Evolution of the Xbox Supply Chain

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C ASE : GS-49 D ATE 04/14/06 David Hoyt prepared this case under the supervision of Professors Charles Holloway and Hau Lee as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright ' 2006 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: cwo@gsb.stanford.edu or write: Case Writing Office, Stanford Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means °° electronic, mechanical, photocopying, recording, or otherwise °° without the permission of the Stanford Graduate School of Business. E VOLUTION OF THE X BOX S UPPLY C HAIN 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. °Robbie Bach, President of the Microsoft Entertainment and Devices Division 1 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±s PlayStation2, but this time Microsoft expected to beat Sony±s 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±s 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±s 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. T HE V IDEOGAME M ARKET 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 1 Jay Greene, ²Robbie Bach is Ready to Rumble: The Honcho of Microsoft±s Xbox 360 Heads for a Bare-Knuckles Brawl with PlayStation,³ Business Week , November 28, 2005, p. 54. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

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 Sony±s 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 Sony±s 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 console°perhaps by a substantial margin. T HE E VOLUTION OF V IDEO G AME C ONSOLES 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. Sony±s 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 Microsoft±s 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 the 2 Christopher Russ and Andrew Kohl, ²Company Note: MSFT: Assessing the Impact of Xbox 360,³ Wachovia Capital Markets, LLC Equity Research Department, May 17, 2005, p. 4. 3 Robert Guth, ²It±s Xbox 360 vs. PlayStation 3, and the War Is About to Begin,³ The Wall Street Journal , May 9, 2005, p. B1. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

Evolution of the Xbox Supply Chain GS-49 p. 3 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±s home PC business. Developing a high-performance console, with a considerably lower sales price than a PC, might solidify Microsoft±s position in the home. The group of gamers (referred to as ²renegades³ by Dean Takahashi in his history of the Xbox project, Opening the Xbox: Inside Microsoft±s 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 enhancements°in 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 don±t understand why that happens, you don±t understand the console business. I understand why [the Xbox] is strategic to Microsoft. I don±t 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. Sony±s initial sales price had been about $300, decreasing to $99 after five years. 6 Unlike computers, where performance typically increased dramatically, but 4 Dean Takahashi, Opening the Xbox: Inside Microsoft±s Plan to Unleash an Entertainment Revolution , (Roseville, California: Prima Publishing, 2002), pp. 103-107. 5 Ibid. p. 168. 6 Ibid., pp. 18, 184. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

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Evolution of the Xbox Supply Chain GS-49 p. 4 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 AMD±s 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 7 Ibid., p. 98. 8 Ibid., pp. 198-211. 9 Ibid. pp. 212-215. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

Evolution of the Xbox Supply Chain GS-49 p. 5 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 Sony±s 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±s 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 concerns°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 the 10 Parts procurement by EMS companies is described in more detail in Stanford Graduate School of Business case OIT-35: Flextronics: Supply Chain Relationships in the EMS Industry , pp. 13-14. 11 Takahashi, Opening the Xbox , op. cit. pp. 183-186. 12 Hau Lee, Microsoft²Xbox Launch and Supply Chain Readiness , Stanford Global Supply Chain Management forum case SGSCMF-003-2003, July 28, 2003, p. 5. 13 Takahashi, Opening the Xbox , op. cit. pp. 220, 270. 14 Ibid., pp. 196-197. 15 The Flextronics industrial park model is described in detail in Stanford Graduate School of Business case OIT-35: Flextronics: Supply Chain Relationships in the EMS Industry . For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

Evolution of the Xbox Supply Chain GS-49 p. 6 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 didn±t 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 (²first party³ games), or independent game publishers sold games (²third party³ 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 Xbox Launch The Xbox was launched in the U.S. on November 15, 2001, selling 1.5 million units by the end of the year. The selling price was $299, the same as the price of Sony±s PS2. 16 O±Brien, op. cit. 17 Takahashi, Opening the Xbox , op. cit. p. 313. 18 Ibid., pp. 315, 320. 19 Ibid., pp. 321, 335, 336. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

