1. What supply chain changes did Microsoft make between the Xbox and the Xbox 360? What was the motivation for these changes?

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1 TEACHING NOTE FOR EVOLUTION OF THE XBOX SUPPLY CHAIN TEACHING NOTE: GS-49TN DATE: 06/06/06 In November 2001, Microsoft launched the Xbox, its first entry in the videogame console market. The Xbox was a complex product with many parts, requiring development of a supply chain unlike anything Microsoft had done before. As a latecomer to the videogame console market, and in order to have its product ready for the important holiday season, Microsoft had to put the supply chain together very quickly. Shortly after launching the Xbox, Microsoft began working on the next generation videogame console, the Xbox 360, which was launched in late The supply chain for the Xbox 360 was different in many ways from that of the first Xbox. This case describes the evolution of the Xbox supply chain. It prepares students for discussion of the changes Microsoft made to the supply chain for the Xbox 360, the motivation for these changes, and how supply chains must evolve to support changing business strategy. Position in Course This case is intended for use in a course on supply chain management. It is best used near the end of the course, after students have a good understanding of supply chain management, and can appreciate how different supply chain approaches can support evolving business strategies. Assignment Questions 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 were the benefits and limitations of this approach? How should Microsoft coordinate the three suppliers? This note was prepared by David Hoyt and Professor Hau Lee for the sole purpose of aiding classroom instructors in the use of Evolution of the Xbox Supply Chain, GSB No. GS-49. It provides analysis and questions that are intended to present alternative approaches to deepening students comprehension of the business issues presented in the case and to energize classroom discussion.

2 Teaching Note for Evolution of the Xbox Supply Chain: GS-49TN p. 2 Analysis The study questions in the case are discussed in this section. In the following section, the business strategy of Microsoft will be discussed, and related to the supply chain issues raised in the study questions. Question 1. What supply chain changes did Microsoft make between the Xbox and the Xbox 360? What was the motivation for these changes? There were at least three important changes: location of production facilities, number of EMS suppliers, and contracting for key chips. Facility Location. For both products, Microsoft used EMS companies for substantial portions of the supply chain purchasing standard parts, assembly, and test. However, for the Xbox, Microsoft wanted production to be geographically near the customers. While Flextronics proposed manufacture in its Chinese industrial park to minimize costs, Microsoft preferred that Flextronics use its Guadalajara industrial park for North American production, and an industrial park in Hungary for European production. Microsoft had observed resupply problems that Sony had encountered in shipping product from Asia to the U.S., and wanted a closer link from plant to customer. However, Microsoft quickly saw that cost control was essential, and Xbox production was moved to China. When it came to planning the Xbox 360 supply chain, all production was to be done in China. This made the global launch strategy more risky, but minimized product cost. Number of EMS Suppliers. For the Xbox, Flextronics was responsible for all initial production, with Wistron added later. For the Xbox 360, Flextronics and Wistron shared the initial production, and Celestica was chosen before launch as a third supplier, to come on line within a few months of launch. Chip Contracting. The third primary change was the way in which Microsoft contracted for the microprocessor and graphics chips. For the original Xbox, Microsoft contracted with Intel and Nvidia to supply these chips, for negotiated prices. Intel and Nvidia owned the designs, and sourced the parts from their own supply chains in-house capacity for Intel, and a Taiwanese contract fab for Nvidia. Thus, Microsoft had limited control over costs during the product lifetime. For the Xbox 360, Microsoft contracted the design to IBM and ATI. Microsoft would pay a royalty to those companies for chip production, but could send have any contract fab make the parts, thus capturing the benefit of manufacturing cost reductions during the product lifetime. All these changes were driven by cost, and the desire of Microsoft to control its own destiny. Producing in China was less expensive than in Mexico or Hungary, taking advantage of low labor rates and a well-developed infrastructure for electronics manufacturing. Flextronics (or any of the major EMS companies) could have handled the

3 Teaching Note for Evolution of the Xbox Supply Chain: GS-49TN p. 3 entire production volume required for the Xbox 360. However, having multiple EMS contractors online provided increased negotiating leverage for Microsoft as compared to the single contractor at the Xbox launch. Finally, owning the design of the key chips enabled Microsoft to take full advantage of manufacturing cost reductions during the 5- year life of the product. Chip manufacturers usually make continual improvements, providing increasingly higher performance for about the same price. However, a game console maintains essentially constant performance over its lifetime, while the manufacturer counts on costs to decrease substantially. The approach used for the Xbox 360 enabled Microsoft to capture the full benefits of manufacturing cost reductions for the chips. Question 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? Phased launch had a number of advantages. First, it enabled companies to resupply each territory as quickly as possible, in order to meet the high initial demand for the product. Second, it allowed the manufacturers to develop marketing programs for each new country, and to offer game packages suited to the needs of each new country (selection of titles, native language content, etc.). No company had attempted a global launch prior to the Xbox 360. If successful, the strategy offered the opportunity to establish the Xbox 360 in all major markets before Sony could introduce the PS3. At the time of the Xbox 360 launch, Microsoft thought that it would have only a few months headstart, and thus a global launch was the only way to beat Sony to market in all countries. Sony had a dominant market share in all countries, and this was a chance to make a substantial dent in Sony s share. With the Xbox experience, Microsoft was far better positioned than it had been in 2000 it was now a legitimate player in the game console market, and hopefully this credibility would translate into rapid adoption, even in countries that had previously not been successful for the Xbox. There were two large risks. One was that there would not be enough game titles ready for each market at launch. After the Xbox experience, Microsoft had a better understanding of what types of games were needed for each country, and had been able to line up game developers, but getting the games ready for launch was still a challenge. If they were not ready in a particular market, sales would be slow for both consoles and (more importantly for profitability) for games the economic reality was that a key profitability issue was the number of games sold per console. The other risk was that supply would not be able to keep up with demand. This could impact the company in two ways. First, if Microsoft could not meet customer expectations for delivery in a reasonable time, customers might wait for Sony s PS3, or just not buy. Secondly, if demand was higher than expected in one area, and lower than

