RECENT advertisements for Microsoft show office workers as dinosaurs, stuck in a bygone era. Aptly, it is an accusation that some are now making about the software company itself.

Microsoft earns more than half its $40 billion or so of annual revenue—and the vast majority of its profits—on just two products: the Windows operating-system and Office, a collection of personal-computer (PC) applications including word-processing and spreadsheet programs. Both, however, are coming under threat from new technologies.

The pressure Microsoft is facing in its core businesses is similar to one confronted by IBM—another firm that was once synonymous with computing. At the beginning of the 1990s IBM had to face up to the shift from a computing world dominated by mainframes to one dotted by personal computers. In this new world hardware became a low-margin commodity and Microsoft's operating system took the privileged position. Today, Microsoft still dominates the PC market. But like IBM before it, today's giant knows that its position is under threat.

The threat to Microsoft comes from online applications, which are changing how people use computers. Rather than relying on an operating system and its associated application software—bought in a box from Microsoft, and then loaded onto a PC—computer users are increasingly able to call up the software they need over the internet. Just as Amazon, Google, eBay and other firms provide services via the web, software companies are now selling software as a subscription service that can be accessed via a web-browser. Salesforce.com, the best known example of this trend, offers salesforce management tools; other firms offer accounting and other back-office functions; there are even web-based word-processors and spreadsheets. This lowers the economic and technical barriers to entry for firms wanting to compete with Microsoft, as well as diluting the advantages the firm gets from controlling how the computer works.

These huge shifts in computing take a very long time, because there is so much inertia in the marketplace—the idea of online applications has taken years to get even this far. Microsoft is still in a position that most firms would kill for. Its two main products—Windows and Office—remain fabulously profitable quasi-monopolies. Even if online applications and open-source software make rapid progress, Microsoft would retain a powerful and profitable position for some time.

For all that, however, online applications clearly threaten the way Microsoft makes its money. Its licensing agreements are geared for a world where software is a physical product, purchased on discs, and paid for at once or in regular instalments. But its online competitors charge each user a subscription: some like Google are even supplying software as a free online service, financed by advertisements. Last month Google acquired the firm that created Writely, a popular online word-processing program that is an obvious potential competitor to Microsoft Word.

Online competitors have also mastered quick development and deployment times that Microsoft cannot match. Meanwhile open-source software—developed co-operatively and distributed free of charge—is also gaining ground. George Colony, the boss of Forrester, a technology-research firm, believes Microsoft faces the biggest challenge in the firm's history: “Bill Gates knows how to compete with anyone who charges money for products,” he says, “but his head explodes whenever he has to go up against anyone who gives away products for free.”

There are signs that Microsoft is feeling the pressure. In recent days the firm said that it would have to delay the introduction of both the next version of Windows, called Vista, and the next version of Office until early 2007. It also announced yet another re-organisation of its Windows division.

In an effort to respond to the new world it faces, Microsoft had already undergone a thorough management restructuring last autumn. Its seven business units were recast under three presidents, all of whom hail from the business side, not the technical one. Oversight of the sprawling Windows division was bundled alongside its internet unit, MSN, an admission of the importance that online services will play in operating systems in future.

At the same time, a relative outsider, Ray Ozzie, a veteran techie brought in last year, has created a stir by questioning why the most successful recent tech products, from Google search to the BlackBerry and the iPod, were not created by Microsoft. His remit is to see that the company reorients itself by adding an online component into virtually all its products. The first steps in that direction are “Windows Live” and “Office Live”. Microsoft, in short, wants to turn the rise of online software into an opportunity rather than a threat. “Before, we sold a cardboard box with a disk in it. We're now in a world where it is easier for us to sell add-ons,” says Charles Fitzgerald, a Microsoft executive.

Fortunately, Microsoft already has within the firm units that have demonstrated the agility and online awareness that the whole company now needs. The Xbox gaming unit boasts more than 2m paying subscribers for its Xbox Live service—which allows users to download games and entertainment and chat—and is the model for Windows Live and Office Live. Meanwhile MSN has captured a small share of the roughly $10 billion online advertising market. But the anchor products of Windows and Office, which in effect subsidise these ventures, have not evolved to reflect the new online era.

So Microsoft now plans to graft subscriptions, downloadable add-ons and advertisements on to its core products. Again, it portrays this as an opportunity to open up new revenue streams, rather than a defensive tactic. “There are three ways to pay for anything in this business: ads, transactions and subscriptions,” says Craig Mundie, one of Microsoft's chief technology officers. “You'll see the company offer a full range of different ways to buy our product.” The difficulty will be getting the timing right, so that new products do not undermine existing cash cows.

For now, however, too many Microsoft managers are still measured by their success with yesterday's business model—selling boxes of software. Microsoft is still formulating its response to the rise of online software. As one former Microsoft executive explains: the company's problems are not just technical but organisational. “It has a vision but not a roadmap; it can see the peaks but doesn't know how to cross the foothills to get there.”