Sony (NYSE:SNE) recently warned investors of a wider than expected annual loss of $2.14 billion, due to a big writedown for its struggling smartphone business, which accounted for 17% of its top line last quarter.

Sony's Xperia smartphones -- which only account for 3.5% of the global smartphone market -- face intense competition from Samsung (OTC:SSNLF) and Apple (NASDAQ:AAPL), which respectively control 25% and 12% of the global smartphone market, according to IDC. Meanwhile, Chinese brands like Xiaomi and Huawei are disrupting the market with cheaper, lower margin smartphones equipped with mid to high-end hardware.

Sony's Xperia Z phones. Source: Sony.

Revenue at Sony's mobile business climbed 10.1% to 314.3 billion yen ($3.11 billion) last quarter, but that gain was mainly attributed to favorable exchange rates. Unit sales fell year-over-year, causing the business to post an operating loss of 2.7 billion yen ($27 million). Ratings agency S&P recently warned investors that Sony's mobile business and the rest of the smartphone industry would face "strong pressure to cut prices" and "thin margins in general."

Since Sony's mobile footprint apparently can't get any bigger without incurring bigger losses, investors are probably wondering if the company should cut its losses, as it did earlier this year by selling its VAIO PC business and spinning off its TV division.

Why Sony should kill the smartphone business
Sony's high-end Xperia smartphones are certainly sold at high margins -- the Xperia Z, which launched for around $540 unlocked last year, only cost $203 to manufacture, according to research firm IHS. Yet those hefty margins failed to produce an operating profit because of payroll, development, and marketing costs.

To protect the segment's bottom line, Sony recently announced that it would lay off 1,000 of the 7,100 workers in the smartphone division, but that's just a temporary fix. To fight back against Samsung, Apple, and Xiaomi, Sony would need to dramatically increase its marketing budget and lower prices to boost unit sales. Both strategies will cause Sony to take continuous losses simply to protect its tiny sliver of the mobile market.

The global smartphone market is expected to grow 23.6% year over year in 2014, according to RnR Market Research. But within that market, smaller mid- to high-end players like HTC and Sony are being crushed between high-end brands like Apple and Samsung, and low-end ones like Xiaomi. Meanwhile, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and its partners recently launched the first batch of Android One handsets, which could fill the low-end market with smartphones that cost just over $100.

There are two paths Sony could take -- to aim at the high-end market and get crushed by Apple and Samsung, or to target the low-end market, sacrificing margins to fight for scraps alongside Microsoft, Motorola, and many other fallen competitors. Since neither choice would lead to a happy ending, it would be logical for Sony to sell its smartphone division before its value completely fades away.

Why Sony should keep the smartphone business
Retreating from smartphones makes sense financially, but it could also be a bad long-term move. To compete against Apple and Samsung in consumer electronics, Sony needs smartphones and tablets as the hubs for its SmartWear wearables, PlayStation games, and Internet-connected devices at home.

Sony is one of the most widely recognized brands in consumer electronics, films, and video games. Unlike HTC, LG, or Motorola, it can leverage its clout in these other businesses to promote Xperia phones.

Under the company's "One Sony" strategy, Sony has already incorporated video and lens technologies from its TV group into its new Xperia models. In May, Sony gave away Michael Jackson's "latest" album, Xscape, to new Xperia owners. Earlier this month, Sony launched Remote Play for new Xperia Z devices, which allows owners to play locally streamed PS4 games on their smartphones and tablets.

Sony's Remote Play on Xperia Z devices. Source: Sony.

Sony also hasn't reached its full carrier potential in many developed markets yet. In the U.S., only T-Mobile offers Xperia phones. If Sony signs new deals with other national carriers, it could gain market share without launching cheaper phones. Sony also intends to reduce its line of mid-range devices and focus on high-end ones, which could make its catalog of 16 similarly named smartphones much less confusing to the average consumer.

The Foolish takeaway
In my opinion, I don't think Sony should sell or spin off its smartphone business just yet. If Sony streamlines its range of devices, boosts cross-segment marketing, and signs new carrier deals, it could regain some market share and retain a foothold in the crucial mobile market. Sony should only consider getting rid of the unit if all of those efforts fail.