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While components drop, Windows stay up

Computers and component prices have been in a free fall for two years, but the cost of the Windows desktop operating system has remained constant, according to trial testimony.

Computers and component prices have been in a free fall for two years, but one building block hasn't: the cost of the Windows desktop operating system, according to executives testifying in the Microsoft antitrust case.

Despite plummeting prices in memory, Microsoft's day in court processors, and other components, the price of Windows has stayed flat at around $35 or more per PC for Microsoft's biggest customers, according to testimony from PC company executives deposed in conjunction with the antitrust lawsuit filed against the software company. In some circumstances, the price of Windows has actually gone up, executives testified.

The testimony sheds light on one of Microsoft's most closely guarded secrets: what it charges PC makers for its OS. It also reveals an interesting trend. Windows is by default becoming a larger part of the cost of manufacturing and buying a PC, especially very low-cost computers.

Smaller PC companies that market low-price and no-name "white box" computers pay between $50 to $86, according to sources. As a result, while the OS used to account for 3 percent of the total cost of a system, it is now likely past 10 percent and more in certain circumstances, and rising.

In depositions released this week, executives at major PC makers provided rare testimony on Microsoft's complicated and closely guarded licensing and pricing policies for Windows 95, and its successor, Windows 98.

Just like ordinary consumers, PC makers have paid the same price for Windows 98 as they did for Windows 95. Retail prices for an upgrade of the operating system have not changed over the last few years: Just like its predecessor, it costs $89 to upgrade a system to Windows 98. And PC makers apparently are in the same boat, according to executives' testimony. (Consumers who do not have any version of Windows and are not upgrading pay approximately $180 for Windows.)

Microsoft does not release information about the details of its licensing agreements with PC makers and declined to comment for this story. Company representatives have previously said that the price of Windows reflects continuing improvements and new features.

Compaq Computer senior vice president John Rose, who used to head the company's desktop division but has different duties now, provided information on the company's licensing agreement with Microsoft in his testimony.

Careful consideration of costs
The operating system makes up about 2 to 3 percent of the total cost of manufacturing a $1,500 computer, Rose testified. In other words, Microsoft charges Compaq between $30 and $45 per computer.

"We consider the cost of every component, whether it's the memory, the disk, the monitor, the communication chips, the software, every cost. We constantly focus on every element," Rose testified, noting that although Compaq has considered the possibility that the price of the operating system could rise, the company has not evaluated any other operating system for its computers.

In some cases, Microsoft has even raised prices on its Windows software, according to Patrick Romano, former research and development manager for the Home Product Division at Hewlett-Packard, in his testimony.

"The price has gone up," he said, referring to Windows 95, despite the fact that other components of PCs have dropped in price while undergoing huge performance improvements.

"The average selling price [of computers] has been in decline fairly steeply from 1995 until the present time," Romano testified. "Price trends of components have been dropping significantly?motherboard prices have gone down. Processor prices have gone down. Memory has gone down. Disk drives have gone down."

As prices have declined, the performance of these components has actually improved, Romano said, pointing to disk drives: "Features measured in speed of access or speed of transfer have increased significantly," he testified. "Storage capacity has increased significantly, and price measured on either a performance or space has gone down significantly."

In fact, PC semiconductor revenue was down 5.7 percent last year to $27.9 billion, according to research from market research firm International Data Corporation, in large part because of depressed average selling prices.

Despite this trend, Microsoft released Windows 98 at the same price as its predecessor. "It certainly is a good indication that [Microsoft is] not sensitive to trends in the marketplace," said Dwight Davis, an analyst with Summit Strategies.

"The ironic thing is people used to complain about Microsoft undercutting the software market and whittling away margins," Davis said. "But you can't discount the fact that Microsoft dominates the desktop operating system and has a lot more leeway to set prices."

In its last quarterly earnings report, the company reported a 40 percent increase in earnings over year-ago levels, seemingly unaffected by the earnings declines of the PC makers who distribute Windows software.

Apples and oranges?
But software prices, especially of sophisticated operating systems, should not be compared to hardware manufacturing costs, some analysts argue, because of the high intellectual property associated with software development.

"Software is more of an art than a science," said Dan Kusnetsky, an analyst at International Data Corporation, who added that Microsoft has benefited from some cost improvements in manufacturing and distribution. "The cost of developing may have gone up, while the cost of distributing has gone down--because of those two functions, the price to customers may stay the same."

Microsoft's pricing for PC makers is dependent on a variety of factors. Microsoft considers volume, service and support costs, as well as previous sales for each PC maker, Kusnetsky said.

Microsoft's business practices with two of its largest partners may follow these guidelines, but smaller upstart PC companies trying to gain attention with bargain-basement prices have less negotiating leverage and thus tend to pay even more per system, sources say.

Stephen Dukker, chief executive of Emachines, unknown only six months ago but one of the early leaders in the sub-$500 PC market, said previously that smaller manufacturers pay up to $70 for the OS per machine.

For low-end computers, a hard drive costs about $80, the processor about $40. Add a CD-ROM drive at $40 and an operating system at $50 to $70, Dukker said last month.

One "white-box" PC company reports paying $86.40 per copy of Windows 98, not much of a discount from the $89 retail upgrade price. This company, which sells no-name computers ranging in price from under $500 to $1,150, purchases the operating system from top-tier distributor Ingram Micro. Like other large distributors, Ingram Micro operates on fairly thin product margins in a competitive market.

Thus, while Compaq may be spending 2 to 3 percent of its manufacturing costs on an operating system, a smaller manufacturer building low-cost boxes could be spending up to 14 percent of its budget on Windows.

"Bigger PC makers get a break because of the quantity of licenses that they deal with," explained Davis. "If you're a low-volume supplier and innovating and driving down the prices of PCs, the operating system becomes a significant percentage of the overall cost."

Compaq and other large manufacturers, of course, are also likely seeing Windows rise as percentage of their costs. Most of them have begun to heartily embrace the low-cost segment. In addition, average selling prices for PCs for most of these companies has dropped steadily for a while, according to analysts.

Barring stringent pricing remedies imposed by the courts, Windows pricing is likely to remain constant amid the cutthroat PC price wars, analysts say. But the PC will likely never become a commodity, even if Samsung begins giving away memory chips, and Intel offers subsidies on its microprocessors, they predict.