Update: Don’t like page breaks? This two-part series is now available as an e-book for the Amazon Kindle.

Editor’s note: This story is the second of two pieces on the 10th anniversary of the launch of Microsoft’s Xbox video game console, which debuted Nov. 15, 2001. The narrative is based on recent interviews as well as my two books: Opening the Xbox: Inside Microsoft’s Plan to Unleash an Entertainment Revolution, published in 2002; and The Xbox 360 Uncloaked: The real story behind Microsoft’s next generation video game console, published in 2006. Part 1 took us through the launch of the Xbox. This story takes us through the aftermath, the launch of the Xbox 360, and the present day state of the video game wars.

It was a miracle that Microsoft got the first Xbox out the door. The company’s first video game console came together in just 20 months from conception to launch. It earned Microsoft a precious toehold in the living room, selling 1.5 million units in its first season. It sold three games for every box and generated $750 million in revenue. Over four years, that grew to 21 million consoles sold.


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But Sony won the war for that console generation. The PlayStation 2 sold more than 90 million units by mid-2005, while Nintendo’s GameCube came in a close third with 20 million units sold. With such a lopsided tally, Sony was able to snare exclusive games such as Grand Theft Auto: Vice City and Grand Theft Auto: San Andreas.

To turn things around, Microsoft had to initiate a new console war with its own surprise attack. Instead of being 20 months behind Sony, Microsoft now planned to hit the market at the same time or before Sony came out with its next console. As soon as the Xbox shipped, Microsoft had to start running full blast. The next project was code-named Xenon. Later dubbed the Xbox 360, it would finish what the Xbox had started.

On the night that the Xbox launched in Times Square, chief Xbox officer Robbie Bach was standing with co-creator Seamus Blackley. “Welcome to the starting line,” Bach said. “Fuck off,” Blackley said, laughing because he was so exhausted.

Bill Gates himself summed up his feelings with a Time magazine writer. He said, “The first generation, it’s just like a video game. If you play perfectly, at the end, it says, ‘You get to play again.’ That’s all it says! You put your hand in the till. There’s no quarter down there. There’s no, like, even tickets to buy funny dolls or anything. It’s just, ‘Hey, play again.'”

Easy come, easy go: $4 billion in losses

Blackley had no more stomach for this second battle. He left Microsoft in the spring of 2002, following his buddy Kevin Bachus out the door. In a recent interview, he had no regrets about leaving.

“The thing I’m really good at is being immune enough to pain to continue to push ideas I really believe in,” he said. “I’m stupid enough to push them even when it is disadvantageous to me. I’m not the right guy to hang out and optimize a business like that.”

A bunch of veterans did stick around. Bill Gates was up for another round, though this time he would do it as chairman, in a secondary role to the newly-minted CEO Steve Ballmer. There were now around 2,000 people in the game division, still less than what Sony had but far more than the 400 that Microsoft had before the Xbox.

But Microsoft had dug itself a hole. After four years, Microsoft’s Home and Entertainment Group reported a total loss of $4 billion. That number included some other money-losing ventures too. But the vast majority of it was due to Xbox and the loss that the company was taking on every machine that it made. Insiders believed that Microsoft lost $3.7 billion on the original Xbox by 2005. That amounted to a $168 loss on every  machine that Microsoft sold.

The toughest part was that the machine wasn’t designed to take advantage of declining prices or volume discounts on component manufacturing, the way a mass-market electronics product would ordinarily be designed. That was driven by necessity, since the machine went from idea to product in about half the time it usually took to design such a complicated device. There wasn’t enough time to design unique chips and hardware that could be made more cheaply over time. Microsoft had to take a lot of costly off-the-shelf parts, including an expensive hard disk drive. When the machine started selling for $299, the cost for making each machine was around $425.

Selling games was the way to offset the losses. But game making was getting costly. One Electronic Arts executive estimated that it took 20 employees to make a PlayStation game, 80 to make a PS 2 game, and 150 to make a PS 3 game. Working for two years, the PS 3 game could consume $30 million in payroll costs, not counting marketing. Xbox game making costs were not so different.

At the same time, the price gamers paid for games was dropping. Fewer games were accounting for all of the big unit sales. If a game wasn’t a hit, it could be a huge drain on a game publisher. Microsoft had entered the market to ease the burden on game developers, but their problems were multiplying. After its first round of hits and duds became clear, Microsoft cut back on its own teams that made duds.

Some observers in the industry were astounded at the losses Microsoft was willing to absorb. The company seemed like it was taking profits from its Windows and Office franchises and flushing it down the toilet of the Xbox. Later on, Microsoft’s pile of cash dwindled and the company found other needs for that cash, such as trying to catch up with Google in search. Even so, at the time, losing $4 billion over four years wasn’t a big deal; Microsoft was generating $4 billion in cash every two quarters. By sticking it out, Microsoft eventually wound up with a game business that was generating more than a billion dollars a year in profits.

“Clearly it was a big investment — but one that paid off well,” said Bach. “A business has been built that is worth much more than the original investment, the ongoing earnings potential is high, Microsoft has an ongoing relationship with millions of consumers through Xbox Live, and the company has a great opportunity in the living room and three screen entertainment space going forward.”

Ed Fries, former head of Microsoft Game Studios, added, “I wouldn’t say we lost $4 billion. I’d say we spent $4 billion building the Xbox brand and business.”

He noted that a recent brand value study says the Xbox brand alone (not counting the actual business) is worth more than $4 billion today.

Only a company like Microsoft could absorb such losses. And Bill Gates saw the strategic value in stopping Sony in its tracks and building a second pillar for Microsoft software, beyond productivity, based on entertainment in the home.

He knew the battle for the living room would play out over two decades, not just four years. Microsoft earned credibility with game developers and consumers by breaking the chokehold of the Japanese game giants. On a consumer level, Microsoft generated its most passionate fans. Gamers loved new titles such as Halo. In this arena, Microsoft was an underdog that had the power to upset the status quo and invigorate a market with new competition. In any other market it entered, Microsoft was always seen as an anti-competitive gorilla. Here, it was the good guy. Microsoft marketer Pete Parsons was able to joke about “world domination” without getting hauled off to court.

Microsoft’s entry into the console industry also had a broader effect on the industry. It strengthened a lot of American game developers, from Epic Games to Electronic Arts. And it forced Sony and Nintendo to come up with more innovations for their own consoles. Nintendo in particular had to move outside its own comfort zone to come up with its own risky console, the Wii.

“It escalated the technology arms race that had been building in the ’90s,” Kevin Bachus, one of the original Xbox founders, said recently.

Microsoft still had to make the transition that Sony had, leaping from hardcore gamers to the mass market. With the Xbox 360, Microsoft would pursue that goal aggressively.

Front image via Scott Akerman

Another state of panic

As they were just beginning their work on a second console, the Microsoft team knew how far behind they were compared to Sony. In March 2001, well before Microsoft had shipped the first Xbox, Sony announced its next console would use a Cell microprocessor (pictured right), a new chip with parallel processing features that Sony was jointly designing with Toshiba and IBM.

“I was thinking, ‘Oh my God,'” said one Microsoft staffer as Sony made the announcement. “It scared the shit out of me.”

The Cell was a grand alliance, much like the PowerPC alliance of Apple, Motorola, and IBM — aimed at stopping Intel in the 1990s. The PowerPC effort failed against Intel, but IBM managed to keep it going with new markets, such as game consoles. With Cell, Sony would use the chip in the PlayStation 3, Toshiba would use it in TVs, and IBM would use it in servers. The only weakness, as perceived by Microsoft’s team, was that the Cell would be horribly hard to program.

Since it could take two years to design and make a chip (and longer to make something like the Cell), the Microsoft chip designers had to get started. The chip and hardware strategists were once again in the role of playing catch-up to Sony.

At Microsoft, there wasn’t much time to sit around and take it easy. The engineers got no rest. The WebTV team shipped a satellite digital video recorder called UltimateTV in the fall of 2000. The team was then almost diverted for a time on Freon, a secret project that would have combined the Xbox with UltimateTV. But Microsoft shelved that idea because UltimateTV turned out to be a dud. Microsoft decided to call it quits on the product line in January, 2002.

