Game Console Wars II: Nintendo Shaves Off Profits, Leaving Competition Scruffy

Includes: MSFT, NTDOY, SNE
by: Roger Ehrenberg

Gaming consoles and razors; games and razor blades. How many times have we heard this metaphor used to justify the losses taken on console sales in the name of making up this money and more on future game sales? I'll tell you - thousands.

And you know what, everyone in business school has done case studies looking at the razor/razor blade phenomenon, yet somehow all those brainiacs have forgotten a few basic principles when considering this model as an analog to gaming:

1. The relationship between the upfront cost of the unit and the ongoing cost of use.

So consider this. What does a razor cost? A high-end razor like the Gillette Fusion costs $9.99 at Let's say, conservatively, that Gillette breaks even on the sale of the razor as a stand-alone unit (after one fully loads the costs of packaging, PR, marketing, etc., though I'd hazard a guess that they actually make money on the sale of the razor). How much does it cost to purchase the smallest unit of blades for the Fusion? $12.99 for 4 at Ok, so do you have the relationship here - the smallest pack of blades available costs 30% more than the razor itself, or a ratio of upfront unit/ongoing unit cost of 0.8x. Not bad, Gillette. I guess that's why Warrent Buffett thought you were such a good investment.

Now let's consider the data on game consoles and games. I am taking price data from

  • Microsoft Xbox 360 console w/20 GB hard drive: $399.00
  • Microsoft Xbox 360 Halo 3 game: $59.99
  • Ratio of upfront unit/ongoing unit cost: 6.7x
  • Sony PS3 console w/60 GB hard drive: $599.99
  • Sony PS3 MotorStorm game: $59.99
  • Ratio of upfront unit/ongoing unit cost: 10.0x
  • Nintendo Wii console: List price $249.99 (asking price between $379-$395)
  • Nintendo Wii The Legend of Zelda game: $49.99 list (on sale for $44.95)
  • Ratio of upfront unit/ongoing unit cost: 5.0x
  • Hmm. So in the case of razors we're talking about a ticket to play (buying the razor) that actually costs less than the ongoing costs of playing (blade refills), far, far different than the relationship between gaming consoles and the games themselves. Also, let's consider that someone who shaves will most likely buy many, many more blade refills per razor purchased than gamers will buy games relative to consoles purchased. So from a business model standpoint, the razor/razor blade example kicks the console/game's ass by a wide margin. So much so, I'd say, that the metaphor is hardly applicable. But let's take this analysis one step further - let's consider the margins on the items themselves and not simply the relationship of their costs at the retail level.

    2. The relationship between cost to deliver the upfront unit and the value received for the unit

    Here, profit/loss is taken as the difference between the retail price of the unit and the cost to manufacture the unit based upon data extracted from the Internet:

  • Microsoft Xbox 360: loss of $126 per unit, from Gamespot
  • But as a result of increased production and marketing costs of the Xbox 360, on which Microsoft currently loses an estimated $126 per unit, its Home and Entertainment division found itself in an unenviable position. Despite the fact the division's quarterly revenue went from $571 million in 2005 to $1.056 billion in 2006, all its new income evaporated. Its quarterly operating loss went from $175 million in 2005 to $388 million in 2006.

    "While [overall Microsoft] revenue increased 13 perecent during the quarter, cost of revenue increased 49 percent, due primarily to Xbox 360 console volumes," Liddel told analysts. "The majority of the variance from our forecast was driven by strong Xbox 360 unit shipments, with the rest due in higher console costs."

    or maybe a loss as high as $300 per unit, from Joystiq

    Earlier numbers by Business Week may have reported that Microsoft is losing $126 on every Xbox 360 sold. That figure is now believed to be a bit higher by some. According to Insider Scoop, the world's largest software maker is losing upwards of $300 per console sold. From the article: "A high ranking friend at IBM, one that worked on the Xbox 360 chip design, tipped us regarding the real expenses involved in manufacturing the Xbox 360... 'It costs Microsoft approximately $715 to make, the manufacturing costs are still too high, another reason why they’re producing relatively small quantities.'”

  • Sony PS3: loss of $300 per unit, from Joystiq
  • What these figures show is that the fate of Sony's console lies in the circuits of two components: the Cell processor and the Blu-Ray drive. It's in Sony's interest to make sure that Blu-Ray drives and Cell chips are sold in vast quantities, which will lower prices and limit the amount of money that Sony will lose on each console. Of course we still don't know how much Sony will be willing to subsidize PS3s. Previous rumors have hinted that the PS3 will launch at $500. In other words, a $300 loss (corrected) on each console.

