The cutscenes are rendered in real time. A static cutscene can be rendered beforehand and the game basically just plays a video, but for dynamic cutscenes that have your character in them for example, the game renders them in real time, i.e. it basically runs the normal game graphics but controls what’s happening on screen and where the camera moves.
You might notice that dynamic cutscenes usually look similar to the game’s graphics while pre-rendered cutscenes tend to look more cinematic.
Imagine you’ve got a bunch of action figures: They all look very different to each other, but their arms and legs can move and bend so that you can pose them all the same.
Custom characters are like those action figures as far as game engines are concerned, so it can apply all the same animations without much of an issue.
In a traditional pre-rendered cutscene, it’s a movie file — every frame was pre-calculated by the developer, possibly using extra time (e.g. multiple seconds / minutes to calculate a single frame), and/or a more powerful computer. Since it’s just playing a movie, the cutscene can have better graphics than the user’s computer can produce.
If your character’s appearing with their equipment, it’s likely an “In-engine cutscene.” Basically the game keeps rendering the graphics as it normally would during gameplay, but have the characters and camera follow a pre-scripted sequence of actions (taking away movement and camera control from the player).
Basically a “custom character cutscene” isn’t “play a movie the developer made and saved,” instead it’s “normal gameplay but temporarily disable the control you usually have over your character and the camera, and change characters’ behaviors so everybody moves and talks according to a script.” In other words, there’s no movie file, your computer’s calculating frames “on the fly” just as it would during normal gameplay. The main difference is that your controls are disabled and the game uses a different set of rules for what the characters do.
An in-engine cutscene is usually way less expensive for the developer than a pre-rendered one. Since it’s displaying characters the same way they are in normal gameplay, as a bonus things like customized outfits are basically free (in terms of development effort) — you just have the game display the character the same way it normally does.
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