As it did so, it threw the fate of the WebTV division, based in the Silicon Valley city of Mountain View, Calif., into chaos. Robbie Bach came down to reassure them and offer them jobs in the Xbox hardware operation. Some of the team was assigned to redesigning the Xbox for each year so that it would become cheaper and cheaper to make. Most took the offer, since there was a recession and jobs were scarce elsewhere.

A few of the hardcore WebTV leaders started planning the chips they would use in the next generation Xbox. Those chips were critical, as they had to outdo the competition yet cost a low amount so that the box could be properly cost reduced over time. Two key WebTV engineers, Nick Baker and Jeff Andrews, operated under the code name Project Trinity (named after the female lead character in the sci-fi film The Matrix) and they worked with Xbox architect Mike Abrash.

Earlier in Xbox history, the WebTV team had been spurned by Bill Gates when the rival Xbox team got approval to make a game console, not the WebTV team. Now, they were back as key members of the Xbox team.

“This time, they had a seat at the table,” J Allard, one of the Xbox chiefs, said. “They were full shareholders and citizens on this project. They were on the highest wire with the smallest net.”

Revving up Xbox Live

Allard (pictured, right) and his buddy Cameron Ferroni (pictured, left) were busy creating an online gaming service called Xbox Live. Because they had the foresight to put an Ethernet jack, and not a dial-up modem, into the Xbox, they were able to plan a broadband-only network. Sony, by contrast, created both dial-up modem and broadband attachments for the PlayStation 2. That made for slow online games.

On the online front, Robbie Bach could legitimately claim that Microsoft had thought leadership. Microsoft’s vision for Xbox Live went far deeper than anything the rivals were planning. Later, Bach would disclose that Microsoft planned to invest $2 billion in Xbox Live, which would change the game by making it all about innovating with software and services — two areas where Microsoft had an edge on its gaming rivals.

Xbox Live wasn’t ready for the launch of the Xbox. But it would be a major addition to the platform when it went live in the fall of 2002. Always aiming to inspire, Allard told his troops, which he came to call the Tribe over time, “If I needed to pick an introductory quote for the ‘History of the Xbox,’ I’d choose the following words spoken by Gandhi: ‘First they ignore you, then they laugh at you, then they fight you, then you win.'”

Veterans and newbies

The team included Xbox veterans who were back for another tour of duty. Robbie Bach was at the top of the management layer as chief Xbox officer, reporting to CEO Steve Ballmer. Todd Holmdahl ran hardware, assisted by Greg Gibson. Marc Whitten ran accessories. Ed Fries ran the game studios.

Allard took on the expanded role of leading the Xbox Platform team, which he described as the team that would create the infrastructure for Disneyland. He was in command of hundreds of people who did everything from the system software to definition of the system.

In January 2002, while much of his team was hard at work on Xbox Live, Allard assigned three people — Mike Abrash, Jeff Henshaw and Margaret Johnson — to explore what Allard called Xbox Next. While that was a good thing to do, this team fell apart in short order.

Cameron Ferroni led Xbox Live and system software. He tapped veterans Jon Thomason, Tracy Sharp, Dinarte Morais and Andrew Goossen as part of a crack team for making system software. Chris Satchell signed up to lead an effort to make better game development tools that made it easy to make both PC and Xbox games simultaneously.

Shane Kim, Stuart Moulder, Ken Lobb, A.J. Redmer (pictured above) and others helped Fries run the game studios. The company also engaged outside development studios such as Lionhead Studios and Epic Games to make exclusives. Thousands of game developers were now inside the Xbox fold. George Peckham ran third-party game publisher relations.

The chain of command could be very deep. Chip experts Nick Baker and Jeff Andrews reported to Larry Yang, the chip chief who in turn reported Greg Gibson, who ran the hardware strategy and reported to Todd Holmdahl, a senior executive who was an Xbox veteran. Mitch Koch ran sales and marketing and Bryan Lee led business strategy and planning. Laura Fryer took over Blackley’s Advanced Technology Group, which cooked up cool things to share with developers. Within that group, experts like Chris Prince figured out how to get a game machine to render things such as hair or fur.

Jonathan Hayes was tapped for industrial design. Don Coyner gathered marketing intelligence to help figure out the look and feel of the next machine, and he hired outside designers in a bake-off to help define what the next box and its components would look like.

The roles were far more defined compared to the original Xbox. It was a lot more corporate, which brought both added bureaucracy and more firepower.

“Where Xbox felt like we were doing a startup, Xbox 360 felt like we got our Microsoft mojo going,” Drew Angeloff, a member of the tools group, said recently. “We built up our staff and we could specialize. We no longer had to do 100 different jobs per person. I started to focus almost entirely on our external relationships with hardware vendors and tools and middleware providers.”

Newcomers like marketer David Reid arrived to help run the growing business. Larry Hyrb came aboard to help program Xbox Live and eventually became the public face of Microsoft as podcaster Major Nelson. Allard had said that the first Xbox was “ready, fire, aim.” This time, everything was more deliberate, and by the end of it, 25,000 people would have a hand in the creation of the Xbox 360.

When Peter Moore (pictured right), former president of Sega of America, arrived as a top Xbox executive, he sat in a meeting with CEO Steve Ballmer, who went into one of his classic shouting routines. Noting that Xbox Live was Microsoft’s ace, he shouted, “Xbox Live!” and pounded the table. He did it over and over. “Xbox Live! Xbox Live! Xbox Live!” Then he slammed into the Polycom conference phone with his fist, breaking it. He looked sheepish. Ed Fries turned to the astonished Moore and said, “Welcome to Microsoft.”

Chip wars

Project Trinity quickly became Xenon because someone else at Microsoft was using the Trinity code name. One of the hardware leads, Mike Abrash, resigned a month after the project began, so Nick Baker (pictured right) and Jeff Andrews in the Silicon Valley hardware team had to take more responsibility.

This time, the whole hardware team knew they needed to get their costs under control. Instead of using off-the-shelf parts designed by different chip vendors for the PC, they needed to control the design much more closely and get the rights to consolidate multiple chips into one over time in order to have a path for cost reduction. That would help accomplish a major business goal: to cut the console’s price over time.

Sony knew how to ride Moore’s Law, the 1965 observation by Intel’s Gordon Moore that held that the number of components on a state of the art chip doubled every two years. With each new generation, chip makers could either double the number of components on the same size chip, making it more powerful. Or they could keep the number of components the same and halve the size of the chip, effectively cutting its cost in half. Following this law, Sony brought the costs of the original PlayStation from $450 when it was launched in 1994 to about $80 five years later. Consequently, it could slash the price of the box, raising the volume of sales and continuing to make a profit on the hardware.

Sony had its own chip factories and could, if it chose, control the complete process of chip design through production. So while the original Xbox sold at a loss, Sony was able to sell the PlayStation 2 hardware for a profit because it controlled the cost reductions for its chips (and it didn’t include an expensive hard drive).

But with proper planning, Microsoft felt it could compete with Sony.

This time, the WebTV team of 100 or so chip engineers in Silicon Valley would design one of the chips entirely by itself. And it would work closely with its major chip vendors, ATI Technologies and IBM. Those vendors won the deals in part because Microsoft generated bad blood with Nvidia in a chip pricing dispute, and because Intel wasn’t as willing as IBM to customize a design.

The tricky part was that IBM was a full partner with Sony on the Cell microprocessor. But, as told in the 2009 book, The Race for a New Game Machine, Sony made a critical mistake in negotiating with IBM. IBM supplied a PowerPC microprocessor core for use as a sub-processor in the Cell chip for Sony’s PlayStation 3. But IBM retained the right to use the core, modified in some ways, in other products.

IBM turned around and supplied the core to Microsoft. In that sense, Microsoft got lucky, since it was two years behind Sony in designing its next-generation machine. It was risky for the relationship with Sony, but IBM couldn‘t refuse Microsoft, since a billion dollars in chip purchases were at stake.

