Some are touting yesterday’s announcement that Microsoft was making Windows (including Windows Phone) free for devices with screens smaller than 9″ as the most impactful news coming out of Build 2014.  While I do think it is important news, I think other changes such as Universal Apps are far more important.  And there is one executive discussion I’d really have liked to sit in on that I’ll talk about near the end.

Current Microsoft profit from Windows Phone and Windows on small screen devices is at best rounding error and at worst represents a loss.  The story on revenue isn’t much better, it is immaterial.  That’s important since it is what matters to investors, and in the long run it is what determines how sustainable a move this is.  Microsoft basically gave up nothing in a “Hail Mary” pass to establish relevance in the software for mobile device market(s).

Some of the software pricing move is related to Microsoft’s evolution to a Devices company so let’s explore Windows Phone first.  With closure of the Nokia Devices acquisition Microsoft will itself be shipping 90%+ of Windows Phone devices.  Today Nokia sells a phone for say $150 and sends Microsoft a check for (say) $15.  Tomorrow Nokia’s sells that same phone for $150 and doesn’t send Microsoft a check.  But since Nokia is now part of Microsoft that $15 still accrues to Microsoft’s finances.  It is, in every sense except a financial reporting one, a neutral financial move by Microsoft.

Microsoft is trying desperately to foster a OEM model for Windows Phone, particularly as it relates to BRIC and developing countries.  In those extreme cost sensitive markets the price of Windows Phone is an issue, while the revenue and profit potential from software for phones alone is immaterial.  Another way to look at this, and it is even possible this is technically how Microsoft’s OEM contracts are structured, is that Microsoft is returning 100% of the price of a Windows Phone license to the OEM as Market Development Funds (MDF).  But even if the contract actually shows a price of zero, in which case Microsoft probably isn’t providing MDF, Microsoft has in effect committed the revenue it might have gained from charging for Windows Phone licenses to marketing.  That’s the correct way of thinking about this.

And the same story applies to smaller screen tablets.  Right now the market for those, aside from the apparent modest success of the Dell Venue 8 Pro, is immaterial to Microsoft’s bottom line.  Microsoft needs to protect its larger form factor Windows revenue stream by taking a very significant share of the smaller form factor tablet market and is willing to “spend” 100% of what it could have taken in on revenue for those Windows licenses to gain that market share.

Why is that market share gain so critical?  Because every iOS or Android device in someone’s hands represents an opportunity for Apple or Google to replace a notebook or desktop as well.  Chromebooks make no sense for me because I am not bought into the Google ecosystem.  The MacBook Air makes no sense to me because I am not bought into the Apple ecosystem.  But if I were a dedicated Android or iOS user I would be, and thus more likely to also become a OS X or Chrome OS user.  So every Windows Phone or Tablet win represents a chance to keep someone in the Microsoft ecosystem and sell them the products for which Microsoft really makes money.

As for the conversation I wish I could have been a fly on the wall for, it’s the one they must have had about setting a precedent.  What happens if Microsoft’s wildest dreams come true and it becomes the top supplier of phone and/or tablet OS software?  Can it raise prices and monetize that success?  This is why I always envisioned the technical pricing details as a 100% kickback in MDF rather than a zero list price.  You can always phase down MDF but raising prices will be like tiptoeing through a dense minefield.  I’m sure Microsoft longs for a day when it must face this problem!