Microsoft took an enormous step forward this morning. It unveiled a free version of its Windows operating system.

Revealed at the company's annual software developer conference in San Francisco, this new OS is called Windows for Internet of Things, and Microsoft will license it for free when hardware makers use the software on devices with screens smaller than nine inches. The door is still open for the company to charge Windows licensing fees for PCs, tablets, and other larger devices, but Microsoft will compete head-on with Android – Google's free mobile operating system – on smartphones and wearables.

It's a big, bold move, but it's one that Microsoft needed to make. Because the code behind Android is open source, anyone can use it without paying a penny, and that has made life difficult for Microsoft in recent years, as the company continued to charge manufacturers about $10 for its Windows Phone operating system on each smartphone and tablet. In a world where Apple is also pushing operating system prices towards zero, Microsoft must forgo its licensing fees just to get Windows onto a more substantial number of devices.

>It's a big, bold move, but it's one that Microsoft needed to make.

Presumably, Windows for Internet of Things will use the same code base as Windows Phone 8, and Microsoft says it will only run mobile apps, not desktop software. But today, the company also announced a new system for building applications that can run on both Windows and Windows Phone as well as XBoxes. So there could be ways of bridging that gap. It's not clear whether home users and independent developers – and not just commercial hardware makers – will be able to download and install the new operating system on their own devices.

There was no talk about open sourcing the Windows code base, a la Android. That means serious hackers can't get into the guts of the operating system – and ensure the code is sound and secure – and it probably means that this new version of Windows won't spread nearly as far or as fast as Android. But the move does show that Microsoft is serious about competing in the mobile market, and that the company is slowly shifting its business strategy, so that it relies more on revenue from cloud services instead of OS licensing. In other words, it's transforming itself into a company that operates more like Google.

The transition won't be easy. Windows has always been a cash cow for Microsoft. It makes sense for the company to keep some of that revenue for now, especially on the desktop, where it faces less competition. But the cloud is where the industry is headed. Everything from Apple consumer service iCloud to IBM's enterprise cloud services like SoftLayer is pointing in that direction. For its part, Microsoft now has a number of cloud services services that can lead the way into the future, ranging from Skype and OneDrive for consumers and professionals, to enterprise services such as Azure, Dynamics CRM, and Office 365.

Convincing people to buy from Microsoft and not one of its myriad competitors will be a challenge in itself. But at least Microsoft realizes what it has to do.