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By Carl Howe

Microsoft (NASDAQ:MSFT) said Thursday that it will write off $1.15 billion to extend the XBox 360 warranty to three years and reimburse owners for repairs. This program will address the phenomenon known to XBox 360 owners as the "red ring of death." Some have estimated that as many as one third of XBox 360's sold to date have failed. And the amount of money being allocated -- $100 per XBox 360 sold -- would allow Microsoft to replace every third XBox with a new base one at retail prices, so that estimate may well be accurate.

We're pleased that Microsoft is doing the right thing by their customers and making good on their commitment to reliable product. This exercise does prove, though, that building great consumer electronics products takes much more than lining up some smart designers and efficient Chinese contract manufacturers. Designing for reliability and manufacturability is an engineering art, and like any art, proficiency comes from long and usually painful experience. Despite Microsoft's claim from its Vista experience that creating software is hard, hardware is harder, and no amount of marketing can really get around that.

But that said, all is not well in XBox 360 land. If you look at the graph below Q2 2007 now is the second quarter in a row where XBox 360 sales have declined year over year, and Microsoft admitted in its statement Thursday evening that it fell short of its sales goals.

small-xbox360-7-07

And Microsoft was losing money hand over fist with XBox 360 before taking another billion dollars in warranty expenses. Microsoft's other hardware product out of this division, the Zune, appears well on its way to imitating the XBox 360 in falling short of sales goals and losing money to boot. The Nintendo (OTCPK:NTDOY) Wii, on the other hand, has sold 8.8 million units in just six months, will soon surpass the XBox 360 installed base with its family-friendly games and unique gameplay, and has done so profitably -- very profitably. And despite Sony's (NYSE:SNE) reputed lackluster sales of its Playstation 3 console, its sales rate worldwide is almost exactly what XBox's was a year ago when XBox was selling better, despite the PS3's higher price. So despite spending nearly nearly $21 billion on this business to date, more than the entire Gross Domestic Product of Costa Rica, Microsoft isn't dominating the gaming market any time soon.

The bottom line: Microsoft is learning some hard lessons about just how challenging it is to create good consumer electronics. At a billion here and a billion there, pretty soon these billions of dollars add up to real money. Shareholders would be right to ask how long they'll have to pay for Microsoft's tuition in the school of hardware knocks.

Full disclosure: The author has no positions in Microsoft, Nintendo, Sony, or Costa Rica at the time of writing.