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Evolution of the Xbox Supply Chain GS-49 p. 7 On May 14, 2002, Sony reduced the price of the PS2 console from $299 to $199. Microsoft matched Sony±s price the next day, and also reduced price in other markets. 20 Even with a price of $299, analysts estimated that Microsoft was losing about $100 on each unit sold at launch. 21 That same month, Flextronics announced it was moving production from its industrial park in Hungary to its industrial park in Doumen, China, in order to reduce costs. 22 On September 2, 2002, Microsoft announced that Wistron Corp. would become its second producer of Xboxes. Wistron was the manufacturing arm of Acer Inc, a Taiwanese computer company. Wistron would build Xboxes in its Zhongshan, China plant, providing incremental volume and helping support the Xbox rollout into additional countries. 23 In October 2001, shortly before the Xbox launch, Microsoft announced that Solectron, then the largest EMS company would provide after-sales service and support for the Xbox. In addition to playing games, the Xbox could be used to play DVDs and as an Internet access device. A web service, ²Xbox Live³ which customers could use to download games, which was launched by Microsoft in October 2002. The Xbox established Microsoft±s presence in the videogame market, but by the time of the announcement of the Xbox 360, it had lost a substantial amount of money. One analyst estimated that from the time of the original Xbox launch in November 2001 to the time of the announcement of the Xbox 360 in May 2005, the product had accounted for $6.1 billion in revenues and generated $4.4 billion in operating losses. 24 Others estimated that annual losses were about $1.2 billion. Game sales had not yet reached sufficient volume to generate margins that overcame the losses incurred on console sales. Third Generation Video Game Consoles: Xbox 360 and PS3 The new generation of video game consoles represented a dramatic technical advance. These consoles would have dramatically increased processing power and speed, allowing games to be presented in very high definition. They also incorporated a substantial amount of memory, which would be required due to the high data content of new games that would take advantage of the enhanced processing and graphics speed. These systems would provide a greatly enhanced experience for gamers, but to take advantage of this power would require a much greater effort on the part of game developers. The Xbox 360 central processing unit used three separate core processors, each running at 3.2 GHz, compared to the single 733-MHz processor of the original Xbox. For graphics, the Xbox 20 ²Nintendo Becomes Lone Holdout Among Console Makers,³ Consumer Electronics , May 20, 2002. 21 Russ and Kohl, op. cit., p. 3. 22 Joint Microsoft and Flextronics press release, ²Microsoft and Flextronics to Open Xbox Manufacturing Facility in China,³ May 15, 2002. At the time of the announcement, the Xbox was available in North America, Japan, Europe and Australia. 23 Microsoft press release, ²Microsoft Names Wistron as Second Manufacturing Partner for Xbox,³ September 2, 2002. 24 Russ and Kohl, op. cit., p. 3. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

Evolution of the Xbox Supply Chain GS-49 p. 8 360 used a custom designed processor, running at 500 MHz. For gamers, this meant that the console could create high definition graphics that were nearly lifelike. The new system was designed to work with high definition televisions. Sony±s PS3 would have even more power than the Xbox 360, using more advanced technology, which was also riskier. In particular, it would incorporate the ²cell³ microprocessor, which Sony had developed together with IBM and Toshiba, and the ²Blu-ray³ optical disc which it developed in partnership with Panasonic and other companies. Sony had invested about $2 billion into the cell technology, which promised to be 35 times as powerful as the CPU in the PS2, with 2 teraflops of computing performance (compared to the fastest IBM supercomputer at the time, with 36 teraflops). The graphics processor in the PS3 would also provide higher resolution than the Xbox 360. 25 Blu-ray was one of two competing formats for high-definition DVD. Sony hoped that including Blu-ray in its PS3 consoles would seed the market, and help establish the technology as the standard. 26 However, Blu-ray was complex and expensive, with first generation units expected to cost $1,000, forcing Sony to heavily subsidize the cost in its PS3 sales. The other technology, HD-DVD, developed by Toshiba, was simpler and less expensive. Blu-ray discs would hold 25 gigabytes of data, compared to 15 gigabytes on the Toshiba format and 4.7 gigabytes on existing DVD discs. Microsoft initially did not take a position on high definition formats, but in September 2005 announced that it would support the Toshiba HD-DVD. This led a number of other major companies to either support HD-DVD or withdraw support for Blu-ray. Microsoft introduced the Xbox 360 with a standard DVD player, but planned to include HD-DVD players in the Xbox 360 by late 2006. 27 Microsoft offered two versions of the Xbox 360. The ²core³ system, selling at $299 in the U.S., included the Xbox 360 console, a wired controller, cables, and an Xbox Live Silver membership. The ²premium edition,³ with a price of $399 in the U.S., consisted of an Xbox 360 console, wireless controller, detachable 20 GB hard drive, Xbox Live headset, Xbox Live Silver membership, and Ethernet cable. Internet access had been an important part of the Microsoft gaming strategy beginning with the original Xbox, and was an area in which the company had a competitive advantage. The Xbox Live Silver membership allowed users to access online games, and to buy game add-ons, such as new game levels. For an annual subscription fee, users could purchase Xbox Live Gold membership for $50 per year, which allowed them to play multi-player games developed exclusively for Xbox Live Gold subscribers. At the time of the Xbox 360 launch, there were 25 Russ and Kohl, op. cit., p. 5. 26 After introducing the PS2 in Japan, Sony found that initial game sales were slow, due to the fact that many consumers bought the unit as a DVD player, as it was much less expensive than the stand-alone DVD players then on the market. Takahashi, Opening the Xbox , op. cit. p. 257. 27 Ken Belson, ²In Sony±s Stumble, The Ghost of Betamax,³ The New York Times , February 26, 2006, Section 3, p. 1. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