Jim Kahle, an IBM fellow on the Cell project, felt it was reckless of IBM to work with both rivals so closely, but IBM had processes in place for separating such projects, as it was also working with Nintendo on its next-generation chip. The fact that it was able to balance these partners was a great victory for IBM, as it shut Intel out of the game console business.

But the process was rocky. In the spring of 2003, I wrote a story for the San Jose Mercury News that Sony had gotten patents for something called a Cell microprocessor. Secretly, IBM was stunned at the disclosure and threatened a lawsuit because Sony had patented work done by IBM’s engineers. Sony sheepishly amended the filing to include IBM engineers.

Ironically, one of the IBM engineers later had his name on a patent for the Cell processor as well as a patent for the Xbox 360 processor.

Dave Shippy, a co-author of the game machine book and an IBM engineer, confessed he felt “contaminated” because he had worked with Sony for two years and was now in meetings with Microsoft over a similar chip design. In one hilarious moment, Shippy had to quickly relocate a meeting near a cafeteria to a more remote place in the IBM offices in Austin, Texas, so that the Sony and Microsoft engineers wouldn’t run into each other.

“We all felt that IBM had violated many of its core business practices in jockeying both horses in this particular race,” Shippy said.

Still, Shippy was a true IBM patriot. He did as he was told.

Microsoft’s planned microprocessor carried the code name Waternoose (pictured right), after the crab-like, five-eyed creature in the Monsters Inc. movie. The Microsoft engineers asked for a lot of modifications on the IBM chip, so much so that it turned out to be a very different kind of custom microprocessor. Ken Kutaragi, head of Sony’s game business, had insisted on eight cores on the Cell, instead of the six that IBM recommended, because “eight is beautiful.” As a result, manufacturing the Cell turned out to be harder and more expensive than it should have been. But in contrast to IBM’s server chips, the Cell was far more power efficient for the processing work that it did.

While the Cell chip had one PowerPC subprocessor and eight other processing cores, the Microsoft chip had three PowerPC cores and a very different graphics chip. The Microsoft engineers wanted something that would be simpler for game creators to program. Their final design wasn’t nearly so complicated as Sony’s, though it did require game developers to learn multicore programming.

Chris Prince, a member of the Advanced Technology Group, said the mandate from above was to break even on hardware costs, so the chips couldn’t be too expensive. He and the rest of the group eschewed “theoretical power” in favor of “usable power,” or capabilities that could be most easily exploited by game developers.  That kind of thinking paid off in the future and enabled a quicker launch of the Xbox 360. Once again, Microsoft had one of the easiest devices to program.

Microsoft and IBM had also figured out a way to bake encryption into the microprocessor itself, making it much harder for hackers to reverse engineer and pirate the system.

In a way, IBM was betraying Sony. On the other hand, it was exercising its legal right to resell a core that could be customized into something else. The balancing act that IBM played in Austin was masterful and the Sony-Microsoft-IBM relationship will go down in history as one of the greatest corporate love triangles of all time.

Ken Kutaragi, the head of Sony’s game business,  and his lawyers could have foreclosed IBM from working with Microsoft in their contract, but failed to do so. It was as bad a fumble as when IBM chose Microsoft and Intel to provide key parts of the personal computer and failed to lock them down under contract so they couldn’t provide those vital pieces for others. That was how the PC clone business was born and IBM lost control of the PC industry.

For the PS 2, Sony was able to drive cost reductions by fusing its graphics chip and microprocessor together by the end of the generation. But with the PS 3, Sony had many stumbles.

At first, it experimented with a graphics processor called the RS, designed by the same team that made the graphics chip for the PS 2. It was a very different kind of graphics chip, but was incredibly hard to program. That effort failed because the chip was too big to be manufactured. Then Sony shifted the plan to include two Cell chips in the system. That didn’t work. At the last minute, Sony hired Nvidia to do the graphics chip as a companion to a single Cell microprocessor.

One of the trade-offs for IBM: it lost Apple, which had been using PowerPC chips, as a customer. As IBM fell behind, Apple made a fateful switch to Intel that helped the Mac regain its position in the market. It was funny how one decision cascaded into another and changed the landscape of both the game and chip industries.

Launching Xbox Live

At the Consumer Electronics Show in 2002, Microsoft showed a funny video that illustrated Xbox Live. In it, gamers play a football game. One particularly player with a menacing voice turns out to be a little kid holding a game controller. The punchline was that you could be virtually anyone online.

It was an appealing pitch, and one that Microsoft was better at making than its rivals, since it had the system that was ideal for online gaming.

By June 2002, Microsoft had sold 3.5 million Xboxes. In the fall of 2002, Xbox Live was ready for its launch, where it was hyped as much like the debut of the Xbox a year earlier. There were some glitches, but Microsoft managed to get Xbox Live launched with a great deal of fan adoration.

Cameron Ferroni said recently that Xbox Live had all of the features to revolutionize online play: player achievements for hitting goals in games, single gamer tags (or identities), consistent sets of friends, a single connected environment where you didn’t have to log in to a new service just to play another online game, and a digital distribution online marketplace. For that, Microsoft charged $50 a year. Charging that fee was a big risk, as Sony followed suit by making its online gaming free.

Eventually, games like Halo 2, Halo 3, Call of Duty Modern Warfare and other giant games came to depend on Xbox Live to hold on to gamers for months at a time. But early on, people were as skeptical about Xbox Live as they were about the original Xbox.

Electronic Arts balked at making online games that worked with Xbox Live because it allowed Microsoft to disintermediate EA. EA’s Larry Probst didn’t like that Microsoft would charge a fee to EA’s customers to play EA games, and he hated the idea that Microsoft would know who EA’s customers were, even as Microsoft was making rival sports games. The impasse was a sore point that meant EA would hold back from full support of the Xbox 360. EA would later exclusively announce that it would make online versions of its games only for Sony’s PlayStation 2 console.

Every year, Microsoft launched new updates for Xbox Live that continuously transformed the service and gave a new look or functionality to the aging Xbox 360 hardware. It was a live service that changed with a simple update of its software. By 2007, Microsoft had more than 8 million subscribers to Xbox Live. By 2011, that number had climbed past 35 million. Indie games could debut on a regular basis on Xbox Live alongside giant console releases. It remains a strategic asset for Microsoft.

The view from the top

After the Xbox Live launch, Microsoft was able to move full-bore into Xenon. A new scouting team (called Xe30) was assembled to figure out what to do for the next Xbox. It included by A.J. Redmer, one of the seasoned game studio chiefs, operating system expert Jon Thomason, and Chip Wood, a business planner.

They latched on to ideas such as making sure that the next console would be able to run high-resolution games on the high-definition flat-screen TVs that were becoming so popular. Redmer didn’t want the system to be “Dreamcasted,” which is what happened when Sega launched the mid-level Dreamcast and Sony then announced a high-end PlayStation 2, drying up demand for the Dreamcast.

The early work forced different Microsoft divisions to cooperate, even though executives were still fiercely territorial.

“We are playing our game this time,” Allard said.

Based on research, Robbie Bach (pictured right) had calculated that, based on Sony’s progress on Cell, it would be able to launch in 2005. The lesson of the first Xbox had been clear. Sony launched 20 months earlier than Microsoft and sold 20 million PS 2 units before Microsoft sold one Xbox. To close the gap, Microsoft had to launch at the same time.

In a stroke of luck, Ed Fries seized an opportunity to steal a big developer away from Nintendo. Rare, the maker of a bunch of Nintendo’s big hits, kept proposing to make $20 million games, and Nintendo kept coming back and asking it to make the games for $2 million. In September, 2002, Fries got board approval for the biggest of deals: the $375 million acquisition of England’s Rare.

But it was a mixed blessing. Fries was under pressure from Bach; if he spent the money on Rare, Bach wanted Fries to cut back on other game development. Though he beefed up his game studios, Fries still got hammered from the hardware side, represented by J Allard, to have a bunch of games lined up for the next Xbox launch.

“Spend less, sell more games,” Fries recalled later. “I don’t know how to do that.”

