So now we have a price and boy is it a doozy: $600 for a PlayStation 3 (Ok, the cheapstakes out there can buy a watered down version for $500). Frankly we are shocked, not so much at the price which Sony had telegraphed was going to be high, but more at what the timing of the announcement says about where Sony is going.

We were surprised that Sony announced such a high price a full six months before launch. To us this seems to be a clear sign that 1) Sony is making a bold statement that it intends to shift focus from the blue-collar mass market to the high-end consumer electronics users and/or 2) internal events had spun so far out of control that $600 was as low as Sony could conceivably go. Either way this will have a profound effect on the interactive entertainment market for the next few years.

To understand the pricing it is important to look at the context of the PlayStation 3 and how Sony’s game division no longer exists in a vacuum. There were many cooks in the PS3 kitchen, as it became a core linchpin of Sony’s overall strategy. In 2006 we are witnessing the results of years of strategic planning and it may be difficult to turn back the clock.

Sony Corp. grew into a premium consumer electronics brand based on superior industrial design, quality, and timely innovation. That reputation allowed Sony to command premium unit prices for decades. Trinitron CRTs are a perfect example. Sony televisions and computer monitors retailed at a higher price than their competitors, and consumers understood why they were paying more.

Much has changed six years into the 21st Century. Led by the personal computer segment, it is much more common for competing technology brands to share many of the same commodity components originating from a small number of sources. Do consumers know where the guts of their Dell PCs come from? Apart from the Intel processor, consumers don’t have a clue who designed the components in their PCs, or realize that Dell had little to do with the vast majority of what goes into its products. Similarly, a Sony or Dell Plasma Display may share the exact same screen sourced from the same South Korean or Chinese supplier. Despite trend-setting cosmetics and flashy advertising, Sony cannot sell its plasma screens at a premium MSRP, and there lies context behind the design of the PlayStation 3.

On the video game side, Sony Computer Entertainment (SCE) president Ken Kutaragi began his career as an electrical engineer and he is widely considered the father of Sony’s video game efforts. He attained much success and stature within the corporation as Sony achieved dominating console market share with the PlayStation and PlayStation 2. The PlayStation 2 reached a market share of around 67% and in March of 2003, Kutaragi’s influence within Sony grew with his promotion to corporate deputy president and chief operating officer under then chief executive officer Nobuyuki Idei. Kutaragi also became president of Sony’s semiconductor division.

Always the engineer, and directly in line to succeed Idei, Kutaragi pushed for a return to design innovation. In 2003 he told Time Magazine, “Sony needs to return to its roots as an innovator of leading-edge technologies, and rely less on sexy design and savvy marketing.” As late as January 2005, when asked what he would do if he were running Sony, Kutaragi told the Foreign Correspondents’ Club in Tokyo, “…the company must revive its original innovative spirit, when it boasted engineering finesse with the transistor radio, Walkman and Trinitron TV.”

To Kutaragi, ensuring the future financial success of Sony meant driving premium, or aggressive, pricing by designing clearly differentiated consumer electronics hardware. At the official unveiling of the PlayStation Portable in Tokyo during the fall of 2004, the investor press questioned Kutaragi about why SCE didn’t use more off-the-shelf components. He replied that SCE relied on Sony’s semiconductor operations for 50 percent of the PSP’s component value. Aggressive pricing was only possible, he said, because key ICs were designed and fabricated internally, using a 90nm process. “You can’t pull off this kind of pricing by depending on off-the-shelf components,” Kutaragi argued.

Kutaragi championed the strategy that internal development and production of “key devices” were essential for differentiating Sony’s end products. Out of this strategy came a PlayStation 3 with the inclusion of Blu-ray high-definition disc storage, and the development of the Cell processor with partners IBM and Toshiba. Under Kutaragi, over $4 billion for the three business years ending March 31, 2007, were invested in semiconductor development for Cell and other key devices.

To support that investment, many of Sony’s distinctive consumer electronics in the future would be built around the Cell and also sold at a premium price. Digital televisions and mobile devices are most often cited as being Sony’s development target for Cell processors. In a May 2004 interview with the Japanese business daily Nihon Keizai Shimbun, chief executive officer Nobuyuki Idei explained the Cell would be used in other devices in addition to the PS3, including a network television that would offer functions similar to a personal computer.

According to a white paper from IBM, the processor is currently targeted for electronics devices projecting graphics-rich images. The paper’s author, Peter Hofstee, IBM’s chief architect on the Cell project said: “Although the Cell Broadband Engine is initially intended for application in game consoles and media-rich consumer-electronics devices, the architecture and the Cell Broadband Engine implementation have been designed to overcome some of the fundamental limitations to processor performance. A much broader use of the architecture is envisioned.”

Early in 2005 IBM indicated that it would pitch the Cell processor at products that rely heavily on imaging, such as aerospace, defense, industrial and medical applications. The current Cell processor to be used in the PlayStation 3, and industrial servers, has one Power PC core supported by eight synergistic cores on the same wafer of silicon. Hofstee says many consumer electronics devices may not need that much power, and could use an abbreviated version of the Cell. “Clearly you don’t want a 3.2-gigahertz chip in a cell phone, or you’d burn your ears off. Today, the implementation is optimized for certain systems. But the architecture we developed can eventually find use for that entire spectrum. You can have a chip with one Power core and one synergistic core, and your chip would be much smaller in size.”

So Kutaragi, ever the engineer, had pushed for an adaptable architecture that in any incarnation would boost digital processing performance compared to existing off-the-shelf competitors. In theory that would give any Cell-powered Sony product a technological edge warranting a more aggressive MSRP. As the first product to use the Cell before the processor’s development costs could be amortized, the PS3 would be in line for the aggressive pricing Kutaragi had envisioned.

