The infamous Xbox 360 "red ring of death" (indicating a failed unit) has caused Microsoft - and its customers - untold pain in the three years since the console's launch in 2005, and cost it $1.15bn (£738m) last year. Microsoft has never said publicly why the console was plagued with faults: it seems that poor production quality was at the heart of the failures - an all-round problem with no single cause except impatience on the company's part as it tried to become the leader in videogame consoles.

It was an ambitious attack. Microsoft's engineers started working on the Xbox 360 at least a year after Sony's engineers began work on the PlayStation 3, yet wound up shipping a year earlier. With the first Xbox, the company lost $3.7bn (£2.3bn) over four years, mostly because costs of the box - particularly its hard drive - were too high. Bill Gates didn't really care about the losses; that was simply the ante for getting into an exciting new business. But Steve Ballmer, who took over from Gates as chief executive during the first generation, really wanted the Xbox business to be profitable second time around.

Software-hearted

Even though early testing showed that production machines had flaws, Microsoft didn't delay the launch because it believed the quality problems would subside. "They got enamored with the idea of the Microsoft army rolling everything out at the same time," says one source. "Their thinking shows that they are a software company at heart," says one veteran manufacturing executive. "They put something out and figure they can fix it with the next patch or come up with a bug fix."

In the hurried design process, Microsoft decided late to add a hard disk drive, and then wireless controllers. The hard drive blocked airflow on one side of the machine; the wireless modules had to have enough space to avoid electrical interference. The console shell was poked full of holes to ensure airflow. In the end, the machine was a series of compromises.

"It turned out in the end that this was all going too far, too fast," says a source. "They were adding too many features after things were locked down. That incremental feature adding just made it fragile."

Some of the defects were latent, potentially not showing up for some time after the machine was used. Up to 50% of all defects can be latent. And production yields - the number of machines coming off the production lines that passed testing - were low. In August 2005, the machines' aggregate defect rate - from Microsoft's contract manufacturers Flextronics and Wistron, in their factories in China - was allegedly just 68%.

In a memo dated August 30 2005, the team reported overheating graphics chips, cracking heat sinks, cosmetic issues with the hard disk and the front of the box, underperforming graphics memory chips from Infineon (now Qimonda), a problem with the DVD drive - and more. At that point, the contract manufacturers were behind schedule and had only built hundreds of units when they were supposed to be making thousands every week.

"There were so many problems, you didn't know what was wrong," says a source. "The [test engineers] didn't have enough time to get up and running." Shutting down production to debug everything properly might have delayed the launch in Europe or Japan.

Microsoft responded to this story (in full at Venturebeat.com) with a statement that it has already acknowledged an "unacceptable number of repairs" to Xbox 360 consoles and had responded to the hardware failures with a free replacement program. "This topic has already been covered extensively in the media," the statement said. "This new story repeats old information, and contains rumors and innuendo from anonymous sources, attempting to create a new sensational angle, and is highly irresponsible."

I have tried to verify the facts. Microsoft has never disclosed its actual return rates. But according to data obtained by VentureBeat, the total number of returns climbed above 1.2m consoles early last year. That is a huge figure, considering Microsoft had only shipped 11.6m consoles to stores by the time of the writeoff in mid-2007.

The warning signs were present even before Microsoft shipped any machines. In August 2005, as Microsoft was gearing up production, an engineer said: "Stop. You have to shut down the line." When production results are really off-kilter, stopping a line and tracing a problem back to its roots is the answer. But in this case, the decision was made to carry on.

Nobody listened to that engineer, apparently because console launches are always hurried affairs. Yields generally start low. As the manufacturers analyse data and tighten controls on each assembly step, they learn how to drive the yields up.

On November 22 2005, the Xbox 360 went on sale. Consumers could run graphically beautiful games on high-definition TVs. But machines started failing almost immediately. At the time, the company said it had received "isolated reports" of console failures and that returns were within the normal range.

According to the Consumer Electronics Association, the average return rate for products where the consumer gets their money back is about 2%. Microsoft's internal data assumed that in the long term 6% or 7% of the consoles would be defective before shipping into the market - a yield of 94% or 93%. The rate of return was expected to be low as well. But even after 2005, Microsoft struggled to ship enough units. The yield was typically only around 70% - far short of the target - until May 2007.

Problems denied

By the end of March 2006, Microsoft said it had shipped more than 3.3m consoles to retailers. But there was a growing "bone pile" of more than 500,000 defective consoles in a warehouse at Wistron and a repair centre in Texas - either duds off the factory line or returned boxes, according to sources. Production yield was climbing, but far too slowly. Meantime, Microsoft stood by its statement that returns were within "normal rates".

The denial of widespread problems infuriated customers such as Chris Szarek, who has had five bad consoles: he felt Microsoft was stonewalling. But as production ramped, Microsoft sent replacement units out more quickly and dealt with those who were unhappy about the shortage. In September 2006 Microsoft conceded that the quality of the consoles made during 2005 wasn't as high as it expected and said that it would extend the policy of free replacement for consoles made during 2005, even though the warranties had expired. But what was actually wrong with the machines? In July 2007 Robbie Bach, president of Microsoft's entertainment and devices division, said of the launch that "we were confident the product was ready. We did a lot of testing. The problem that shows up with the three red lights on the console is a complex interaction with some very complex parts."

There was no single reason for the failures - though many could be blamed on the graphics chip, which could overheat so much it warped the motherboard. This stressed bad solder joints, causing them to fail early in the machine's life - and the console was also one of the first products that had to meet new environmental standards in Europe prohibiting the use of lead in solder. Paul Wang, a Microsoft test engineer on the Xbox 360, said in a speech in 2007 that lead-free solder created a lot of problems.

Wii takes the lead

Sometimes the heatsinks on top of the GPU were put on the wrong way, resulting in overheating. Games would sometimes crash because of sub-par memory chips from one of the two suppliers. Problems with the DVD drive lasted longer than expected. Eventually, in January last year, Microsoft shut down manufacturing of the console and didn't build any more machines until June.

Early this year, SquareTrade, which sells warranties for electronics, reported that was seeing a 16.4% failure rate for Xbox 360s. Michael Pachter, an analyst at Wedbush Morgan, estimates that the number is 3m, about 15% of the total.

In the meantime, Nintendo's Wii has outstripped rival consoles around the world, having sold some 35m machines since its launch at the end of 2006. Microsoft has sold about 22m Xbox 360s since its 2005 launch, while the Sony PS3, which came late to the party with a European launch in March 2007, has sold 16.6m consoles around the world.

But is the war really lost? Shane Kim, head of the game division's business development efforts, recently said that it was too early to call the console war in favour of Nintendo. We won't know the winner, he says, until somebody sells 100m units. Microsoft's plan is to sell 75m Xbox 360s. The only way it could ever do that is to be more aggressive on its pricing. And by doing the right thing for its customers from now on.

• A longer version of this article first appeared on VentureBeat.com