The company also posted lower fiscal second-quarter earnings that missed analysts' forecasts.
Microsoft will slash 1,400 positions immediately, with the rest of the cuts coming by June 2010. The company also said it will freeze employees' pay in 2009.
Microsoft said it will save about $1.5 billion in operating expenses and $700 million in 2009 capital expenditure from the job cuts and pay freeze.
"Economic activity slowed beyond our expectations in the quarter, and we acted quickly to reduce our cost structure and mitigate its impact," said Chris Liddell, Microsoft's chief financial officer, on a conference call. "We are planning for economic uncertainty to continue through the remainder of the fiscal year, almost certainly leading to lower revenue and earnings for the second half relative to the previous year."
Thursday's was the first mass job cut announcement in Microsoft's 34-year history. Prior to the cuts, Microsoft had been hiring rapidly, growing its global workforce by 14% since September 2007. But even as it cuts staff, the company said it will continue to hire a few thousand employees in the current quarter, mainly in its online advertising division.
Many analysts on the conference call questioned whether Microsoft was cutting enough, given the strong headwinds it is facing in a tough economic environment. Some believe that more cuts could be on the way, as the company takes a slow approach to evaluate its capital situation.
"Obviously, no one has any real visibility as to how things are going to go," said Brent Williams, analyst at The Benchmark Co. "But if they cut too much, too fast, it's going to hurt them."
Shares of the company fell more than 9% in midday on the news.
Microsoft (MSFT, Fortune 500) also announced second-quarter net income of $4.17 billion, down 11% from a year earlier. The company reported earnings per share of 47 cents, missing analysts' estimates of 49 cents, according to a consensus compiled by Briefing.com
The Redmond, Wash.-based company reported revenue of $16.63 billion for the quarter, up 2% from $16.37 billion a year earlier.
The software maker said software sales, including its Vista operating system, slumped 8% on weak PC sales as well as a continued shift toward lower-priced laptop computers.
Microsoft's Online Services division, which includes the online portal MSN and its online advertising sales, continued to lose money - $471 million in the quarter - even as that sector's sales were up 7% from the same quarter a year earlier. Microsoft continued to struggle to compete with rivals Google and Yahoo (YHOO, Fortune 500) in the online advertising business.
But sales grew in other areas. Revenue from its entertainment and devices division, which includes the Xbox 360, rose 3% over the same period a year earlier. Microsoft said holiday Xbox sales were strong, selling a record 6 million game consoles in the quarter.
The company also performed well in its server unit, with revenue growing 15% in that sector.
Still, some analysts question Microsoft's strategy of participating in seemingly every aspect of the tech market.
"In the short term, it's all about PC unit demand, but once they surmount that problem, they go back to their longer-term strategic issues: they can't match the speed, economics, or the quality and reliability of their competitors," said Williams. "They may ultimately suffer a fate worse than death - big, but irrelevant."
Microsoft did not offer specific earnings and revenue guidance for the coming quarter "due to the volatility of market conditions going forward," but it said consumer, business and advertising sales will likely continue to decline for at least the next six months.
The company said Xbox sales will probably decline at least through June as well, as consumer confidence and spending wanes.
Microsoft also suggested that investors should not rely on previous fiscal 2009 estimates.
"The economy is resetting to a lower level of consumer spending due to reduced leverage in the economy," said Microsoft CEO Steve Ballmer on the conference call. "Consumers have less money to buy discretionary second and third PCs."
Microsoft's announcement comes a day after rival Apple Inc. (AAPL, Fortune 500) reported net income rose 2% in the most recent quarter, trouncing analysts' expectations. Ballmer noted that Apple's Macintosh computer sales were strong in the quarter, but he predicted that trend may drop off soon.
"The price premiums that people pay for Macs versus PCs will be looked at much more critically in the next two quarters," said Ballmer. "Neither the consumer nor business side is immune to the economic conditions."
Though Ballmer called the current economic dislocation "unprecedented," he called the recent downturn in the tech sector "just a pause."
"Nothing will stop the forward march of our industry or Microsoft," Ballmer said. "There will soon be renewed growth in the tech industry and certainly in Microsoft."Google (GOOG, Fortune 500) is set to release its quarterly financial report after the market's close Thursday.