But the costs of bankrolling such semiconductor R&D, at the same time Sony’s existing consumer electronics products were not selling well enough, caught up with Kutaragi long before PlayStation 3s reach store shelves. During the previous five years, Sony shares lost two-thirds of their value, and the consumer electronics division lost money in both fiscal 2004 and 2005. So in a major executive reshuffling in March 2005, Idei retired, and Kutaragi lost control of the semiconductor and consumer electronics divisions, while remaining president of SCE.

Incoming Sony chief executive Howard Stringer quickly dubbed the PlayStation 3 as one of the company’s “champion” products. Like it or not, short-to-long-term Sony profits would depend a great deal on the Cell-powered PS3, and new management publicly fell in line behind the demoted Kutaragi at his core-contingency. “Obviously the PS3 is a vital device for the company going forward. So I am under no illusions about the value and importance of Kutaragi-san,” Stringer said in an April 2005 interview. Ryoji Chubachi, who replaced Kutaragi as Sony’s No. 2 man behind Stringer, as well as president of the semiconductor division, also had high praise for Kutaragi. “I respect him as an engineer,” Chubachi told journalists in Japan. “In the area of semiconductors, I consider him my teacher.”

But not long afterward, Chubachi publicly began soft-peddling some of Kutaragi’s cherished initiatives at a press conference. “Semiconductors are important, the investment should be continued. But I like to consider it a matter of balancing the total corporate strategy,” he said. “Cell is also important for Sony’s products, not just for PS3. We should continue to invest. But how to implement the processor in products is a challenge.”

Yet the technological die was cast with the PS3. Whatever its costs, it was now time to start selling the system. Sony Computer Entertainment America’s president and chief executive, Kazuo Hirai, attempted to put PS3 pricing in a value context at the 2005 E3 convention. “What we try to do, true to our DNA, and being a part of Sony, is to make sure we pack in a lot of technology and provide that at a very good value proposition to the consumers. We haven’t decided on a price yet, but rest assured, we have a very good relationship with consumers. We’re not going to suddenly decide to change that philosophy.

By June and July 2005, however, an unrepentant Kutaragi was making statements in Japan hinting at just how much PS3 technology may cost consumers. “Whether consumers think a product is expensive or cheap all depends on the balance between its appeal and price. Our ideal is for consumers to think to themselves, ‘OK, I’ll work more hours and buy it.’ We want people to feel that they want it, no matter what,” Kutaragi told magazine Toyo Keizai on June 28. “When Nintendo was selling its 16-bit machine at around 12,500 yen ($114), we sold the first PlayStation at 39,800 yen ($364). The press was saying that it was expensive, but it was a huge hit. It’s the same thing with the PlayStation Portable from last year.”

At an SCE briefing in Japan on July 30, Kutaragi continued with the same theme on PS3 pricing. “I’m aware that with all these technologies, the PS3 can’t be offered at a price that’s targeted towards households. I think everyone can still buy it if they wanted to. But we’re aiming for consumers throughout the world. So we’re going to have to do our best. I’m not going to reveal its price today. I’m going to only say that it’ll be expensive.”

By September 2005, SCE vice president Masatsuka Saeki held the PS3 price card much closer to the vest in an interview with Famitsu Weekly. “Concerning the PS3 price tag, I believe we will keep having meetings about it until the very last moment.”

Given this comment we were expecting a price announcement much closer to launch. This was especially true given the November 2005 launch of the Xbox 360 at $400 (with a $300 watered down version). With a $200 price difference now announced, consumers that were sitting on the fence can feel free to go buy an Xbox 360. For that reason alone we would have thought Sony would have held off on announcing such a price difference.

Sony clearly feels confident with its brand strength and does not worry much about the competition in the video game space. Of course, with the PlayStation 2 there was not much need to worry. Furthermore, video game buyers in recent years have been remarkably price insensitive when it comes to high-priced, high profile hardware. In the portable market, Sony’s PSP, outside Japan, has been able to hold its own at a price nearly twice the competition.

However, at $600 we are talking a whole new ball game. This is not only well above the current competition, it is twice the initial PS2 price. The video game business model has been to build an installed base of tens of millions of users in a very short-time frame. A key factor in this model is relatively low cost hardware. At a $600 price point the PlayStation 3 is targeted at the much smaller base of elite power users. Of course, hard-core video junkies may go for the PS3′s Blu-ray capabilities, as $600 is cheap for a new high-end technology like Blu-ray. But if those guys are not buying game software that does not do game publishers any good.

The PlayStation 3 needs to justify its price difference as a game machine. In terms of game software it currently looks like the Xbox 360 will be able to match the PS3 punch-for-punch in the important genres like shooting, RPGs, racing, sports, Grand Theft Auto IV and others. Will Sony’s brand name alone explain a $200 price difference to the gaming audience?

Next month DFC Intelligence will be releasing updated forecasts for the interactive entertainment industry based on new announcements from E3. Suffice to say the higher priced the hardware, the lower overall industry growth will be. Our big question going forward is how fast can Sony bring that price down. Sony could just be waiting to milk the early adaptors that will snap up any new units no matter what the price. Unfortunately, there is a sinking feeling that things may have spun out of control for Sony and thus price cuts will be slow in coming. While that may be good news for Microsoft and Nintendo it could spell rough times for publishers that have come to rely so much on Sony’s ability to build a huge market of devoted video game consumers.