months before the Xbox in the U.S., the PS1 was also well established. As a result, there was a substantial number of games available for the Sony consoles, compared with those ready when the Xbox was released. In addition to confronting Sonyís substantial brand presence, the design of the Xbox had faced resistance in markets such as Japan, where users criticized it as unattractive and considered the game controller as too large.3 (The Xbox share in Japan was less than 1 percent, dramatically less than its share worldwide.)

Microsoft hoped to overcome these problems with the Xbox 360. After four years in the market, the company had established a presence, and was no longer a newcomer. Microsoft enlisted a number of top game design firms to develop games for the new product. It had used an outside design firm to create an attractive look for the product. Microsoft also expected that subscriptions to Xbox Live, a Web service in which users could download games and participate in online games, would be a highly profitable business, as many customers now had broadband Web connections. And, it was going to be the first to market with the next generation game consoleóperhaps by a substantial margin.

THE EVOLUTION OF VIDEO GAME CONSOLES

The initial video game consoles were introduced by Sony, Sega, and Nintendo in 1994. These were based on 32- and 64-bit processors, and used to play relatively simple games. The most successful manufacturer of first-generation video games was Sony, with its PS1. The Nintendo 64 trailed the PS1, while the Sega Saturn failed in the marketplace.

Second Generation Video Games

Sega introduced the next major technology advance in videogaming in 1999, when it launched the Dreamcast. The system sold well initially, but sales fell rapidly when Sony introduced the PS2, and Sega eventually exited the market. This second generation of consoles was a major technical advance, using a 128-bit processor. Sonyís PS2, launched in March 1999 in Japan, and in the U.S. in October 2000, sold extremely well despite production and delivery delays which limited supply to the U.S. market. The Xbox, launched in the U.S. in November 2001, used more advanced technology than was offered by Sony, but Microsoft did not have the established base of games and gamers that Sony enjoyed, and Sony continued to dominate the market.

The Development of the Xbox

Microsoftís Xbox project began in early 1999 when a group of Microsoft employees with videogame backgrounds began to explore the possibility of creating a game console. At thе time, Microsoft offered PC-based games, but personal computers had to be able to handle a wide range of applications, and thus were not optimized for videogaming.

While the gamers were trying to get Microsoft to develop a console, Microsoft management was also concerned that consoles such as the PS2 threatened the company ís home PC business. Developing a high-performance console, with a considerably lower sales price than a PC, might solidify Microsoft ís position in the home.

The group of gamers (referred to as ìrenegadesî by Dean Takahashi in his history of the Xbox project, Opening the Xbox: Inside Microsoftís Plan to Unleash an Entertainment Revolution) worked on their own to define a game console, including meeting with potential critical component suppliers. They made their initial proposal to Bill Gates on May 5, 1999, including a preliminary estimate of parts costs. The proposal was for a product that would leapfrog Sony, offering superior performance, and including a built-in hard disk drive that would enable online gaming and downloading of games and game enhancementsóin contrast to the PS2, which did not offer a hard drive, but at the time was considering one as an add-on. The console would also include a broadband Internet connection, despite the fact that broadband was available at relatively few homes at that time. The early plan anticipated sales of 1.8 million units in 2000, growing to 30 million in 2005 (at which time Microsoft would have a 35 percent market share)4 The project was legitimized as a business by the appointment of an executive to lead it in July 1999.

The Xbox team included potential suppliers in its planning from the beginning. Flextronics, a potential contract manufacturer of the Xbox, provided cost estimates and advice long before contract negotiations began. Nvidia, a leading developer of graphics chips, also provided cost and technical advice. In considering potential manufacturers, the Xbox team approached PC companies, such as Dell, since the Xbox was basically a computer. Discussions with the computer makers made it clear that the computer business model was inconsistent with manufacturing game consoles. Console makers typically lost money on each box, but made profits on selling games. Cutting prices on consoles made them more attractive to consumers, driving more game sales. Computer makers, on the other hand, had to make money on hardware sales. As Michael Dell explained:

When Sony cuts prices on its PlayStation, their stock price goes up. Every time I cut prices, my stock price goes down. If you donít understand why that happens, you donít understand the console business. I understand why [the Xbox] is strategic to Microsoft. I donít understand why [it] is strategic to Dell.5

Two factors were critical to profitability in the console business: driving costs down, and game sales. Microsoft estimated that the original PlayStation cost Sony $450 when it was launched, but just $80 five years later. Sonyís initial sales price had been about $300, decreasing to $99 after five years.6 Unlike computers, where performance typically increased dramatically, but prices stayed relatively constant, consoles maintained constant performance while costs decreased. As the project line matured, the loss on each console decreased, and eventually the manufacturer generated a profit on console sales.

This model fit well with the use of contract manufacturers to produce the consoles, and Microsoft began discussions with potential suppliers, eventually selecting Flextronics to build the consoles.

