What's Killing the Video-Game Business?

Hint: It's not the economy.

Like pretty much every industry these days, video-game publishing is in some
financial trouble. Electronic Arts, the world's largest game publisher, best
known for Madden and the Sims, lost $641 million in 2008's fourth quarter.
Activision-Blizzard, owners of the cash cows World of Warcraft and Call of
Duty, reported losses of $72 million in the fourth quarter of 2008. (They lost
$194 million the quarter before that.) THQ, the third-largest publisher in the
United States, and known for lucrative licenses ranging from the Ultimate
Fighting Championship to Pixar, had $192 million in losses over the holidays
and is laying off 24 percent of its work force.
News of development-studio closings and layoffs are being reported around the
world. And while publishers focus on internal cuts, many independent
developers have closed outright. Such gloom, in a normally raucous industry,
has set the talking heads, bloggers, and trade press to a quick conclusion:
Losses and layoffs are the direct result of an economic crisis (on the premise
that "things are tough all over").
But that idea, which makes intuitive sense, is completely at odds with recent
sales numbers. In reality, video games are selling better than ever. The
retailer GameStop announced sales of nearly $3 billion worth of games,
hardware, and accessories during the nine weeks around the 2008 holidays
22 percent more than during Christmas 2007.
According to the research firm Media Control GfK, game software accounted for
more than half of global packaged entertainment sales in 2008, beating DVD
sales for the first time. The firm pegs game sales at $32 billion worldwide.
(The U.S. market accounts for around 45 percent of the world total.) The NPD
Group, which tracks sales for the industry, also reports that game software
sales were up 26 percent in 2008.
So how can publishers lose money amid such incredible sales and record
growth? The answer is simple: They're spending more than they're bringing in.
Game development budgets have ballooned, and publishers are reeling
because they can't keep the costs under control.

Games weren't always expensive to make: In the early days, a boy with an
Apple II could rule the world. While there are still scads of cheaply made
games on the market, all of today's big publishers employ hundreds of
professional developers per game. These projects take years to complete, as
each new generation of hardware allows for unprecedented advances in
graphics, sound, and everything else. The greater the complexity of the game,
the larger the development team. The larger the development team, the bigger
the budget.
While industry leaders anticipated that budgets would creep higher, the shift to
high-definition gaming with Microsoft's Xbox 360 and Sony's PlayStation 3 has
proved to be more expensive than estimated. At a conference in the spring of
2006, then-Midway developer Cyrus Lum sounded the warning, telling his
audience that game development budgets could rise as high as $15 million to
$25 million for a single titlepreviously unheard-of averages. "We need to
rethink how we're financing games," Lum concluded.
When a newspaper quoted this frightening view, Lum found himself in hot
water with his employer for making such sensationalist comments. It turned
out that Lum's prediction was too low: Midway would go on to spend between
$40 million and $50 million developing This Is Vegas, an action title set for
release in late 2009.
That figure is not unusual. Budgets for next-generation development have
continued to rise steadily across the board. And while executives and
technologists knew that there would be heavy initial investment costs to
retoolElectronic Arts spent a record $372 million on research and
development during 2008's third quarterthey expected returns on that
investment, something that's so far failed to materialize.
Production difficulties and product delays continue a full 26 months after
Sony's PlayStation 3 reached store shelves. When companies regularly spend
$40 million to develop a title and contribute more to the marketing, they need
to sell at least 2 million units to break even. While Halo 3 racked up pre-orders
of 1.7 million copies, and Gears of War 2 has sold more than 3 million units,
only a handful of titles each year do that well. Consider that Will Wright's
Spore, which sold 1 million copies in its first 17 days, was supposed to be a big
hit for Electronic Arts; but the development cost was so high that that internal
estimates now say it will take five yearsand a bunch of sequels and
expansionsfor the company to recoup its initial costs.

Rockstar's Grand Theft Auto IV, released last May, is the prime example of a
blockbuster game. GTA IV sold 6 million copies during its first week, bringing
in $500 million. True to form, it cost Rockstar $100 million to produce, 1,000
people worked on the project, and it took three-and-a-half years to complete.
Six months later, sales began to foundera major setback to a publisher that
bet the farm on the title and predicted sales throughout 2009.
Despite GTA's declining returns, the initial sales numbers were so compelling
that other companies are desperate to follow suit. During Electronic Arts' last
quarterly call, CEO John Riccitiello explained that the company would be
pursuing blockbuster hits as a primary revenue source. Perennially successful
sports franchises like Maddentitles that always come out on time and on
budget because the company's bottom line depends on ithave given EA a bit
more wiggle room than its competitors. Riccitiello has decided to use that
wiggle room to craft expensive games of exceptional quality, products that
don't ship until they're deemed perfect.
The industry has long discussed going with this "Hollywood model," in which a
few games/movies turn a profit, those hits more than covering the other
losses. The analogy between the Hollywood blockbuster model and the games
business falls apart, however, because of the huge difference in overhead
costs. Electronic Arts steadily employs 7,400 developers. The industry
standard is a $10,000 man-month, meaning the company burns through more
than $74 million for development each month. The big Hollywood studios, by
contrast, make movies by giving money to temporary production companies,
which then hire temporary crews with one-project contracts. The temporary
entity will make the film from start to finish. And once production is complete,
the studio receives a finished product that it can distribute to theaterswithout
the continued overhead expenses that game publishers often face.
Companies like EA and Activision are two kinds of businesses at once, making
games themselves while publishing the work of other developers. It was a
natural evolution: Publishers built distribution and marketing networks for
themselves, grew successful, and found that they could use that same pipeline
to sell somebody else's games. Though publishers rake in more profits when
they own the titles they're releasing, working with outside firms enables them
to put out more games.

Of the 48 titles EA released last quarter, eight were from other developers
mostly in the Rock Band serieswhile 40 were developed internally. If a
publisher is looking to do blockbusters, that figure needs to be reversed. Using
an external production company means you don't have to bear the burden of
overhead, and when the game inevitably slips and needs more time, it isn't a
problem for the publicly traded publisher needing to meet a quarterly window.
But, perversely, EA's Riccitiello has said the company plans to cut the number
of titles it's developing, hoping that releasing fewer games with even more
effort will generate more blockbusters. That means costs will rise above the
$40 million mark, an extraordinary gamble.
It's unrealistic for a company that employs many thousands of developers to
abandon internal production immediately. In the short term, Electronic Arts
should consider copying the old Hollywood "studio system." During the Great
Depression, a movie could be made in two weeksand people would go to see
a new movie each week. EA could make games that cost less. How? Change
the scale and scope of the world. Make the story shorter. Use lower-quality
graphics. Recycle proven tools and technology.
Consider the case of Portal. The first-person puzzle game began as a student
project before it was scooped up by Valve Software. Valve polished the game
up and took it to EA, which distributed the game at retail as part of its "Orange
Box" collection. As of two months ago, they'd sold 3 million copies. Electronic
Arts, though, doesn't seem to have absorbed the lesson of this success story.
EA doesn't need to find its own Grand Theft Autoit needs to let 1,000 Portals
bloom.

By N. Evan Van Zelfden SLATE.com