Could a Cheaper Sony PS4 Kill Microsoft’s Xbox One?

Sony (SONY -0.33%) expects lower PS4 hardware costs to lead to higher operating income, the company said in its first-quarter earnings report. As a result, Sony now has the option to continue reaping higher profits or boost sales volume by reducing prices.

If Sony opts for the latter, Microsoft's (MSFT -2.45%) Xbox One -- which has sold only 5 million units compared to Sony's 8.7 million PS4s -- could be in serious trouble.

Sony's PS4. Source: Sony.

How badly could a cheaper PS4 hurt the Xbox One?
When the PS4 and Xbox One launched last November, Microsoft made two big mistakes -- bundling the new Kinect with the console, and setting the launch price at $499. Research firm IHS iSuppli estimates that the Xbox One costs $471 to manufacture, of which the Kinect accounts for $75. By comparison, IHS estimates that the $399 PS4 costs $381 to manufacture.

Microsoft had hoped that the Kinect would set it apart from the PS4 with voice and gesture controls. Unfortunately, customers weren't willing to pay $100 extra for the Kinect, especially when the device was needed for only a handful of games. Meanwhile, most Xbox One games were cross-platform titles that were also available on the PS4.

When the PS4 started to pull ahead earlier this year, Microsoft offered a $100 rebate toward the Xbox One for Xbox 360 and PS3 owners willing to exchange their old consoles. That was a bad deal, considering that the used consoles could be sold for more to GameStop.

When Electronic Arts (NASDAQ: EA) launched Titanfall in March, Microsoft aggressively bundled the game with the console for $500, taking an additional $60 loss per console sold. To make matters worse, Wal-Mart, Target, and Best Buy further slashed the price of the bundle to $450. In May, Microsoft finally realized that it had no choice but to remove the Kinect -- its only defining feature -- from the Xbox One to match the PS4's $399 price tag. Yet even that painful move failed to help the Xbox One catch up.

Considering all of these past problems, it's obvious that a slightly cheaper PS4 could leave the Xbox One in the dust forever.

History is not on Microsoft's side
Sony won't slash prices right away, especially when it remains in the lead with higher sales and higher margins. However, Sony has a tradition of launching "slim" versions of its consoles several years after their initial releases:

Source: Industry websites.

These slim versions are smaller and cheaper, thanks to lower hardware costs. The PS3 Slim offered a 120GB hard drive (compared to the 60GB drive with the $599 version), consumed 34% less power, and was roughly a third smaller and lighter than the original.

The Xbox 360 (L) and the Xbox 360 S (R). Source: Wikimedia Commons.

Considering that the time between Sony's original and slim launches has decreased over the past three generations, and hardware costs are falling faster than anticipated, we might see a cheaper and slimmer PS4 within two years. This would make it tough for the Xbox One or $300 Nintendo (NASDAQOTH: NTDOY) Wii U to remain competitive.

Microsoft previously adopted a similar "slim" strategy with the Xbox 360. It launched the slimmer 360 S and 360 E in 2010 with a starting price of $299, with beefier specs than the Xbox 360 Elite, which originally cost $480 in 2007.

But the key difference with the Xbox 360 is that it gained an early lead over the PS3 thanks to smarter pricing -- the cheapest version of the 360 initially cost $300, while the cheapest PS3 cost $400. Today, Sony and Microsoft's roles are reversed. Whereas Sony learned its lesson from its pricing mistakes with the PS3, Microsoft launched a pricier console that foolishly tried to take over the living room as an all-in-one media center.

The Foolish takeaway
Looking ahead, the Xbox One remains crippled by the lack of major exclusive titles. The new Gears of War, which still doesn't have a confirmed launch date, and Halo 5: Guardians, which will arrive late next year, are the Xbox One's best hopes at drawing back gamers.

If Sony lowers the price of the PS4 or launches a slim version earlier than expected, Microsoft will immediately have to match, or beat, its price. That would lead to heavier losses at the Xbox division, which already loses $2 billion per year, according to estimates from Nomura Securities analyst Rick Sherlund. To make matters worse, a price cut might not even lead to higher Xbox One sales.

That's not a huge deal for Microsoft, which posted $86.8 billion in revenue in fiscal 2013, but investors are right to wonder if Microsoft should spin off the division altogether, as Bill Gates once recommended, before Sony delivers the knockout blow.