How the Strategy Process Killed Innovation at Microsoft 

SINCE MICROSOFT LAUNCHED Windows 3.0 in 1990, it has dominated the industry for
PC operating system (OS) software with a 90 percent market share. Microsoft’s huge installed
base of Windows operating systems on PCs and its long-term relationships with original
equipment manufacturers (OEMs), such as Dell, HP, and Lenovo, create tremendous entry
barriers for newcomers. Intel’s semiconductor chips are the perfect complement to Microsoft’s
operating system. Every time Microsoft releases a new operating system, demand for Intel’s
latest microprocessor goes up, because new operating systems require more computing power.
Because of the complementary nature of their products, Microsoft’s and Intel’s alternating
advances have created a virtuous cycle, benefiting from network effects. The successful
combination of Microsoft’s Windows and Intel’s processors has produced the Wintel (a
portmanteau of Windows and Intel) standard in the PC industry. By 1999, Microsoft was the
most valuable company on the planet.

Fast-forward to 2017, two years after Microsoft released Windows 10, its latest version of the
ubiquitous operating system. For the past quarter century, Microsoft’s business model was to
establish and maintain the dominance of the Wintel standard in the PC industry. With this
standard, Microsoft made money off consumer and business application software such as its
Office Suite. Microsoft remains hugely profitable: With some $85 billion in annual revenues in
2016, it generated over $20 billion in profits! Windows and Office still generate about 40 percent
of Microsoft’s total revenues and 75 percent of profits. The gross margin of “classic” Office is
90 percent, while the new cloud-based Office 365 only has a 50 percent profit margin.

Although Microsoft is highly profitable, its stock price was flat through the 2000s, trailing the
tech-heavy NASDAQ-100 by a wide margin. This started to change even before Satya Nadella
became CEO in 2014, but under Nadella’s strategic focus of “mobile first, cloud first,”
Microsoft’s stock market valuation has appreciated rapidly in recent years, in fact, more than
doubling over a recent five-year period. Yet Microsoft is having to work hard for its performance
to match that of other tech companies such as Google, Apple, and Amazon because they created
entirely new areas of computing from scratch, and as a consequence, their stock prices have
soared. One reason Microsoft’s fell and flattened in the 2000s was that it saw its mission
differently. Protecting its existing portfolio, Microsoft largely failed to commercialize any
category-defining products or services. Why? The answer: Microsoft’s strategy process killed
innovation!

Top-Down Strategy Process Killed Bottom-Up Strategic

Microsoft actually came up with some major breakthroughs, but failed to successfully
commercialize them. The root of the problem seemed to lie with Microsoft’s top-down strategy
process. Once Windows became the industry standard in 1990, Microsoft’s strategy was
defensive: Any new product or extension had to strengthen the existing Windows-Office
franchise; if not, it would be “killed.” Here are some great products and services that Microsoft
invented, but never commercialized.

ONLINE SEARCH

Google is now the leading search and online advertising company, with close to $100 billion in
annual revenues and a market capitalization of some $700 billion in 2017, making it one of the
most valuable companies globally. What haunts former Microsoft CEO Steve Ballmer is that
Microsoft had its own working prototype of a Google forerunner, called Keywords, long before
Google’s ascent.

Scott Banister, then a student at the University of Illinois at Urbana-Champaign, had come up
with the idea of adding paid advertisements to internet searches. He quit college and drove his
Geo hatchback to the San Francisco Bay Area to start Keywords, later joining an online ad
company called LinkExchange. In 1998, incidentally the year Google was founded, Microsoft
bought LinkExchange for some $265 million. The newly formed Microsoft online search team
urged top managers to continue to invest in the burgeoning online search technology. Instead,
Microsoft executives shut down the project in 2000 because they did not see a viable business
model in it. One team member actually approached Ballmer and explained that he thought
Microsoft was making a huge mistake. But Ballmer said he wanted to manage through
delegation and would not reverse a decision made by managers three levels below him. This
decision put an end to Microsoft’s first online advertising venture.

In 2003, Microsoft got a second chance to enter the online advertising business when some mid-
level engineers proposed buying Overture Services, an innovator in combining internet searches
with advertisements. This time, Ballmer, joined by Microsoft co-founder Bill Gates, decided not
to pursue the idea because they thought Overture was overpriced. Shortly thereafter, Yahoo
bought Overture for $1.6 billion. In 2008, Ballmer offered to buy Yahoo for close to $50 billion
to help his company gain a foothold in the paid-search business where Google rules. Fortunately
for Microsoft, the offer was turned down by Yahoo, which was sold for $4.5 billion to Verizon in
2017.

Having missed two huge opportunities to pursue promising strategic initiatives that emerged
from lower levels within the firm, Microsoft has been playing catch-up in online search and
advertising ever since. In the summer of 2009, after spending billions of dollars and being about
a decade late, it launched its own search engine, Bing. Industry pundits joked that Bing is an
acronym for “Because It’s Not Google.”

PORTABLE MUSIC PLAYER

In 2001, Apple launched the iPod, a portable music player, with which the floundering
company’s resurgence began. This was followed up in 2003 by the launch of iTunes Music Store
with 200,000 songs at 99 cents each. The iPod and iTunes laid the foundation of Apple’s hugely
successful ecosystem tightly integrating software, hardware, and services. In 2005, during an
employee meeting, one Microsoft engineer asked Steve Ballmer whether Microsoft should
compete with Apple’s iPod and iTunes. In a sarcastic tone, Ballmer asked the room for a show of
hands, “How many people think Microsoft is in the business of selling music?”1 Not surprisingly,
none of the intimidated Microsoft employees raised their hands. More than a year later,
Microsoft introduced its own digital music player, the Zune (see photo above), which flopped.