After all, he had to treat his teams like the artists they were, or they would walk to Sony or Nintendo. Allard wanted Fries to crank out new versions of Halo just about every year, since that would ensure a Halo game would arrive for the Xenon launch. But Fries wasn’t about to force the Bungie team to rush its game-making process. A hot game like Halo could make up for a dozen bad games. But if Bungie were forced to do nothing but Halo, it wouldn’t have the resources to do any original games.

Bach favored Fries in this internecine fight, and he gave Fries control of third-party publishing as well. But Bach didn’t want the team to retreat into silos, for that would doom the integrated planning of the next console launch.

Fries wanted a hard drive in the system again to support higher game quality and better online games. But the first system’s hard drive cost $50 and could barely be brought down to $30 by the end of the four years. It contributed to considerable losses, and Ballmer said that it wasn’t a good business decision to include it because it didn’t enable Microsoft to charge a higher price for its console. So business-minded executives fought against the hard drive, leaving Fries to wonder, “What is exciting about this box?”


Finally, in February 2003, the executive team gathered for a retreat at the Salish Lodge & Spa, overlooking the beautiful Snoqualmie Falls (pictured) that was the opening scene for the Twin Peaks television show. There, Bach came up with his 3-30-300 plan. Bach would set strategy with a 3-page memo; Allard would follow up with a 30-page execution plan; the rest of the team would fill in the details with a 300-page plan.

Bach wanted the Xbox division to be profitable in 2007. He wanted Xenon to launch in 2005, timed with the other console launches. That made sense because of the timing of the high-definition TV adoption, which promised much better quality games. That meant the Xbox life cycle would only be four years, but that was good because Microsoft was losing so much money on the first box.

He wanted the hardware to be break-even and for Microsoft to own its intellectual property for the chips. He targeted about 40 percent of the market, up from about 20 percent in the first generation. Xbox Live would be built into the next system. Bach came back from the retreat with a plan in place and he sent it to Gates and Ballmer on April 2, 2003. They approved it. Since they had been meeting with the executives every six weeks, they were plugged into the thinking.

For those who played Age of Empires, as Bach did, it was a classic “early rush” strategy, or catching your opponents off guard before they were ready. Later in the year, consultants figured out how to save Microsoft $300 million a year in its operations in the game business. But the company was still losing a billion dollars a year.

Defining Xenon

The Xe 30 team made the rounds with the game developers, collecting feedback. They focused on high-definition, a feature of game graphics dubbed procedural geometry, and building Xbox Live into the box. But the executives kept pushing back because Xenon was so uninspiring.

Because Microsoft had plenty of time to commission its own hardware, industrial design, and chips, it was able to contain the costs of the Xbox 360. That made it possible to make money on each console sold, thanks in part to the fact that Microsoft was willing to consider selling its machine at a higher $399 price. And that made it much easier to make a profit on the overall business.

The planning team now had to pull together an execution plan within about six months. Microsoft was taking longer than it wanted to sign the final contracts with IBM and ATI. The chip deals for the first Xbox locked in wasted performance and wasted costs. This time, that wasn’t going to happen.

Barry Spector, a Microsoft business development director who worked for finance chief Bryan Lee, had the job of being an emissary. In the spring of 2003, he started working with vendors on the short list. He knew he had to get the terms right, or it could turn out to be a financial catastrophe for Microsoft. Billions of dollars were at stake. He wanted checks against price gouging and bonuses for hitting schedules.

With ATI, Spector drove the negotiators — such as ATI’s engineering vice president, Bob Feldstein — crazy. Spector would say, “I want to drive a BMW, but I can only afford to buy a Yugo. I really can’t afford to pay for a BMW.” This was coming from a guy at one of the world’s richest corporations. Spector even went back repeatedly to Nvidia to try to cut a deal with them, despite the bad blood. Whatever the deal, Microsoft wanted to make sure it got access to cool new pixel shader technology.

In the summer of 2003, Jeff Andrews was getting nervous that they would run out of time to get the chips done. Key to the deals was that one day, Microsoft would be able to significantly cut costs by fusing the graphics chip and the microprocessor — the two most expensive chips — into a single chip, just as Sony had done with the PS 2. While Sony could do that because it was one company, it was a hurdle for Microsoft because the rights would be split among several companies that didn’t want to surrender intellectual property. Greg Gibson, the hardware design chief, had to pursue multiple design scenarios, depending on which vendor signed the contract.

Gibson joined Spector in the negotiations to get over the impasse, while Rick Bergman joined Feldstein on the ATI side. Finally, ATI agreed to penalties if it missed its schedule, and it agreed to allow Microsoft to shop for a second source on the chip and to fuse it into a microprocessor at some point. They signed a deal on August 12, 2003, leaving ATI with just a little over two years to deliver its graphics chips.

The engineers were designing the hardware to be cost-effective, but there were big fights that bubbled up to the top. As the executive team fought over the hard drive, Nick Baker and his engineers decided to rely on “virtualization,” or allowing a game to be saved regardless of what kind of storage device was there: a hard drive or a flash memory card. Laura Fryer took heat from game developers, who still insisted on the hard drive. She lost that battle, as Microsoft came up with a Solomon-like solution, where it would have a low-end version without a hard drive, selling for a lower price, and a high-end model with a hard drive that sold for more.

Developers such as Tim Sweeney (pictured above) at Epic Games hated that solution, as it meant many developers would target the lowest-common denominator, or a box without a hard drive, for their games. But Sweeney won a battle; Microsoft relented on a plan to contain the amount of main memory (random access memory, or RAM) at 256 megabytes. Sweeney convinced Microsoft to increase that to 512 megabytes, even though that was a commitment of an additional $1 billion in costs over time.

Microsoft had another huge fight over whether to use a DVD drive in the box, or something that rose as a counter to Sony’s Blu-ray drive. The HD DVD alliance arose in its place, but Microsoft decided it was too late in coming. Eventually, the DVD drive won. If game developers really needed the extra disk space, they could include a second DVD disk with their games.

One of the key decisions the engineers made was to put the huge power supply into the power cable, taking it out of the box itself. That made the power cable look like a boa constrictor that had swallowed a bar of gold. But nobody cared about that because the power cable would be out of sight. And it allowed the designers to make the box itself much smaller than the original Xbox, which Peter Moore had joked “was so big it couldn’t fit through the doorway in most Japanese homes.”

The marketing plan

J Allard was still stewing a bit about the Newsweek cover story that talked about all the things the “Amazing PlayStation 2” would do. For Xenon, he wanted the system to be on the cover of Time magazine. He asked the team to conceive of what a Time magazine cover story would say about the launch of the Xbox 360. That inspired the team to think about how to market the new box.

The first Xbox was a hardcore gamer’s dream. But the second one had to broaden the audience, making gaming more approachable, social and interactive. David Reid (pictured right), took the lead role on the design team to represent the marketing team, which had a project it called “North Star” to synchronize Xenon with the rest of Microsoft’s plans for home entertainment.

That work involved working with Jeff Henshaw to define the non-game functions that the Xbox 360 would do. They started with a wish list of 150 items and tried to narrow it down to 10 priorities. One of those ideas was to put a Media Center Extender into the Xbox 360, so that it could play content that was stored on a networked PC. That was one way the box could be more broadly appealing and reach the goal that Allard envisioned: reaching a billion people. And it was something that Sony couldn’t do.

At the same time, Microsoft had to avoid throwing the kitchen sink into the machine, a problem that was slowing Sony down. The team considered staging a global launch, debuting machines in Asia, Europe and North America at the same time. But they decided the marketing costs associated with such a launch were prohibitive.

One marketing idea raised a huge stink. Reid’s team had determined that so many Xbox fans were playing Halo 2 on multiplayer — long after the game shipped — that Microsoft had to enable that game to run on the Xbox 360 if it wanted to get those players to shift to the new game box. That brought back the technical challenge of backward compatibility. J Allard hated the idea, as it required him to take some of his very best software programmers and reassign them to do something which had been ruled out earlier as stupid.

