Source code - compiler - hardware - kernel OS

The kernel is a compiled collection of drivers that control how your hardware interacts and how software is to interact with the hardware. When you load a LiveCD it loads the kernel and all included applications just as it would in a physical installations. Now, when you install the distro, it installed the kernel, libraries and applications in there workable forms which may or may not be compiled (based upon the development core). Some distros ship the source code in the installation disks, but many do not as the requirement is to have it available and accessible and they keep it online until you download it.

Compiling a program is when you use a code compiler to convert the human-readable source code to the machine readable binary instructions.

Are you wanting to just build a liveCD or are you truly looking at having a custom operating system with specific components installed on your server(s)?

The key difference between windows and Linux kernels installations is that the Linux kernel contains nearly every device driver that is needed and the windows kernel contains basic drivers which required the users to locate and install the more advanced drivers themselves.

Most Linux distros ship their installation kernel with most device drivers installed to simplify setup, however you can always customer compile or recompile the installed kernel to include only the drivers that are specific to you system. The same can be said for the installed applications, you can always trim a distro down to the bare elements and install apps that you need.

An example is that I took my cr-48 chromebook and installed a minimal slackware base, recompiled the kernel for necessary drivers, setup the environment to be CLI only and installed specific network services that I want active. Now my cr-48 is the time, dns and proxy server for my home network. Now the device runs on an average load of .2%, has an extended battery life and has among the best availability of any server you can find.

If you wish to learn how a distro is built and truly make a custom distro you can always try Linux From Scratch which will make you build everything from the source code and choose only the software that you want.