  • Nintendo Wii: profit of $92 per unit, from Kotaku
  • The Wii has been cracked open, its entrails spilled, its blood consumed and its organs dissected, categorised and sold off to the highest bidder. The market value for each is as follows:

    Graphics chip: $29.60
    CPU: $13.00
    DRAM: $7.80
    Optical disk drive: $31.00
    Power supply: $11.30
    Manufacturing cost: $19.50
    Cost total: $158.30

    Now I don't think Gillette is getting their face ripped off on the sale of the razor. Sure, they might not be making a bonanza, but they are certainly not digging themselves a deep hole out of which the need to climb to become profitable. This clearly isn't the story with our friends Mssrs. Xbox 360 and PS3, who are looking up at the sky from a deep hole from which they must climb in order to become profitable via game sales. NB: and what about Mr. Wii? He is smiling as game sales are just icing on the cake. But isn't this the way that Nintendo has generally operated - by not getting killed on the sale of the console and raking it in on the games. So, in short, it appears that Nintendo could be in the razor and blade business, but most assuredly not Microsoft or Sony.

    3. The profit dynamics of the ongoing costs of use

    Gillette manufactures those Fusion blades. It isn't paying royalties to someone for designing the blades, creating the tooling for the blades and packaging the blades. Ergo, its profit margins on blades ROCK. The amount of money it collects relative to the retail sales price is very high. Now let's consider game sales for the consoles mentioned above. Sony and Microsoft are heavily reliant on third-party titles; this is in their culture, their business model, their DNA. This contrasts markedly with Nintendo, which has tightly integrated their hardware and software development, creating a seamless union between the two that is unrivalled in the gaming world. This also has a pronounced impact on revenues, as in-house titles are far more profitable than third-party titles, for which the console manufacturer might only garner 10-15% of the price of the game. So, to be clear, it's not all about TIE ratios. It's about the composition of the TIE ratio - first-party vs. third-party. Again, Nintendo is the only one that follows the razor and blade metaphor while Microsoft and Sony are operating a completely different business model. Consider this perspective from

    Why shouldn't Nintendo follow SEGA's example, then, and leave the CPU and GPU arms race to the multinational giants with cash to burn?

    The simple answer is because "The Nintendo Difference" isn't just a cunning marketing slogan; Nintendo genuinely is different. Its structure and business model are a radical departure from how every other company in the interactive entertainment industry works, and the comparisons between Nintendo and SEGA are merely skin deep.


    Nintendo's entire philosophy is focused on the platform - not on hardware or software as separate entities or businesses, but as the platform as a whole. Unlike Sony and Microsoft, where it's apparent that Chinese walls have been erected between the designers of the hardware and the creators of first-party software, Nintendo actually places its top software designers at the helm of hardware design. Consoles are designed to suit the game concepts which will run on them - a working model which is apparent in the design of both the Nintendo DS and the Wii, and which allows the company to create early first-party titles that really showcase the hardware.

    This top-down approach, which creates consoles based on the games that will run on them, is the antithesis of Microsoft and Sony's approach, where the design comes from the bottom up - first creating a console and then worrying about what games will run on it. It gives Nintendo an enormous competitive advantage that wouldn't be evident if it were a third-party publisher, and allows its top first-party software to innovate and evolve in ways that would be impossible on another company's hardware. It's also the approach that has informed the decision to restrain the specifications of the Wii - and indeed the DS - to a manageable level, which allows development to take place faster and less expensively than on rival consoles.

    These factors combine to make Nintendo into the company it is today - a company whose low development costs, tight integration between hardware and software and enormous profit margins allow it to take creative risks, drive forward innovation and promote the growth of the gaming market as a whole. Without Nintendo's unique business model and first-party status, games like Nintendogs, Brain Age, Animal Crossing and Wario Ware simply could not exist; they either rely heavily on the hardware which supports them, or are so far off the beaten track that creating them on a system with higher development costs and lower profit margins would be commercially untenable.

    And to reinforce the point, here is an interesting extract from ProductWiki as it relates to an analysis of NPD Group numbers:

    Looking at Nintendo's numbers it's instantly obvious that Nintendo takes the lion's share of the game sales on their platforms. On the Playstation platforms the game sales are substantially more spread out. Take note that these numbers are from 2001, but there's been very little that's happened over this generation that changes these things, except for Sony's growth.

    So, in a nutshell, Nintendo is shaving away while Microsoft are Sony are getting positively scruffy. They can't yet buy a razor to shave that beard. That's what you get for living in the bottom of a hole. Better to start on top and keep on climbing.

    NTDOY.PK vs. SNE vs. MSFT 1-yr chart:

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