The Xbox would have over 1,000 components, of which about 45 were critical, either because of cost or because they were only available from single suppliers. One of the most important choices was the graphics processor, which was essential to the product performance. Sony had spent $1 billion to build a plant to manufacture its own graphics chip, enabling it to control its own destiny and reap all the benefits of future cost reduction.7

Microsoft leaned toward purchasing graphics chips from Nvidia, the preferred choice of game developers, despite a relatively high cost. In addition to considering other graphics chip companies, Microsoft also considered having its WebTV unit license technology and design the chip in-house. The chip could then be manufactured by a contract chip fabrication company, allowing Microsoft greater control over costs. Microsoft went so far as to promise a substantial investment in a new graphics chip company, GigaPixel before finally deciding to buy chips from Nvidia. (Microsoft did follow through with the investment, however.) They chose Nvidia because they believed that a reliable supply was more critical than obtaining the lowest possible cost. Nvidia had the best performance, and an excellent record of on-time development and delivery. GigaPixel was unproven, and did not have the available capacity to develop the chip. The eventual Nvidia contract included a maximum margin per chip, and decreasing maximum prices based on cumulative volume.8

Another critical component was the microprocessor, for which Intel and AMD were the competitors. AMD had been the front-runner through much of 1999, as it was eager to increase capacity, while Intel had dominated the market and took a hard line on prices. However, during the year, AMD introduced the 600 MHz Athlon processor, which did very well in the market, using up all of AMDís capacity. In order to make chips for the Xbox, AMD would need to add capacity, and wanted Microsoft to provide about $400 million for that purpose, plus a $300 million guarantee on chip purchases. AMD also increased its price. On the other hand, Intel had available capacity, and came down in price (though not as low as AMD), with prices declining each year. In March 2000, Microsoft signed with Intel to provide chips for the Xbox.9

In addition to manufacturing the Xbox, Flextronics also provided mechanical designers that helped with parts specifications. Parts procurement was handled in one of three ways. Commodity parts were purchased directly by Flextronics, which often used the same parts for many OEM products, and thus purchased in very high volume. For some custom designed parts, such as the controller, Microsoft negotiated the contract with the vendor, and Flextronics ordered the parts against the Microsoft contract. For parts such as the microprocessor and graphics chip, Microsoft purchased the parts from the vendor and delivered the parts to Flextronics.10

In December 1999, Microsoft decided that it would delay the launch of the Xbox from the fall of 2000 to the fall of 2001. A 2000 launch would force the company to use technology that did not offer a substantial improvement on Sonyís PS2, which was scheduled for launch in spring 2000. By waiting, Microsoft would be able to incorporate much faster graphics and microprocessor chips, offering dramatically better performance than the PS2. The delay, however, added the risk that Sony would solidify its position, making it harder for the Xbox to gain market acceptance.11

When the Xbox was launched in November 2001, it used Intel ís 733 MHz Pentium III chip as its central processor, with a 250 MHz Nvidia graphics processor. The Xbox also had a DVD player, 64MB memory, an 8 GB hard drive, and built-in broadband modem for Internet access.12 The system processed 116 million polygons per second, the critical measure of graphics performance, compared to 66 million for the PS2.13

Xbox Manufacture

In November 1999, Flextronics recommended producing Xboxes in a plant in China in order to minimize costs. Microsoft, however, wanted plants close to customers due to shipping concern sо Microsoft wanted to be able to replenish supply quickly. Sony had experienced delays in replenishing U.S. supply, which had to be shipped from Asia. In January 2000, Microsoft reached an agreement with Flextronics to build the Xbox, using its industrial parks in Mexico and Hungary.14

When the decision was made, Flextronics was the fourth largest EMS company with $4.3 billion in revenue, behind Solectron, SCI Systems, and Celestica. One of Flextronics unique features was its industrial park concept, which improved supply chain efficiency.15 The company obtained land, built a production facility, and invited selected vendors to locate their facilities in the park. Co-locating greatly reduced shipping costs to Flextronics and improved information flow between Flextronics and its vendors.

When the Flextronics began work on the Xbox program, it had industrial parks in Hungary, China, and Mexico. The Guadalajara, Mexico industrial park was designed to supply the Xbox to North America, and the park in Hungary would supply the European market. In Guadalajara, Flextronics dedicated a section of its industrial park to the Xbox. The park operated around thе clock, seven days a week to meet the production volume requirements, with supplies continually arriving, and one tractor-trailer full of completed Xboxes leaving every two hours.16

Flextronics planned to begin production on June 15, 2001. However, the system design was not stable enough to begin production in June. The Nvidia graphics chip had to go though several revisions, with prototypes produced at a contract fabrication facility in Taiwan, tested and modified in California, then remade and retested. Eventually, the chip met all specifications by itself, but the overall system was still unstable, crashing frequently. An incorrect power supply specification was discovered, and was readily fixed.17

As a result of design delays, production didnt start until September 2001, with Flextronics Mexico plant coming on line first, and reaching capacity in just over one month. The Hungary plant, benefiting from the Mexico experience, was at capacity within 3 weeks. Both plants produced 175,000 units weekly, more than the original expected capacity, and sufficient for product launch in November.18

Game Development

The other essential element was creating games, since that was the reason customers bought consoles, and was the profit driver for console companies. Console manufacturers made money from game sales in two ways. They sold their own games, either developed in-house or by others (first party games), or independent game publishers sold games (third party games) and paid a royalty for each game sold (typically about $7 per unit). Microsoft had in-house capability, as it developed games for the PC. For PC games, however, there was no royalty, which led to a flood of games, most of which were poor quality. Microsoft originally planned not to charge a royalty to independent game developers of Xbox games, figuring that would foster game development. However, developers actually encouraged royalties, as that was a way to limit the number of games, ensure that only high-quality games were produced, and improve the visibility of each game. Royalties also were essential to a profitable business model, so Microsoft charged royalties for third party games.

Microsoft actively recruited game developers to create Xbox games, and bought some game companies to make first party games. Third party game developers submitted their plans to Microsoft, which decided which games it would license. At the U.S. launch, there were 19 titles available, of which 5 were first party games. For each Xbox purchased between launch and the end of 2001, consumers bought more than three games, with the best selling game, Halo, selling over 1 million copies. There were many other games in development, both internally and by third party developers. (By the end of 2001, there were 220 PS2 titles available, and Sony was generating a profit.)19