Evolution of the Xbox Supply Chain GS-49 p. 9 already 2 million subscribers to Xbox Live, at $50 per year. 28 Peter Moore, the Microsoft vice president responsible for Xbox marketing, commented, ²We truly believe the future of gaming is online ´ bringing together massive communities from around the world to play or just hang out.³ 29 Xbox 360 Design and Production For the Xbox 360, Microsoft planned to use its existing EMS suppliers, Flextronics and Wistron, to provide the initial production requirements. A third EMS, Celestica, was scheduled to begin production in early 2006 from a new facility in China. 30 Microsoft applied a number of lessons learned from the original Xbox when designing the Xbox 360. The original product, designed in-house, had been criticized for its poor appearance and large controller, factors that hurt sales, particularly in Japan. For the Xbox 360, it outsourced design to Astro Studios in San Francisco, which developed a small, elegant machine. 31 Microsoft contracted with chip companies so that it owned the designs of the critical Xbox 360 chips, and would be able to go to any contract chip manufacturer in order to continually reduce costs. Intel and Nvidia, the suppliers of the processor and graphics chips used in the initial Xbox, resisted this approach. Microsoft signed up IBM to design the processor chip, with IBM developing a three-core chip by the December 2004 deadline. ATI designed a unique graphics chip, also completing the task by the end of 2004. 32 The overall product design, incorporating more than 1,000 parts, was primarily done by the engineering team that Microsoft had acquired when it purchased WebTV in 1997, which had extensive experience in console design. Microsoft also brought its existing Xbox manufacturers, Flextronics and Wistron, into the design process so that they could design production to be optimized for the Xbox 360. Xbox 360 production was anticipated to involve more than 10,000 workers in China. Once produced, the products would be transported by ship to North America, Europe, and Japan. 33 28 Configuration and Xbox Live subscription data from Adam Holt, ²MSFT: The Xbox Playbook,³ JP Morgan North American Equity Research , November 21, 2005, pp 2-3. 29 Associated Press, ²Microsoft Reveals Xbox 360; Next Gen Console Expected by Thanksgiving,³ Daily Variety , May 12, 2005. 30 Announcement by Bryan Lee, CFO of Microsoft Entertainment and Devices, at the Harris Nesbitt Media and Entertainment Conference, Nov. 8, 2005. Online at http://www.microsoft.com/msft/speech/FY05/BryanLee110805.mspx (March 2, 2006). 31 Dean Takahashi, ²Xbox Reloaded,³ Electronics Supply & Manufacturing , December 2005, p. 46. 32 Ibid, pp. 46-48. 33 Ibid. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

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Evolution of the Xbox Supply Chain GS-49 p. 10 T HE X BOX 360 M ANUFACTURERS Flextronics Flextronics had been the fourth largest EMS company when it began working on the original Xbox 2000. It grew rapidly through the late 1990s and 2000, but sales flattened as the technology market softened. The company continued to gain market share, however, and in the first quarter of calendar 2002, Flextronics passed Solectron (the company providing after-sales service for Xbox) to become the largest EMS. By the time it began work on the Xbox 360, all Xbox production had been transferred to Flextronics± industrial park in Doumen, China. In addition to manufacturing, Flextronics had developed a substantial business in providing engineering services. It provided services for a wide range of industries, such as telecommunications and computers. In the fiscal year ended March, 2005, Flextronics had revenues of $15.9 billion, with net income of $340 million. It had 82,000 employees worldwide. 34 Wistron Wistron was a Taiwanese EMS, which had been owned by Acer, a Taiwan PC manufacturer. In 2001, Acer spun off the company, maintaining about 40 percent ownership. Wistron offered a wide range of engineering and manufacturing services to its customers, primarily in the computer business. In 2004, Wistron had revenues of $3.7 billion, suffering a small loss. 35 Celestica Celestica began in Canada in the early 1900s when it was created by IBM to make parts. As IBM grew, Celestica developed as a manufacturing organization, providing circuit boards, memory devices, and power supplies. IBM sold Celestica in 1996, and two years later it went public through an IPO. Celestica became one of the world±s leading EMS companies, with sales in 2005 of $8.5 billion, while losing $47 million. 36 X BOX 360 L AUNCH P RODUCTION P LANS There was some data which could shed light on the early potential for Xbox sales. Sony had launched the PS2 in March 2000, and sold about 2.8 million consoles in the December quarter. (The transition from PS1 to PS2 in consoles and game sales is shown in Exhibit 3 .) The following year, Microsoft shipped 1.5 million Xbox consoles between the time of its mid- November launch and the end of the year. 37 An analyst report by Bernstein Research studied the lifecycles of the first two generations of videogame consoles. For both the first generation (32/64-bit machines such as the PS1, first 34 Hoover±s Online (March 6, 2006). Employment is 2004 data. 35 Ibid. 36 Ibid. 37 Russ and Kohl, op cit., pp. 1-2. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

