What will happen if Microsoft cuts XBox One Price by $100

A security analyst from Wedbush securities thinks Microsoft must cut its XBox One price from $499 to $399. The reason? Market share and possible revenue from increased footprint.

“The reason Sony beats Microsoft is solely the price,” Michael Pachter, a technology analyst with Wedbush Securities said.

Speaking at the Game Monetization Summit in San Francisco, the outspoken analyst predicted that the PS4 will go on to sell between 100 and 120 million units, compared with around 90 million Xbox One consoles he says will be sold during the device’s lifecycle.

He added: “Microsoft loses the next generation unless they cut price. If Microsoft drops its price to $399, I expect the sales to be equal to the PS4.”

By his numbers the total market (let us ignore Wii here) is  210 million units (using 90 and high end of 100-120 million estimate). And if his prediction of XBox One  sales equalling PS4 comes true, each would garner 105 million units over their device lifecycle (sic).

With $100 price cut, Microsoft would lose $9 billion in pure profit (that is the $100 per unit lost on 90 million units). It would gain 15 million more units because of the price cut. Let us assume at $399 price tag they are breaking even on the device.

That means those 15 million units need to make up for the $9 billion profits lost from the price cuts. That is $600 in lifetime profit (not revenue) from each of those 15 million units. Let us give a generous gross margin of 50% on games, media, royalties, add-ons and other subscriptions sold from those additional 15 million units. That comes to $1200 revenue per customer over their lifetime.

If an average user holds on to a device for 5 years (generous estimate), that is a $240 per year spend on games and extras. How realistic is that? How about we try to test this by using these numbers to estimate the entire market.

If these 15 million new customers can generate $240 revenue per year so can every one of the 105 million customers. So total incremental sales from games and extra from 115 million Xbox one customers  will be $27.6 billion a year.

$27.6 billion a year for Microsoft alone just from games and extras while the entire video game market including consoles and software is $66 billion a year (growing just 2% a year).  And as a reference Microsoft made $10 billion in total revenues (including consoles, gaming software, accessories and royalties).

Now you tell me if Microsoft should listen to the analyst recommendation of $100 price cut for capturing future bigger profit?

 

 

Cost Allocation Trap

Businesses, small and big are almost obsessively focused on allocating a portion of every cost incurred to every unit produced. The distinction between sunk costs and  marginal cost is lost on them. Costs that are incurred regardless of volume produced are spread over units produced. For example, a Cupcake business allocates a portion of the mortgage, insurance and other fixed charges to each cupcake.

The problem is complicated by the way these businesses set pricing, they simply tack on an artificial margin to come up with unit price

Cost Based Pricing: Unit Price = Unit Cost * (1+ % Unit Margin ) (WRONG!)

There is no logic behind the % Unit margin, it is either based on what competitors are reporting or a magic number someone comes up with. An arbitrary number that has no meaning and no indicator of absolute profit becomes the number everyone in the organization works towards. No effort is spared to protect  (and increase)  % Unit Margin leading to drop in absolute profit.

The net result is the business has no way of knowing what the market demand is and how the market will react if they were to change prices. Due to their fixation on protecting he % margin they end up selling at the wrong price and losing out on the absolute profit. Since the unit cost is wrong to start with the % margin leads to higher prices. In addition, in this method of cost allocation, any increase in volume will reduce unit cost and any decrease in volume will increae unit costs (because fixed costs are spread over more units).

Increasing market share requires them to produce more unit and it also helps with reducing unit cost. So they produce more, flood the market and end up discounting heavily, destroying the very margin they were trying to protect.

Businesses are reluctant to give up market share in favor of profit because producing less “eats into % margin”. When business have high market share and operating at near full capacity, the unit cost is at its lowest. Due to the incorrect cost allocation, higher market share is wrongly associated with higher % margin. So businesses spend all energy in defending market share.

If the demand shifts down (due to recession), businesses are reluctant to  reduce volume produced because the decrease in volume increases unit cost and hence “eats into % margin”.

This is the same reason businesses are reluctant to increase prices because any price increase leads to lower volume which affects unit cost and % margin.

What starts as cost allocation mistake leads businesses down the wrong path of protecting market share and % margin.

The Convenience of Conventional Wisdom

There is considerable comfort in knowing we are not alone – be it in our ideas or actions. The comfort comes from the challenges in objectively evaluating the merits of an idea to make an informed decision.When we see many others adopting an idea – especially in the social media- we treat that as mental shortcut for adopting it.  Not all the people who follow an idea or a Guru  can be wrong, can they?

On the flip side, when we see someone going against the flow – taking decisions that do not fit our accepted norm, the conventional wisdom, then we tend to see that as risky or worse, foolish.

It is crazy to raise prices in recession: Almost everyone wrote off Starbucks for increasing prices.

It is risky to cut on inventories: NYTimes described the move by luxury retailers to cut inventories as risky.

It is stupid to give up market share: Almost all stock analysts ding companies that give up market share to maintain price premium.

If it does not fit the conventional wisdom it must be wrong.

In his book The Affluent Society, Galbarith first introduced the concept of Conventional Wisdom. He wrote,

In the never ending competition between what is right vs. what is merely acceptable, even though strategic advantage lies with the former all tactical advantage is with the latter. Acceptance comes from convenience, because finding what is right is hard and not convenient. Ideas that are familiar are easy to accept because everyone does it and end up having great stability.

