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 title—previously 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 retool—Electronic Arts spent a record $372 million on research and development during 2008’s third quarter—they 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 years—and a bunch of sequels and expansions—for 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 founder—a 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 Madden—titles that always come out on time and on budget because the company’s bottom line depends on it—have 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 theaters—without 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 series—while 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 weeks—and 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 Auto—it needs to let 1,000 Portals bloom.