TABLET COMPUTERS

Long before Apple launched the iPad in early 2010, the inventor of Microsoft’s highly successful
Xbox gaming console had developed a tablet computer called the Courier. The Courier was a
fully functioning tablet that folded like a book and allowed users to draw on a touchscreen,
among other features. Rather than compete against Apple, Ballmer informed the Courier team
that he was pulling the plug on the tablet to redirect resources to the next version of Windows,
the launch for which was more than two years away. To add insult to injury, it was Windows 8,
Microsoft’s failed attempt to straddle desktop and mobile computing.

In the meantime, Apple had sold more than 250 million iPads, which have been instrumental in
strengthening Apple’s ecosystem. This ecosystem allows Apple to be the world’s leader in
mobile computing. (One other mobile computing invention that Microsoft killed was wearable
devices such as smart watches.)

OFFICE FOR IPHONE

As soon as Apple released the iPhone in 2007, Microsoft engineers tweaked the company’s PC-
based Office Suite to run on the Apple mobile device. Ballmer shut the project down—he had a
visceral disdain for Apple, once stomping on an iPhone in an all-employee meeting when he saw
a subordinate using the popular Apple device—telling the group that Microsoft needed to focus
its resources on Windows 8.

In the meantime, Apple has garnered over $1.2 billion in iPhone sales since it was launched in
2007, making it one of the most successful products ever. In 2017, the average price for an
iPhone was close to $700. Apple's 10th anniversary phone, the iPhone X, is the first smartphone
to cross the $1,000 price threshold. Although Apple holds some 15 percent market share in the
smartphone industry, it captures more than 90 percent of the profits. A whopping two-thirds of
Apple’s annual revenues of some $220 billion is from iPhone sales, surely sufficient to have paid
a handsome licensing fee for a Microsoft Office Suite for the iPhone.

CLOUD-BASED OFFICE SOFTWARE

Long before cloud-based computing took off, Microsoft in 2000 developed a fully functioning
suite of software applications for the web including an Office-type word-processing software
called NetDocs. This project was discontinued in 2001 because Ballmer feared it would
cannibalize sales of the “classic” Office suite. This opened the door for Google to offer cloud-
based computing applications such as Google Docs, Google Slides, and Google Sheets, which
with Google Drive and Gmail make up the core of Google’s cloud-based computing services.
These in turn established Google Chrome as the dominant web browser and helped Google’s
Android become the leading mobile operating system with some 80 percent market share. In
contrast, Microsoft’s Windows has less than 1 percent market share in mobile computing.

CAR SOFTWARE

In the early 2000s, dozens of Microsoft engineers developed—on their own time—car software
that allowed drivers to use online maps, have e-mails translated to voice and read to them, as
well as play digital music. Ballmer shut the project down, arguing that Microsoft—one of the
most cash-rich companies on the planet—could not afford another big bet at the moment.

Today, Tesla is as much a software and sustainable energy company as it is a car company, with
a market cap of more than $60 billion. Both Tesla and Google are proving that driverless cars (all
based on software and sensors) are viable within a few years and promise to be a multibillion-
dollar industry.

While still CEO, Ballmer admitted problems in Microsoft’s strategic management process—to a
degree: “The biggest mistakes I claim I’ve been involved with are where I was impatient—
because we didn’t have a business yet in something, we should have stayed patient.”2 Ballmer,
who became Microsoft’s CEO in 2000, was replaced in 2014 by Satya Nadella. Under Nadella,
Microsoft has made strides in reinventing itself with a “mobile first, cloud first” strategy. Can
Microsoft once again innovate successfully? 

Microsoft’s strategy often gets its most critical look when it holds its developers’ conference and
announces new initiatives. Even though the jury may still be out for the long term, in recent
years Microsoft has been getting much better press, even as its stock evaluations rise. Pundits
applaud how Microsoft is releasing, fixing, and refining products like a modern cloud company.
The company has broken free of Windows platforms and gone to universal availability,
sometimes jumping from device to device. And it has even found new ways to provide iOS and
Android apps. In short, it appears its cloud first, mobile first approach is allowing Microsoft to
offer competitively matched experiences across consumers’ platform of choice.3

Moreover, Nadella has created a culture in which the company manages a full stack of hardware,
software, and data centers, and where bottom-up innovation appears to be embraced. In fact,
failure is accepted as part of that process. Microsoft has created prototype labs so new ideas can
be developed and tested, and if necessary, “to fail faster.” In 2017, The Economist proclaimed
that Microsoft has indeed transformed its culture for the better, but that getting cloud computing
right remains a hard thing to do. 

DISCUSSION QUESTIONS

1. Describe the strategic management process at Microsoft under CEO Steve Ballmer (2000–
2014). How were strategic decisions made? What were the strengths and weaknesses of this
approach? Explain in detail.
2. Although Microsoft invented some promising computing breakthroughs, and often before
competitors, why did Microsoft fail to successfully commercialize them?
3. Why is it so difficult for CEOs of large and successful companies such as Microsoft to
balance exploitation—applying current knowledge to enhance firm performance in the short
term—with exploration—searching for new knowledge that may enhance a firm’s future
performance? What are the trade-offs? How could they be reconciled?
4. In contrast, what can you infer from information in the case about the current design of
Microsoft’s strategy process under Microsoft CEO Satya Nadella, who started in 2014?
5. What advice would you give Nadella in his current efforts?