4 Teaching Note for Evolution of the Xbox Supply Chain: GS-49TN p. 4 expected in another, there would be unhappy customers waiting for consoles in some locations, while consoles sat on shelves somewhere else. Question 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? Having three EMS suppliers provided the ability for Microsoft to ensure that price competition among the suppliers resulted in the lowest possible product cost. If Microsoft was able to get lower prices from one supplier, it could shift supply to favor the low cost EMS. Another potential advantage was the ability to rapidly ramp production, using capacity from each EMS. However, this might not be possible if production was limited by the supply of critical components such as the microprocessor or graphics chip. In that case, the total production capacity would be determined by the production capacity of the critical component. A third benefit (and one that Microsoft viewed as extremely important), was that the videogame console business was characterized by extreme peaks in annual demand. The period leading up to the end-of-year holiday season was one of high demand. Demand then decreased to a steady state. It was essential to have product available for the peak season. This posed a problem for suppliers, who had to balance their production lines with manufacturing other products. By splitting production between three suppliers, the disruptive impact of peak demands was minimized for each supplier, and they were more able to meet Microsoft s total requirements. One potential limitation of splitting the production was that none of the EMS companies could gain the scale benefits of the full production volume. If the production costs decreased with volume at each EMS, using multiple EMS suppliers meant that each of them was producing at a cost higher than would be possible if it was the sole supplier. However, Microsoft believed that the as high volumes were achieved, the potential for scale-related cost reductions reached a point of diminishing returns. It believed that each of the three suppliers would be operating at this point, so there was little to be lost in scale benefits due to using multiple suppliers. A second limitation was the cost of coordinating production among the three suppliers. In addition to determining the total production required (and the destination, voltage, language, etc.), Microsoft had to apportion the production among the three suppliers. It had to make sure that the key components were allocated appropriately, so that each supplier had the parts it needed, and that none of the EMS companies had a surplus of a key part, while another had shortages. (Commodity parts were ordered by the EMS. However, key components such as the microprocessor and graphics chip were ordered by Microsoft for shipment to the EMS see GSB case OIT-35 for a discussion of the ways in which different types of parts were contracted in an EMS/OEM relationship.)

5 Teaching Note for Evolution of the Xbox Supply Chain: GS-49TN p. 5 The needed coordination would be made relatively seamless by linking the electronic supply chain management systems of Microsoft and the EMS companies. Microsoft could provide requirements plans for the EMS companies to procure commodity parts and plan production capacity, while ensuring that it (Microsoft) ordered the needed critical parts for delivery to the appropriate EMS (and that each EMS had the critical parts when needed). Teaching Approach This case is designed for a class discussion of 1 to 1½ hours. It can be presented by discussing the strategic situation facing Microsoft when it launched the original Xbox, and how that situation differed when it launched the Xbox 360. Following this discussion, students will be ready to discuss the evolution of the supply chain. Microsoft s Challenges with the Original Xbox Students can be asked to describe the challenges facing Microsoft with the original Xbox. Some include: - Little experience in consumer electronics, or in the game console market (including little credibility in the marketplace in these areas) - Little experience in manufacturing and designing hardware products - Little exposure in managing supply networks - High technical performance requirements for the product, requiring critical parts choices o processing speed o graphics resolution o memory requirement o Internet access - Time pressure to introduce the product in time for the Christmas season - Strong competitors with established markets - High production ramp-up (0 to 100,000 in a week) - Cost pressure (retail at $299, manufacturing cost estimated at $450). Xbox Stakeholders Students can then be asked to consider the various stakeholders for the Xbox. Some include: - Key technology partners (Intel, Nvidia, Samsung) - Contract manufacturer - Game developers - Retail chains and end-consumers - Logistics providers - Internal stakeholders (such as employees), and external investors - PC game market - Competitors - Broadband suppliers These stakeholders form the ecosystem that Microsoft existed in when trying to develop its business strategy and supply chain for the Xbox.