Allard threw a huge fit. But he went to his team of ninja programmers and made it happen.Very late in the game, Microsoft went to IBM to ask it to support emulation, which would allow backward compatibility so that older Xbox games like Halo 2 would run on the Xbox 360. IBM had to make some modifications to enable the emulation.

Meanwhile, a branding team figured out what to call Xenon. Clearly, Microsoft couldn’t call it the Xbox 2, because that would sound inferior to the expected PlayStation 3. Don Hall, a branding manager, ran with the idea of putting the gamer at the center of a 360 degree circle. Xbox 360 was the name that stuck.

Industrial design

The first Xbox taught Microsoft the importance of industrial design, largely because it generated so many complaints. So the approach to the new console was much more methodical.

Don Coyner, a former Nintendo marketer, was appointed the “director of user experience” for the new machine. He had to collect intelligence, organize design bake-offs, and manage the people who came up with the industrial design.

The older system was roundly criticized as the result of a mad rush. It was big and intimidating. This machine had to fit in with the rest of the things people had in front of their beautiful flat-screen TVs. And it had to have “sofa,” or “significant other factor of acceptance.”

In February 2003, Coyner traveled the globe and collected design “gestures,” or early submissions for prototypes, from six design firms. To run the internal industrial design, Coyner turned to Jonathan Hayes, a non-gamer who had been designing joysticks and early smart phones.

Nothing was working great, so Hayes invited a pitch from Astro Studios in San Francisco. They came up with the design that eventually became the winning one and worked with Japan’s design house, Hers Experimental Design Laboratory, to implement it. While the original Xbox looked like it was about to explode, the Xbox 360 looked like it was inhaling.

One of their signature ideas was “the ring of light,” which was the on/off button for Xbox 360. It had four glowing green lights, each of them divided into quadrants around a the ring that told the gamer which wireless controllers were operational. Later on, the rings would come to mean something else.

But for once, something that Microsoft designed looked cool. It even looked like Apple could have designed it. It would look nice in the stack of other consumer electronics boxes in the living room.

By the fall of 2003, Bill Gates and Steve Ballmer reviewed everything. And they gave it the green light. The big green Xbox was more like The Incredible Hulk. This time, the machine would be more like Bruce Lee. The final box would have more than 1,700 components in it, but it would look beautiful on the outside.

On the business side, Steve Ballmer and Bill Gates looked at the plan. Gates was still clinging to the idea of getting Windows to run on the Xbox, and raised the option of creating a high-end Xbox that could be a full Media Center PC. A team was assigned to explore the idea, code-named Helium, but the team never pulled it together.

Bach had reiterated his decision that Microsoft wasn’t going to lose money on hardware, period. But he wasn’t being cheap. Microsoft’s leaders were willing to commit Microsoft on a path that meant spending $17 billion on the game business over the course of a decade. The whole team was now free to execute on a plan.

The Halo of Xbox 2

There were 50 games under way at Microsoft’s growing game studios, now at 1,200 people. But it wasn’t clear which ones should be created for the Xbox and which ones should become launch titles for the Xbox 360. Fries still needed better games. In February 2003, he went to an industry conference called D.I.C.E. in Las Vegas. By chance, he met with Cliff “Cliffyb” Bleszinski, who pitched Fries on making the “Halo of Xbox 2.” Fries replied, “I might give you that chance.” The game would later be called Gears of War.

One of Fries’ problems was that Halo 2 had run off schedule. It had to be redone and Bungie decided late in the process to chop the game in two, leaving the second half as Halo 3. Other problems forced Fries to lay off hundreds of developers, even as he was still responsible for making games for the PC, Xbox, and Xbox 360. The rest of the executive team pressured Fries to ship Halo 2 in the spring of 2004 so that Bungie could be ready for a 2005 launch of Halo 3. Fries refused and got them to relent.

But it cost him a lot of political capital. Bach asked him to submit his game contracts to approval from finance executive, Bryan Lee. Fries again refused, seeing that as a loss of the independence and authority that he had always had. It put a finance executive with no knowledge of game development in charge of Fries’ budget.

After some soul searching, Fries decided to resign in early 2004. He had a hand in creating 18 titles that sold more than million copies in his game career. But it was time to move on. He couldn’t get the broader authority he wanted to keep the games group independent. A. J. Redmer said of Fries’ departure, “You could call it a Greek tragedy.”

His replacement, Shane Kim, took a different approach. He cut back on the studios and organized the launch titles. Gears of War slipped out of the launch window to 2006. Halo 2 shipped in the fall of 2004, as Fries wanted, and became the best-selling game in Xbox history.

Kim lined up what he could for the Xbox 360 launch, but he didn’t have as much firepower this time. There was a risk that the Xbox 360 wouldn’t have a ton of great titles at launch. But fortunately, Microsoft now had so much credibility that the third party game publishers were more than willing to step into the breach. Among the most promising titles came from Infinity Ward, an Activision studio which was making Call of Duty 2, a spectacular first-person shooter World War II action game. Full told, Microsoft was now planning for 15 third-party titles at the launch and 40 before the end of the first holiday season.

IBM finishes up

Amazingly, IBM’s engineers finished Waternoose in 11 months, partly because Sony had commissioned work on the core years earlier. In fact, IBM finished both the Sony and Microsoft chips in September 2004. Sony’s game developers were at a huge disadvantage, as they couldn’t start game design because there was no similar chip on the market already.

But Microsoft’s game developers could start earlier on their game designs because its chip resembled the IBM PowerPC 970 processors that were being made for Apple. It was a weird day when a bunch of Macs showed up at Microsoft. But those machines enabled an army of developers to go to work with plenty of time to finish top-notch games in 2005.

While working primarily with IBM’s manufacturing, Microsoft exercised a right to have a second-source manufacturer with Chartered Semiconductor of Singapore. In January 2005, IBM got the first chips back and debugged them over the phone with Microsoft operating system expert Dinarte Morais, who was watching the Super Bowl at the time. IBM’s Dave Shippy (pictured right) got to play the first game on the Xbox 360 prototype hardware.

One day, as he stepped out of the elevator, Shippy realized he was in the elevator with representatives of Sony, Toshiba, Microsoft and IBM. A sign said, “Do not discuss confidential information in this area.”

After Sony’s chips arrived in February, 2005, the Sony team got to work on games. But delays in the PS 3’s other big component, the Blu-ray drive, pushed the PS 3 launch into 2006. Sony also had to enlist Nvidia to provide a graphics chip at the last minute, because Sony’s own engineers had failed to create one. By accident, Microsoft was going to go first in this round.

ATI’s rush to the finish line

ATI’s team was also hard at work. The company had to put solid walls in place, just as IBM had, because it was building a graphics chip for Nintendo as well as Microsoft. Microsoft’s Nick Baker and Masoud Foudeh kept in close touch with the progress. Their boss, Larry Yang, kept in touch with Greg Gibson and Todd Holmdahl. To meet the schedule, ATI had to finish its first prototype by the fall of 2004 to stay on the production schedule for the summer of 2005. Chips rarely work the first time, and debugging can take months.

Microsoft still entertained the idea of launching worldwide in three markets at once. To do that, it needed to have 3 million consoles on hand in the fall of 2005. No console maker had every launched with such a plentiful supply, though they always tried. By 2004, ATI had 180 engineers working on the chip, or about half the size of IBM’s team. IBM’s first prototype emerged from a factory in August, 2004, while ATI’s first prototype was ready in November, 2004. That was late enough to make everybody a little nervous.

IBM started cranking chips out of its factory in December, 2004. That enabled more Xenon development kits to be built for the game developers, who then had close-to-finished hardware to build games upon. Game publishers such as Brian Farrell, CEO of THQ, were stunned to learn that Microsoft was hitting its targets for getting developer tools out.

Meanwhile, six weeks went by and ATI’s graphics chip kept crashing while running code. Because it took 12 weeks to get a chip through a factory, the engineers had to wait and hold their breath to see if their hardware bug fixes would resolve the problem. A large part of the engineering team was now focused on bug hunting. IBM’s final Waternoose chip was ready by May. No such luck for ATI.