Evolution of the Xbox Supply Chain GS-49 p. 11 launched in 1994), the peak in annual shipments occurred in the fourth year, when the second generation systems were first introduced. The total lifecycle was about 11 years. They found a very similar pattern in the second generation (128-bit machines, first introduced in 1998). Peak shipments occurred in the fourth year (2002). The peak annual shipments for the second generation consoles was just slightly higher than for the first generation. The estimate of total second generation units sold through the end of the expected lifetime was about 22 percent higher than the total first generation units sold. 38 A survey of U.S. consumers conducted in June 2005 by SG Cowen & Company (and repeated in November), concluded that there was a potential demand of 14 million Xbox 360s in the U.S. alone by the end of 2006, but that supply constraints would make that unattainable. 39 Microsoft indicated that it planned to sell 2.75-3.0 million Xbox 360 consoles within 90 days of launch. Most analysts believed that Microsoft would be supply constrained for the first few quarters after launch, as demand would be high and continued delays in Sony±s launch of the PS3 would increase Xbox 360 demand. Five years earlier, Microsoft had entered the market with a technically superior product, but a year later than Sony. Sony had continued to be the dominant player in the videogame market, but Microsoft had established a position. Now the tables were turned. Microsoft was launching a next generation product well in advance of Sony°beating Sony to market by as much as a year, but Sony±s product promised to be more technically advanced than Microsoft±s. Microsoft was betting that its ambitious global launch would help it beat Sony in the marketplace. S TUDY Q UESTIONS 1. What supply chain changes did Microsoft make between the Xbox and the Xbox 360? What was the motivation for these changes? 2. Previous videogame launches had been characterized by initial demand exceeding supply, even though launches had been regional, with many months separating each geographic expansion. What were the benefits and risks of the global launch planned for the Xbox 360? 3. Microsoft planned to use three EMS firms for the Xbox 360, all manufacturing in China. What are the benefits and limitations of this approach? How should Microsoft coordinate the three suppliers? 38 Charles Di Bona II and Jennifer Swanson, ²Microsoft: Assessing the Xbox Opportunity,³ Weekly Notes , Bernstein Research, July 1, 2005, pp. 2-3. 39 Drew Brosseau and Adam Liebhoff, ²Microsoft: Survey Confirms Upbeat Outlook for Xbox,³ SG Cowen & Co., July 20, 2005, p. 1. The follow-up survey, by the same authors, was published on November 21, 2005. For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

Evolution of the Xbox Supply Chain GS-49 p. 12 Exhibit 1 Worldwide Videogame Revenue 0 5 10 15 20 25 2002 2003 2004 (E) 2005 (E) $ Billion This chart shows sales through the second generation of videogame consoles. Console sales decrease, while sales of software (games) increase. Exhibit 2 Worldwide Console Shipments, 2002-2005 0 5 10 15 20 25 30 2002 2003 2004 (E) 2005 (E) Millions of Units Source (Exhibits 1 and 2): Russ and Kohl, op. cit., p. 4. PS2 Xbox GameCube PS1 Hardware Software For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

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Evolution of the Xbox Supply Chain GS-49 p. 13 Exhibit 3 Sony: Transition from First to Second Generation Console Unit Sales: PS1 and PS2 0 5 10 15 20 25 FY 2000 FY 2001 FY 2002 FY 2003 FY 2004 Units (Millions) Sony PS1 and PS2 sales by fiscal year (ending March). In Q4 1999, when the PS2 was launched, Sony sold 1.1 million PS1 consoles, and 1.4 million PS2 consoles. Videogame Shipments: PS1 and PS2 0 50 100 150 200 250 300 FY 2000 FY 2001 FY 2002 FY 2003 FH 2004 Unit Shipments (Millions) Sony PS1 and PS2 videogame shipments, including both first and third-party titles. In Q4 1999, when the PS2 was launched, there were 38 million PS1 game shipments, and 2.9 million PS2 game shipments. Source: Russ and Kohl, op. cit., p. 3. PS1 PS2 PS1 PS2 For the exclusive use of Z. Zhang, 2024. This document is authorized for use only by Zhenghe Zhang in SCM 502 2024 Evening MBA Q4 Coursepack taught by Gregory Collins, Arizona State University from Mar 2024 to May 2024.

Evolution of the Xbox Supply Chain

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