Decision making is not a popularity contest. If it is just about following what is accepted, familiar, (Re-Tweeted the most) and convenient where is the competitive advantage?

Are you ready to leave the convenience of conventional wisdom and do the hard work of evaluating ideas on their own merits regardless of who said it and how popular it is?

Profit Share Over Market Share

In the mobile phone market there is almost no correlation between market share and share of the total profit. On one hand we have Nokia that has 45% market share and 59% share of total profit and on the other hand is Apple with 20%  profit share with less than 2% of market share. In the middle there is Sony Ericsson has 10% market share with almost no profit to show for.

Now both Nokia and SonyEricsson are  doing something about it:

Both companies aim for their coming launches to primarily boost profit margins rather than market share.

Nokia also hopes to boost its gross margin and profit by launching an increasing number of touch-screen and full-keyboard devices, Mr. Simonson told Dow Jones Newswires. He added that those efforts would be more important than gaining market share.

This is positively good sign and points to return to what the business should have always focused on – profits not market share.

Instant Coffee Price Is About Skimming

Update 8/19/2010: Via sales stands at $100 million

Instant coffee may be a $21 billion market but Starbucks’s new instant coffee Via is definitely not about taking a share of the revenue.

A trio of single-serve Via packets will sell for $2.95 in the United States and 12 packets will sell for $9.95. Those prices are significantly higher than Nescafe’s Taster’s Choice single-serve packets that sell in Los Angeles for roughly $1.50 for six and around $4 for 20.

At $1 per serving, Via is  four times the price of the market leader, Nestle. Via is priced for profit, not for capturing market share.

Nestle’s overall margin of 12% tells us the upper bound of overall market profit is $2.4 billion. For Via, the cost per serving cannot be any more than twice the retail price of a serving of Taster’s choice (assumption). Conservatively we can assume Via has 40% margin. Starbucks will be more than happy to get just 3% or so market share. How will Via get  its 3% market share? It comes from two sources. One, there always exist a segment that wants premium instant coffee and is willing to pay premium price. Two, by bringing in new customers who have not tried instant coffee before (some of these will be ex-Starbucks customers who stopped visiting the coffee shops).

If Via gets 3% of the $21 billion market, that is $630 million in revenue and $250 million in profit. That is, at 3% market share Via will gain 10% of the market’s total profit. That is not that different from the strategy of Apple and Blackberry that have 30% of the mobile phone profit share with less than 3% of market share.

Pricing Via is about skimming profits not market share and a very prudent one.

PS3 Price Drop Not A Game Changer

Sony was used to being the market leader in gaming consoles prior to PS3. Their previous model, PS2 sold 138 millions units worldwide, far ahead of Microsoft’s XBox and Nintendo’s Gamecube. That all changed in the next generation of gaming consoles. Now Nintendo, with its Wii and its  innovative wireless controller is the leader with 50 million units sold in the three years since its introduction. Sony managed to sell only 24 million units so far.

In an effort to drive up its market share, Sony cut the price of PS3 by $100. Technically it is on a different model they introduced called PS3 Slim.  Is this a good profit maximizing move?Is low market share a concern that requires such drastic price cuts?

I have written before the need to focus on profit share over market-share. In the case of gaming consoles, it is a platform market. The sale does not end with the console rather starts with it. There are many revenue opportunities from sale of games and accessories over the lifetime of the console. Now there is also a new opportunity for subscription revenue from online gaming. It is not enough to just look at gross margin on the hardware, we should include margins from all the complements. In other words, the customer margin.

Larger the market share, larger is the number of games available for it as more developers will commit to developing games for that platform. With marker leadership comes exclusivity. A console maker can convince the game developers to  make certain popular games available only for their platform, at least for a limited time. But this has not been the case lately as Financial Times reports

With many third-party game developers no longer willing to make games exclusive to PlayStation, Sony has also suffered from a lack of hits by its in-house games division compared to Microsoft’s success with its Halo franchise, Mr Baker said.

Suppose we assume the gross margin on the new PS3 is $120 per console. Assume that at current market share and growth rate the incremental margin from sale of games and accessories over the lifetime of the console is $150.  So the total customer margin today is $270. With the price cut of $100  and the expected increase in market share from it, let us assume that the incremental margin per unit goes from $150 to $200. There is however  no reason or data to believe this, given the point made by Mr.Baker in  the FT.com story.  So the total customer margin in the new case is ($120-100+$200) $220.

Sony will be  losing $50 in customer lifetime value per unit sold with its price cut. To make up for it, its sales have to increase (over its current sales rate) by  50/220 = 23%.

The price cut would have given them competitive sales advantage only if Microsoft and Nintendo could not do the same. But it is not the case. Microsoft cut its prices by $100 and Nintendo might do the same (although doubtful).

Microsoft acted to consolidate its lead over Sony in the current generation of games consoles as it cut the price of its top-end Xbox 360 on Thursday to counter a similar move last week by its Japanese rival.

It is now questionable whether Sony can deliver a sales increase of 23% from its price cut. Note that this number will be much higher if the customer margin numbers we used are lower.

The net is, price cut is not going to be a game changer for PS3 sales.