By February, 2005, ATI’s engineers figured out one of the major problems and submitted it for a new round of production tests. But the final bugs weren’t exorcised until July. Three months after that, working graphics chips started coming out of the factory. It was late. Microsoft had multiple box assembly factories in place, but the lateness meant that Microsoft would not get its supply of 3 million consoles to ship by November. It was going to be lucky to get half of that. And it would later learn the graphics chip would be the cause of one of the Xbox 360’s fatal flaws.

The first to get to 10 million wins

From the completion of the design to the launch of the console, a whirlwind of events happened. At E3 2004, Peter Moore committed Microsoft to the Halo 2 launch in the fall. Electronic Arts came back into the fold and agreed to make games for Xbox Live. Nintendo and Sony took the wraps off their designs for new portable game systems, but they had no consoles to show. By the spring of 2005, Sony’s game chief, Ken Kutaragi, was demoted. He was no longer in the running to be CEO.

In May 2005, Microsoft scored a marketing coup as MTV aired a special half-hour TV show to unveil the Xbox 360. Microsoft began showing the machine off to the press and Moore expressed his excitement about Microsoft being first. Usually, the first console in a generation to get to 10 million units sold wins, he said. And Microsoft planned to get to 10 million units before the holidays of 2006, when its rivals were launching. 

At E3 that year, Microsoft was alone in preparing to launch a new console. Sony said its PlayStation 3 would come in the spring of 2006 (it would later push it back further for the U.S.). Sony also tantalized the crowd with a beautiful demo of Killzone 2, a next-generation game which was amped up to look like game play but was really a pre-rendered animation. Nintendo, meanwhile, took the wraps off something it called The Revolution, coming in 2006.

Microsoft’s approach was much more mainstream than in the past, in recognition of the broader goals. Square pledged support for the Xbox 360.

“Here we are, at the end of the beginning,” Bach announced.

Just before the launch, Microsoft held major events in Amsterdam and at a giant aircraft hangar in Palmdale, Calif., in the Mojave Desert. Fans drove across the country to make it to the Zero Hour event, which culminated in the Nov. 22 launch of the Xbox 360. Ominously, some fans reported their consoles were overheating. But Call of Duty 2 turned out to be the smash hit for the season.

By early 2006, Microsoft announced it had sold 1.5 million units in the holiday season. It was short of its goal of 3 million, but it was selling just as well as the first Xbox had done.

The red rings of death

Sales for the Xbox 360 climbed throughout 2006, but a growing number of complaints were holding it back. Gamers like Chris Szarek went through four failed consoles, suffering problems known as the Red Rings of Death, or RROD, for the red lights shining from around the power button when the system crashed due to overheating.

By the summer of 2007, Microsoft said it would replace machines with the RROD for free. By the spring of 2008, there were at least a million or two other people like Szarek. For the Xbox team, it was its worst crisis.

Bach’s rush to market may have led to the disaster, though there was no exact connection between trying to get out early and the product’s high rate of malfunctions. The Japanese, ever wary of quality problems, steered clear of the Xbox 360. Once again, despite a heavy investment in Japanese games, Microsoft’s console landed on the Japanese market with a thud.

Microsoft knew it had flawed machines, but it did not delay its launch because it believed the quality problems would subside over time. With each new machine, the company figured it would ride the “learning curve,” continuously improving its production. Even though Microsoft’s leaders knew their quality wasn’t top notch, they did not ensure that resources were in place to handle returns and quickly debug bad consoles. There were plenty of warning signs, but the company chose to ignore them. The different parts of the business weren’t aligned. Microsoft had a culture where you shipped your software and fixed bugs later. But with hardware, that strategy was a recipe for consumer outrage.

In August, 2005, as Microsoft was gearing up production, an engineer raised a hand and said, “Stop. You have to shut down the line.” This wasn’t just a brief moment. The engineer spoke up repeatedly, as we reported in our Xbox 360 defects story.

That engineer, who asked not to be identified, had deep experience in manufacturing. When production results were really off kilter, stopping a line and tracing a problem back to its roots was the answer. But the higher-ranking engineers, managers and executives chose to risk going forward. There wasn’t a universal backlash from the engineering ranks, according to one engineering source.

Nobody listened to that engineer — who spoke on condition of anonymity — apparently because console launches are always hurried affairs. At that time, the defect rate was 68 percent, meaning that for every 100 machines made, 68 didn’t work.

It reminded me of the German war machine just before World War I, as chronicled by Barbara Tuchman in the classic history book, “The Guns of August.” The German generals were intent on keeping their trains on time, but the leaders overlooked their chances for stopping the war altogether. The Schlieffen plan called for them to strike first. Once the Russians and French mobilized, the Germans had to move into action. They marched off blindly into tragedy.

Microsoft’s effort to jointly create the graphics chip with ATI Technologies ran into a physics problem. They had a huge chip and it was mounted on a circuit board through a ball grid array package. That grid of tiny balls held the chip to the board, but it was a rigid structure. When the chip became hot and that heat was distributed unevenly, it caused uneven expansion. That put a lot of stress on the solder joints, which led to hairline cracks and failure when the graphics chip became unglued from the board.

“This should have never happened and it’s fairly basic chip engineering, but this was Microsoft’s first attempt at making a huge chip,” said Rob Wyatt, a former Xbox architect, looking back on the problem many years later.

Millions of machines were defective, suffering from the Red Ring of Death problem that we chronicled in a post on VentureBeat. There was a growing “bone pile” of failed machines in a repair center in Texas. Microsoft had to take a $1.05 billion to $1.15 billion write-off to pay for the cost of returns. The damage to Microsoft’s reputation was pretty severe, as one survey noted that 24 percent of the consoles failed after two years. The normal defect rates for consumer electronics products are about 2 percent.

For six months in the first part of 2007, Microsoft shut down Xbox 360 production in order to figure out the source of its quality problems. It was only when Microsoft shipped a redesigned version of the Xbox 360 that the quality problems ceased. In 2009, Michael Pachter, an analyst at Wedbush Morgan, estimated that the number of failed machines was 3 million, or about 15 percent of the total at the time.

Seamus Blackley himself went through three failed Xbox 360s.

“It’s hard to ship a new hardware device,” Blackley said. “People can say they released it too early. When you engineer something as complicated as that, it is really hard. I don’t know if it is true that extra time would have helped with that problem.”

Robbie Bach made the right decision in turning the tables on Sony by going first. He put Sony behind Microsoft, and it never caught up during the generation. But the early rush was only a 90 percent success, like in the film “A Bridge Too Far,” about the battle of Operation Market Garden in World War II, when a whole British airborne division was lost at the last bridge that the allies couldn’t take. While Microsoft had spent billions generating a great Xbox brand, the Red Rings of Death — while largely forgotten now — did more to damage that brand than anything else that happened to Microsoft in the console wars.

Microsoft could have captured more gamers during this product generation, yet the RROD problem held it back. It delayed Microsoft’s plan to aggressively slash prices and market the machine heavily, stopping it from reaching a broader mass market. It forced Microsoft to lower its ambitions to merely beating Sony. The Xbox 360′s defect problem will go down as one of the worst snafus in consumer electronics history.

Almost famous, almost golden

Microsoft sold its 10 million units, but the Red Rings of Death hurt its early lead. Microsoft barely made a dent in Japan.

Sony and Nintendo got into the market in the fall of 2006 and they didn’t have the same quality problems. The PlayStation 3 came in at a hefty $500 to $600, making it a non-starter for many gamers. But Nintendo created something altogether different with the Wii.

The Wii had a non-traditional controller with a built-in accelerometer (and later a gyroscope) that could sense motion. It was more like a remote control than a controller, so it was less intimidating to non-gamers. Gamers picked it up and started laughing as they played games such as Wii Sports together. Non-gamers, from little kids to women to the elderly joined in on the fun. Nintendo sold the Wii everywhere, even in sports stores where it could highlight its Wii Fit game for non-gamers. The demographics of the game industry broadened as Nintendo invited more of the masses to become gamers in a way that Microsoft never imagined possible.