6 Teaching Note for Evolution of the Xbox Supply Chain: GS-49TN p. 6 Critical Success Factors for the Original Xbox An understanding of the challenges and stakeholders leads to discussion of critical success factors for the original Xbox. Of course, an essential part of this discussion is Microsoft s strategy for the Xbox, and its strategic objectives for the product. This can either be discussed at this point, or after both the Xbox and Xbox 360 are considered. In this note, the strategic objectives of both products will be discussed after consideration of the issues facing each product separately. Some critical success factors for the original Xbox were: - Superior product features, and meeting time-to-market objectives, even at the expense of cost o Concurrent design development to compress the design cycle o Close link between design and manufacturing o Continuous testing and iterative re-design o Initial manufacturing close to customers to facilitate fast product introduction (initial production in Mexico and Hungary). - Information integration with key suppliers, requiring co-investment by suppliers and EMS - Ability of EMS to ramp up rapidly - Ability of EMS to provide a trajectory of cost reduction after introduction (e.g. Flextronics moving from Mexico and Hungary to China) - Lining up game developers, including Microsoft investing in game development - Convincing retailers that Microsoft was in the business for the long run that the company was willing to stand behind the product despite heavy losses. Differences in the Environment for the Xbox 360 With an understanding of the situation facing Microsoft when launching the original Xbox, the class can discuss the different business environment facing Microsoft as it planned the Xbox 360 and the supply chain for the new product. These differences include: - Microsoft now has a presence in the market - Microsoft can beat Sony to market with its next-generation product, offering substantially improved performance - HDTV technology is developing, enabling superior performance. Microsoft s major competitor, Sony, is the major force behind a new technology (Blu-Ray) that is expensive, technically complex, and may delay Sony s next generation product. - There is substantially more broadband access to households - Gaming is part of a bigger home entertainment ecosystem, including high definition TV and heavy use of digital video recorders. The class can then discuss the supply chain changes that Microsoft made for the Xbox 360, which are described above in response to Question 1. Strategic Changes Supply chain evolution in response to changing business strategy is a key lesson in this case. Thus, we need to understand the business strategy of Microsoft.

7 Teaching Note for Evolution of the Xbox Supply Chain: GS-49TN p. 7 Microsoft was not a hardware company. It s presence in the videogame market was never based on a desire to sell hardware it was intended to drive software sales. Microsoft saw that the videogame console was becoming a central part of a larger home entertainment system that eventually would rival the PC. This system would require substantial software, in the form of games, DVR software, Internet applications, and productivity applications currently run on the PC. To get a place in this evolving market, Microsoft felt it was essential to become a factor in the videogame market. And, to get into the market, it had to make a console. When Microsoft began working on the original Xbox, Sony held a dominant share of the market. The Xbox would have some technical advantages over the PS2, but would come to market more than a year after the PS2. The primary strategic purpose of the original Xbox was thus to establish Microsoft in the market, learn from the experience, and prepare the way for future products. With such a late entry, and with no experience in the market, making a profit on the original product was unlikely. If Microsoft missed the 2001 holiday selling season, it would be too late to introduce the Xbox. Waiting for the next holiday selling cycle would be futile, and the company would then be faced with launching a new generation product several years later without having established a presence in the market. Microsoft s supply chain development for the original Xbox was driven by these strategic considerations. Time-to-market was paramount. The product had to have superior technology, but it also had to be reliable there was no time to go with unproven vendors or highly risky design approaches. These considerations meant that compromises would have to be made on cost. Having introduced the original Xbox, Microsoft quickly turned to the next generation product. High definition capability was essential, requiring high-capacity storage capability. Broadband Internet access was also a critical factor as the Internet was a critical part of Microsoft s software-driven console strategy (unlike the strategy of Sony). Cost was also a more important part of the strategy. And, the company had learned from its first generation Xbox experience. It thus made many changes to its supply chain to meet the different strategic objective of the Xbox 360. The changes described earlier all align with the strategic differences between these two products. By contrast, Sony was an entertainment hardware company. The PS2 had driven development of the DVD market. Sony hoped that the PS3 would establish Blu-Ray as the standard for high definition storage, creating a large, profitable hardware business. Thus, incorporating new technology was an essential part of Sony s strategy. Microsoft had no interest in promoting a particular high definition DVD technology it would use whatever was available. This also explains Sony s slow adoption of on-line capability an on-line capability enhanced a software strategy, but was not a top priority for a hardware company.

8 Teaching Note for Evolution of the Xbox Supply Chain: GS-49TN p. 8 Other Information Actual Sales Actual Xbox 360 sales through the end of 2005 were 600,000 units, well short of the 1.5 million plan. This was primarily due to production shortages. As of late March 2006, there was still a problem with one component vendor. 1 Sony PS3 Launch On March 14, 2006 Sony announced that PS3 launch would be delayed until November Thus, Microsoft had a one-year head start in third-generation consoles. 1 Telis Demos, Ballmer: Xbox Will Capitalize on PS3 Delay, Fortune, May 17, Online at: (March 20, 2006). (To be in issue distributed on March 23.)