Lower-end devices are where both Windows Phone and Windows 8 tablets are showing the most traction.  On the phone side the (Nokia) Lumia 520/521 is where a lot of the volume growth has come from.  On the tablet side the first 8″ Windows 8.1 tablet to broadly hit the market, the Dell Venue 8 Pro, has garnered quite a fan base.  I wish we knew its volumes, but by any subjective measure it’s been a hit for Dell.  One regularly sees the Lumia 520/521 for under $99, sometimes way under. The Dell Venue 8 Pro has a list price of $299, but on any given day it can usually be found for $279, $259, $229, or on occasion (e.g., Microcenter’s in-store only special) for $199.  Wow.

If you combine today’s Mobile World Conference announcements from Microsoft with rumors about a big price cut for OEMs putting Windows on sub-$250 devices you start to get a picture of a strategy focused on winning at the low-end.  First let’s talk about the pricing rumor, then review the announced hardware requirements, then talk strategy.

I’m going to take as a given the oft-repeated OEM price of Windows as $50 since absolute accuracy isn’t required to explain what is happening.  With the exception of SKU expansion (e.g., Windows Pro), Microsoft has held the price of Windows pretty constant over the years.  When you were a OEM making primarily PCs that sold for over $1000 the cost of Windows was not your biggest issue.  At $50 it would not have made your top 3 component costs.

Components that are driven by Moore’s Law, or manufacturing scale, have been dropping over the years while the price of Windows has remained constant.  Let’s assume that Bill of Materials (BOM) cost represents 50% of the list price of a device shipping in volume.  A $300 tablet thus costs around $150 to manufacture.  From a OEM perspective the cost of Windows as a component has mushroomed from about 5% to about 30% and left it little room to maneuver.  On a $200 tablet the BOM would be around $100 with Windows representing 50% of that cost.  It is unclear you could create a tablet capable of running Windows with only $50 for hardware components and system integration.  And you certainly couldn’t do it profitably.

Meanwhile over on the Android/ChromeOS side of the world they have a lower cost structure for the software.  Yes they have to pay patent royalties to a number of parties, including Microsoft.  Yes they may have to license some CODECs or other software that is included in Windows but not the Android distribution.  But the bottom line BOM impact is still much lower.  Let’s guess that it is in the $15 per device range.

Now $15 seems to be a pretty magic number, not just because that might be the effective cost of using Android.  Lots of the major component assemblies used in phones and tablets hover in the $15 price range.  The processor.  The memory.  The sensor module.  The battery.  The camera.  Etc.  These will vary by a $1 or two depending on capabilities, but you get the idea of the ballpark for major components of a mobile device.  So demanding a price for software that is in the same ballpark as the other major device components is defensible.

And that’s exactly what Microsoft is rumored to have now done.  By pricing Windows for devices that sell for $250 or less at $15 it has (a) equaled the effective cost of using Android, (b) addressed OEM concerns that OS pricing sucks all margin out of low price devices, and (c) helped lower the BOM to the point where sub-$250 (and really sub-$199) devices become feasible.

Is there a financial downside to Microsoft’s action?  I don’t think there is much of one.  To begin with most devices sold in this price category are additive, they do not replace existing devices using higher priced Windows licenses.  For example, back around Christmas an acquaintance was telling me she saw a Best Buy deal for $250 notebooks and bought a dozen of them as gifts for her kids and their cousins.  Previously the kids were sharing a single hand-me-down PC.  My brother’s mother-in-law bought each of his kids Kindle Fires, so they ended up with individual computing devices at least 5 years before they would have ended up with individual PCs at higher price points.  And few of those Dell Venue 8 Pros are going to replace any other device, they are tablets for people who carry around a notebook a lot but wanted an additional content consumption device.  You see this kind of example all over, low-cost devices are expanding the market.  Microsoft is counting on market expansion to far outweigh any cannibalization of its higher-priced offerings.

For Windows tablets and low-end notebooks the other change that will allow for extremely low-cost devices is support for devices with only 16GB of storage and 1GB of main memory.  We’ll probably have to wait for Build in order to understand how they’ve done that, but I can imagine that they’ve given OEMs the option of removing the recovery image from shipping devices.  While this has always been available for a user to do once they received their device, having the recovery image ship on the device itself was previously a requirement for the OEMs.  And that made 32GB the minimum device size.  I don’t know how the recovery environment works in this new world.  Will OEMs ship a recovery image USB stick?  Will the device come with some minimal bootable image that can download the recovery image over the Internet?  We’ll just have to wait and see.

One important note about the reduction from 2GB/32GB to 1GB/16GB is that it should take about $15 (there is that magic number) out of the BOM for a low-cost device.  With the pricing change that’s $45 (30%) off the previous minimum BOM of about $150!  On top of that these lower priced devices will tend to use older components that are further down the price curve.  The cost of the 1280×800 displays now found in most 8″ tablets is bound to drop quite a bit as 1920×1080 and above becomes more common.  So we are certainly on our way to entry-level Windows 8 tablets with a BOM of under $100 and perhaps eventually as low as $75, enabling Windows tablets to retail in the $150-199 range.  Entry-level notebooks will follow these same pricing dynamics.

Similar changes are coming on the Windows Phone side with the support of lower performance, low-cost device targeted chipsets and support for on-screen soft buttons rather than the dedicated hardware buttons previously required by the Windows Phone specs.  Imagine devices selling for half of the very successful Lumia 520/521 and you get what Microsoft seems to be enabling.  This is both a defensive move against low-cost Android phones and an offensive move to increase Windows Phone volumes to reach critical mass (to attract app developers, create mind share, etc.).

As I look at Microsoft at this point I think they are following a two-tier strategy.  The first is a high-end push aimed at their traditional PC customer base.  With Windows 8.1 Update 1 they pay significant attention to desktop-focused users, something that will continue with “Windows 9”.  Their 2-in-1 efforts are aimed at bringing their vision of the next generation of notebooks to drive a refresh cycle and push the core of the PC business back into a healthy space.  And their premium tablet and phone efforts are aimed at providing both consumers and business committed to the Microsoft ecosystem with companion devices that bring the best of these consumption optimized experiences without having to give up the Microsoft ecosystem benefits.

And then there is the low-end push aimed at market expansion.  Capture the billions of phone users who have yet to move off of feature/basic phones.  Capture the billions of people who have not yet made any commitment to a tablet for a multitude of reasons, from pure cost constraints to those whose price threshold for a secondary device is particularly low.  Capture the low-end notebook market where people are sharing devices or living with ancient Windows XP desktop and notebook systems by having devices priced so they can afford to upgrade to a modern device and have a device per user rather than sharing.  And win big in the developing world, where these trends are particularly strong.

Of course winning at the low-end is also critical because the current vacuum there plays to Android and ChromeOS’ favor.  And whoever owns the low-end is setting themselves up for future upgrades into higher end devices, where the real money will eventually be made.  By capturing a significant share of the low-end, and bringing those users into the Microsoft ecosystem,  it won’t have to fight to take them away from Google (or someone else) later.  It will have the upper hand on retaining them for many years, and device generations, to come.

My major intent here was to show how Microsoft’s latest moves can really change the game at the low-end of the market.  The pricing and spec moves shave 30% off the BOM for a low-end Windows 8 tablet or notebook, and I suspect the lowered Windows Phone spec requirements amount to a similar improvement.  Besides growing its own customer base, the kind of volume growth that these low-cost devices cause make Windows Phone a more interesting target for developers and that should help close the App Gap.  So even if you are mostly a fan of flagship devices, this low-end focus is likely to benefit you greatly.