When the Wii went on sale in the fall of 2006 for a mere $250, it was the smash hit of the new console generation. Microsoft had ironically beaten Sony on just about every front with the PS 3 vs. Xbox 360 battle. But it had taken its eye off an even broader mass market that Nintendo had targeted. Microsoft executives had written Nintendo off as a non-entity, and it came back to haunt them. In hindsight, the executive team wished they had done something more innovative with the Xbox 360. Nintendo had just subjected Microsoft to a classic case of disruptive innovation.

Apple interruptus

Even as Nintendo began doing its victory dance, Apple sideswiped the game industry, by accident. It created the iPod in 2001, the iPhone in 2007, and the iPad in 2010. All of the devices became capable of playing games that could be easily distributed as apps. Nintendo and Sony felt the impact first, as sales of their handheld game devices slowed down. It turned out that playing games took off like wildfire on the Apple devices.

At Microsoft, J Allard turned his attention to this new threat. Under the direction of Robbie Bach, he led the team that designed the Zune music player, as well as its sequel the Zune HD. Both were abject failures, since Apple’s iPod hardware and iTunes media store proved to be unbeatable. In this regard, Allard’s attempts to take on Apple were regarded as copycat maneuvers, too little to late.

The same fate befell Windows Mobile, the phone operating system whose market share has tanked with the rise of the Apple iPhone. Bach orchestrated an effort to take on the iPhone with the Windows Phone 7 operating system, which tightly integrates PC functions with a phone. But Apple’s iPhone already has a huge advantage in that market and Microsoft barely made a dent.

Allard’s last project at Microsoft was Courier, which Ballmer canceled earlier in 2010. It was viewed as an attempt to take on the Apple iPad. Allard claimed he did not quit because of Courier, but he wanted to do more personal adventures such as bike and off-road truck racing. The iPad continues to attract a swarm of game developers.

While Bach’s division is profitable now, it may be remembered for its inability to take on Apple in the increasingly critical mobile business. The failure to take on Apple may be why both Bach and Allard left the company last year. And that may explain why  Apple’s market capitalization has become bigger than Microsoft’s. Of course, this endless cycle of disruption in the game industry continues, as Google’s Android is now disrupting Apple.

Zynga’s emergence on Facebook

Microsoft was also taken by surprise with the rise of Zynga on Facebook and the popularity of social games on the world’s biggest social network. Microsoft didn’t completely miss the boat, as it was able to make a $240 million investment in Facebook. But Microsoft hasn’t taken the plunge into the social game market yet, as it argues that it already has a huge stake in social with Xbox Live.

Facebook now has more than 800 million users, or about eight times the number of Xbox Live users. Zynga captured Facebook’s users with cute cartoon-like titles that didn’t even seem like games, such as the FarmVille farming game.

Zynga became a financial juggernaut using the free-to-play model, where gamers pay for free and pay real money for virtual goods.That, in turn, is forcing many traditional online game publishers to follow suit.

Much of the excitement around the consoles shifted to Apple and to social games from Zynga. As Zynga prepares for its initial public offering, the traditional game industry has become jealous of all of the attention it is getting. Free, or free-to-play games remain a huge threat to the consoles, which have seen flat to negative sales during the past two years.

Blackley’s perspective on the impact of Apple and Facebook on gaming is different.

“The console makers have been trying to suck new users into playing on dedicated hardware,” Blackley said. “Now there is this pressure that is driving the consumers to play games wherever they can. The audience is demanding games on every new platform, on every new device with a display. The game business will become an entertainment business that is slowly going to be divorced from dedicated hardware.”

With new technologies like cloud gaming from companies such as OnLive and the proliferation of gaming on every kind of device, it is quite possible that the dedicated game console is now an endangered species.

The Xbox 360’s comeback with Kinect

To this day, the Wii holds the largest market share. Nintendo has sold 89.5 million Wii consoles, for a 44 percent market share. Microsoft has sold about 57.9 million Xbox 360s, for a 28.6 percent share. And Sony has sold 55.4 million PlayStation 3s, for a share of 27.3 percent. Meanwhile, Nintendo has sold 149.3 million DS portables, and Sony has sold 70.9 million PlayStation portables.

That’s usually where the calculations end. But it’s worth pointing out that Apple has sold more than 250 million iOS devices, and every one of them can play games. Zynga has more than 205 million monthly active gamers. Those are numbers that Microsoft clearly wishes it had for Xbox Live, which never really flourished as the marketplace for indie games in the way that would have made both the iPhone and Facebook irrelevant. It was a lost opportunity.

The story of the Xbox might have ended there, but Microsoft pulled a rabbit out of its hat. For the last 12 months, the Xbox 360 has been the fastest-selling console in the U.S. Nintendo’s Wii sales have fallen off a cliff, and Sony hasn’t been able to beat Microsoft in spite of shipping the PlayStation Move controller. Last month, Microsoft had 44 percent of the console market.

The reason is Kinect, the motion-sensing system for the Xbox 360 that shipped in the fall of 2010. Kinect, began as Project Natal (named after a city in Brazil) in Microsoft Research as long as a decade ago. There, it started as research on natural user interfaces, or ways to communicate with a computer beyond the mouse and keyboard, said Shane Kim, former head of Microsoft Game Studios. After the Wii came out, it became a higher priority at Microsoft. The engineering project came together within 18 months.

While the Wii and Sony’s PlayStation Move controller track single points on a handheld controller, Kinect detects your whole body’s movement using 3D depth cameras, which send signals into the entire room that bounce back and give the image sensor a 3D map of the room in real-time. Kinect also has three microphones for capturing your voice and recognizing commands. It sends the data into the Xbox 360, which can interpret the signals as commands for games. No game controller is necessary.

Kinect was viewed as the Wii on steroids. Microsoft locked up the technology by purchasing 3DV Systems, a motion-sensing chip maker. It also used a motion-sensing chip from PrimeSense. It licensed technology from GestureTek, and after Kinect shipped it finally bought 3D depth chip maker Canesta. Despite all those purchases, Kim felt the secret sauce was in software.

“To me, the magic is more software,” he said. “You’re talking about an extraordinary amount of data that has to be processed in real-time. You saw the latency was very good yesterday. You can parse voices, recognize faces. It’s complex hardware, even more sophisticated software, and simplified for developers to use it immediately. All of that so that consumers can have the most simplistic and easy experience to get into gaming.”

Microsoft also learned its lesson with hardware. Engineers Dawson Yee and Scott McEldowney said at a conference this summer that their team engineered Kinect to be as sturdy as possible. It was design to withstand high temperatures, drops, careless shipping, abusive gamers, a sudden loss of power and even surges from lightning strikes.

“You had to test it by dropping it on concrete,” said Yee, who has worked at Microsoft for 12 years and at Intel for a decade before that. “That was the level of robustness.”

One of the tough things was that Microsoft’s hardware engineers had to design the system out of thin air. They didn’t know exactly how software creators would use it. Nintendo had made the motion-sensing Wii, which depends on hand-held Wiimotes. But Microsoft had to design something with different kinds of sensors that were capable of sending signals around a room and then receiving them so that it could produce a digital representation of the spatial features of that room, without depending on remote controllers. The system had to see what was in the room, who was moving, and what they were doing. While the Wii could detect your arm motion, Kinect could go further. If you want to kick a ball in a Kinect game, you make a motion with your leg to kick a ball.

On the outside, Microsoft watchers noticed yet again that Microsoft was shutting down a lot of its longtime projects such as the Flight Simulator studio. At the time, it seemed like the company was in a retreat from the game business. But a lot of those developers were reassigned to a higher priority: making games for the Kinect launch that would take full advantage of the system and appeal to a wider audience.

Raising its ambitions once again, Microsoft, under the leadership of former Electronic Arts executive Don Mattrick, aimed Kinect at the mass market. It commissioned games like Kinect Sports or Kinect Adventures to capture the same kind of non-gamers that Nintendo snared with the Wii: the people who would never pick up a game controller. It added the ability to control your TV or movie viewing with voice commands for fast forwarding or playback. Like Nintendo’s Wii ads, Microsoft’s ads for Kinect focused on the fun that players were having.

