Microsoft financial incentives for internal collaboration become clear

Ballmer has given the 'one Microsoft' reorg a financial basis, dividing costs to promote internal collaboration Credit: Microsoft

Microsoft's recently quarterly figures were good enough to beat market expectations, with 16% increase in revenue, 19% increase in operating income and 17% in net revenue. They're also the first to be reported under the new One Microsoft reorg, where divisions like Windows, Office and Server and Tools are replaced by two 'segment groups' each with two or three segments. Devices and Consumer is divided into Licensing, which is what we used to call Windows, Hardware and Other; everything from the Windows Store to search advertising, Xbox Studio games to Office 365 Home Premium and the retail stores. Commercial has two segments, Licensing, which is all the on-premises server products and their client access licences, and Other, which is cloud services like Azure and Office 365.

Behind the unimaginative names lies the complexity of Microsoft's many technology groups and researchers. Take the network stack in Windows; it's used in both Windows 8.1 (and RT) and in Windows Server, and even in Windows Phone and Xbox One. It used to be written by the Windows Server team, often with input from Microsoft Research, and then picked up by the desktop Windows team. Now it's written by the core OS group and then adopted by all of the product teams. So who picks up the bill for that?

The figures in the quarterly report show that the one Microsoft reorg goes all the way down to the balance sheet. Operating expenses are allocated not to the individual segments, but to the two main segment groups, to encourage the collaboration and cross-team goals that the one Microsoft reorg needs to succeed. And while marketing costs are split simply by what each team is spending, other expenses are usually divided according to how much each team brings in; "Due to the integrated structure of our business, allocations of expenses are made in certain cases to incent cross-collaboration among our segment groups so that a segment group is not solely burdened by the cost of a mutually beneficial activity as we seek to deliver seamless experiences across devices, whether on premise or in the cloud."

So the Devices and Consumer group pays for all that marketing Microsoft is doing for Surface 2 and Windows Phone, but "general and administrative expenses" are allocated based on the gross margin of each segment. And the cost of making Bing work well on Windows 8.1 doesn't fall all on Bing (or all on the Windows 8.1 team), nor does Windows 8.1 have to pay for the voice recognition work behind Kinect and Xbox One. "Research and development expenses are primarily shared across the segment groups based on relative gross margin but are mapped directly in certain cases where the value of the expense only accrues to that segment group."

In the last year, the increased cost of R&D has been "mainly related to Office 2013 and Windows 8;" apparently. Some of that will be things like the natural language Q&A in Power BI, which is part SharePoint, part Excel, part Office 365 and part MSR - as well as part Windows 8 for the Windows Store app and part whoever makes the iOS app.

Microsoft really seems to get that its divisions can't succeed in isolation and that the whole of its resources ought to be more than the sum of its parts - if it can get the integration right. Delivering it still takes work, but getting the financial incentives for the different teams (and the leaders whose bonuses will be based at least in part on how the figures look) is an important part of encouraging integrated rather than siloed approaches.

Microsoft by the numbers

The current state of Microsoft broadly is clearly visible in the figures, even without looking at the version of the accounts that splits the numbers out by the old divisions for comparison. Windows sales are down overall, because consumers and businesses alike aren't buying new PCs from OEMs as often, but Windows Pro sales are up because businesses are upgrading (in some cases to get off Windows XP). The consumer PC market is bigger than the business market, so the business gains don't make up for the consumer losses.

Cloud takes investment; building the data centers for all those cloud services costs too; another $185 million which is 51% more than last year. Even so, Windows Server, Office 365, SQL Server and the on-premise server products like Exchange and Lync are doing well.

This is Microsoft's profit engine because businesses pay more for products than consumers do. But that it doesn't mean Microsoft should get out of consumer products or devices, because that is increasingly what gives them access to enterprise sales. If users are bringing Android tablets to work, Microsoft can sell Lync and SharePoint access licenses to the business; but if they're bringing a Surface tablet (or any other PC), Microsoft can sell an enterprise license for Office as well. Plus, if you can't make products users actually like, which a consumer business teaches you to do, you're not going to do well in business where the employees are increasingly acting like consumers too.

Surface is making more money than last year ($400 million sales adding up to 37% more revenue) though its gross margins are 54% lower and the cost of making that Surface revenue was $645 million more. "Surface product costs increased with higher volumes sold, while other costs grew as we ready inventory lines for the Surface 2 launch and the holiday sales cycle," says the Microsoft balance sheet. That means the more sales Microsoft made the more it cost them, presumably because it started to sell Surface at much cheaper prices. Microsoft also had to buy twice as many raw materials as the previous year, to make Surface 2 and Surface Pro 2 devices as well as the original models, and it spent 37% more on advertising Surface and Windows Phone. Windows Phone revenue is up by $102 million, including the money coming from patent licenses to Android device users.

It doesn't matter whether you view the state of Surface as a modest improvement, the cost of doing business or a giant boat anchor; Microsoft is still committed to the devices part of its services and devices strategy, so Surface isn't going away.

The tension of consumerization

It's also interesting to see Microsoft mentioning some of the disadvantages of consumerization in its comprehensive risk section (behind cyber attacks and ahead of earthquakes). "Our internal IT environment continues to evolve. Often we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. These practices can enhance efficiency and business insight, but they also present risks that our business policies and internal security controls may not keep pace with the speed of these changes."

That's an excellent summing up of the challenges most businesses face today from the tension between users looking for tools to help them get their job done and IT teams trying to follow regulations and protect confidential data and company resources. It's also one reason why the latest versions of System Center and Intune include device management and Windows Server 2012 R2 has ways of letting iOS and Android users connect to line of business apps and remote desktops; Microsoft knows that companies need those tools because it needs them itself.

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