Kinect represented Microsoft’s return to innovation and thought leadership. The result was that Kinect became the fastest-selling accessory in the history of the game industry. Microsoft also claimed it was the fastest-selling consumer electronics device in all of history. In its first season, it sold more than 8 million units. Indeed, Microsoft had the honor of having the worst snafu in consumer electronics history, and its biggest success.

Kinect is something that neither Sony nor Nintendo — even with its revolutionary Wii motion-sensing technology — has duplicated. Microsoft introduced Kinect a year ago, and it has outsold Sony’s PlayStation Move motion-sensing controller by far. It was the kind of innovation that some observers thought should have accompanied the launch of the Xbox 360 in 2005.

“This is an example of where Microsoft shines and Sony and Nintendo should be worried,” said Rob Wyatt, the former Xbox architect.

Added Ed Fries, former head of Microsoft’s game studios, “Kinect showed that Microsoft could expand its audience and continue to innovate on the platform even later in its life cycle.”

The impact of the Xbox

Ten years after Microsoft shipped the first Xbox, the console wars continue. Nintendo is gearing up to ship the Wii U next year. Microsoft and Sony are reported to be working on their next game consoles. The war isn’t over. But Microsoft has made enough progress to be able to make some bold claims.

“The Xbox 360 was the accelerant that took us from membership to leadership,” Robbie Bach, the former chief Xbox officer, said recently.

Some of the impact of the Xbox seems mundane for consumers, but easing the development pains became critical for game developers, particularly as costs spiraled toward $30 million per game.

“I think the significance is that with Microsoft’s entrance into the console space, the console space was infused with new ideas about what developer platforms should look like (Xbox Developer Kit, Visual Studio) what support should be like (Xbox ATG), what connected entertainment is (Xbox Live), and the exploration of new ideas and paradigms in gaming that can broaden gaming demographics (like Kinect),” said Drew Angeloff.

Chris Prince, the former Advanced Technology Group member, said, “One of the long-lasting effects of Xbox is an emphasis on ease of development. Or, to perhaps put it differently, the idea that software is king, not hardware.”

For consumers, the Xbox has generated billions of hours of entertainment. Those who experience that fun may call it mindless, or they may call it experiencing a new art form. It was part of a broader movement that made the process of making games into one of the coolest professions. Before, if you introduced yourself as a game designer at a party, people saw you as a geek, Blackley said. Now, it is one of the coolest jobs available.

“Xbox really opened my eyes,” Blackley said. “It showed me what stood in the way of creative people. The most important people in the business are gamer designers. Everything you do in their favor is good. Everything you do against them is suicide.”

The newfound respect for game developers means that more people are viewing games as acceptable and respectable. Microsoft’s entry into games was a brand endorsement that made it OK to be gamers. And it enabled game developers to legitimately claim that they were making works of art.

A.J. Redmer said, “I think Microsoft would consider it to be the company’s biggest success over the past decade. It has taken the lead over Windows when driving the user experience in areas like mobile devices, smartphones, music players and other things.” Redmer said that the system and services targeted what the team called DEL, or the Digital Entertainment Lifestyle. In fact, it became a hub for watching TV, streaming music and movies, photo and video sharing and other non-game content.

Xbox also put games on the road to becoming the biggest form of entertainment. Thanks in large part to sales on the Xbox 360, Activision Blizzard has been able to claim for the last three years running that its Call of Duty game launches have been the fastest-selling entertainment launches in history for any medium. Last week, Call of Duty Modern Warfare 3 sold more than 6.5 million units and generated $400 million in revenues in a single day. Most of those who played that game online played it on Xbox Live.

The Xbox diaspora

The Xbox did another good thing for the industry. It pulled a team together, honed them in a very intense experience, and spun them out again into the industry. Some liked it so much they stuck around for the Xbox 360. But many left. Alex St. John was out the door before Xbox really began. He is now the president of game-focused social network Hi5.

Peter Moore, who ran the Xbox team under Bach, left to join Electronic Arts to head its sports game label and is now chief operating officer there.

Steve Perlman, who had sold WebTV to Microsoft for $425 million, took his money and started an incubator called Rearden. He founded companies such as Moxi Digital, Mova, and helped Andy Rubin, former head of Danger, maker of the Sidekick phone, start something called Android. Google bought it and turned it into a mobile operating system phenomenon. But Perlman’s focus has been on OnLive, a game streaming venture that, if it works, will make game consoles obsolete.

Kevin Bachus, Blackley’s sidekick, also left before the Xbox launched. He wound up at Capital Entertainment Group with Seamus Blackley, who had stayed at Microsoft through early 2002. He stayed through the launch and resigned on the day that my book, Opening the Xbox, was published in the spring of 2002. At CEG, Bachus and Blackley tried to create a financing and production machine for game developers, but they were starved for capital themselves and never got off the ground.

Bachus went on to other game companies and wound up as the No. 2 executive at Bebo. Blackley spent years at Creative Artists Agency representing game designers and getting them their fair share of royalties and ownership of their intellectual property. He left this summer to work on a new startup in games.

Ted Hase, one of the four co-founders of the Xbox, left Microsoft in 2004. He is now vice president of research and development and global games at Aristocrat Technologies. Otto Berkes, another co-founder, worked at Microsoft on low-power handheld technologies through mid-2011. He recently left to join an unnamed startup.

Cameron Ferroni left Microsoft, but his buddy J Allard stayed through the Xbox 360, the Zune, and the design of a tablet called Courier. After that was canceled, Allard left in 2010. Allard hasn’t surfaced yet, but Ferroni is vice president of engineering and operations for TheClymb, an online flash sales site for outdoor gear.

Robbie Bach also left the company in 2010, retiring after a glorious business career of 22 years at Microsoft. Allard and Bach had a long run, presiding over Microsoft’s greatest successes and some of its worst failures.

Rob Wyatt went on to work on the PlayStation 3 for Sony and worked on games at Insomniac Games. He recently became chief scientist at game streaming firm Otoy and is writing game reviews for VentureBeat.

Since retiring from Microsoft in 2004 after more than two decades there, Ed Fries continued to work in the video game business as a board member, advisor, consultant and speaker for many game companies around the world. He’s part owner of a game company and runs his own high-tech startup. Shane Kim, Fries successor, also retired from Microsoft and is now advising startups.

A.J. Redmer, who helped put the Xenon plan together, left Microsoft in 2006 after seven years on the Xbox team. He now serves on the boards of international companies and is based in Austin, Texas.

Chris Prince, the former member of the Advanced Technology Group and one of the hardware designers, left in 2004 to work at Google, where he stayed for seven years as technical lead for Google Voice. He is now at a startup. Mike Sartain of the ATG left in November, 2001 and spent 10 years with Abrash at Rad Game Tools. He joined Valve Software earlier this year to work on Defense of the Ancients 2.

Horace Luke went on to do a number of internal projects but left to lead smartphone design for HTC. He recently left that job for something new.

Drew Angeloff left Microsoft after the Xbox 360 to work at ATI Technologies, which was later acquired by Advanced Micro Devices. After that, he returned to work on Microsoft’s XNA game development program and Windows Phone. Now he is in charge of production at Turn 10 Studios, which just shipped the Forza Motorsport 4 game.

David Hufford has played a variety of roles since the launch, but is back in charge leading the public relations team. Oddly enough, Hufford didn’t organize any public recognition of the 10th anniversary of the Xbox launch. Microsoft has recreated a version of its blockbuster Halo game (now called Halo CE Anniversary) to celebrate its 10th anniversary. But that’s it.

Occasionally, the team has reunions at different events. Of those interviewed recently for the story, all of them said the most memorable things about the Xbox were the people on the team. We regret we couldn’t reach everyone. Not everybody got proper recognition for their work.

“The Greeks said nostalgia is a disease,” Blackley said. “It interferes with your ability to live in the day. If you worry about getting credit about something, it should remind you that you are not doing something yourself at the moment that is fulfilling. But we all know that, in that first year, if someone failed to do their job, it was the life or death of the project. In the end, it’s so awesome. I’m really proud of those of us who stuck our necks out to get it going.”

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