Monday’s Musings: Total Account Value, True Cost of Ownership, And Software Vendor Business Models

Published on April 5, 2009 by R "Ray" Wang

Recession creates an opportunity for frank vendor – client discussion

A fine equilibrium exists between the vendor’s success and a client’s success.  Its time for the enterprise software industry to have a frank and honest conversation about software costs and vendor business models. To date, comparing cost among different vendors remains difficult as license, maintenance, implementation, and other operating costs lack easily comparable benchmarks.  Moreover, the timing of these costs span across different periods of time.  In context, the current customer outrage at some vendors over maintenance increases makes sense for those clients given arguments and assurances that they would receive a smaller upfront discount but pay less on maintenance on the back end.  When a vendor jacks up your maintenance after making that argument, well, you could expect some outrage!

Now the converse of this argument is also true. If a client got a great discount upfront and pays a higher rate for maintenance, one could argue that the costs might even out.  However, if the clients take that great upfront discount and come back to complain about maintenance fees, vendors face a significant issue.   Vendors have a right to be outraged and one could say the client is in poor form.  Yet, odds are high that the client does not understand that the discount was predicated on a predictable revenue stream for the next 7 to 10 years. In most cases, the client could care less because this is after the fact.  So we could reach a lose-lose situation when clients receive a good deal and the software vendor goes bankrupt.   Now if  vendors profit too much at the expense of the client, well, their clients will go bankrupt and we also achieve a lose-lose.

This illustrates the case why the industry needs a frank dialogue to clients about the true cost of ownership; how Total Account Value (TAV) impacts the vendor; and what ramifications exist for recession time software vendor business models.  In today’s economic climate, industry leaders need to lead in striking the right balance with customers, or face more “Le Rebellions“!

Total Account Value (TAV) should drive most licensing and pricing decisions for vendors

Whether perpetual or subscription, on premise or on demand, TAV should drive everything from discounts to maintenance fees.  With every product line, vendors should seek to maximize revenue streams. This is why business models matter.  How can you evaluate what’s an equivalent deal from your competition without a fair comparison.  Let’s take 1000 users and a list price of 4000 and see what would be equivalent between 2 common business models:

SCENARIO 1: Creating equivalency between 2 business models highlights upfront versus downstream revenue requirements

  • Vendor W’s upfront revenue maximization strategy. (i.e. modest license discount/ low rate of maintenance). 60% discount on license = 1600 per user.  Total license = 1,600,000.  15% maintenance for 10 years = 2,400,000.  Assume a free upgrade.  Total cost 4,000,000
  • Vendor R’s make it up on maintenance strategy (i.e. big license discount/high rate of maintenance). 75% discount on license = 1000 per user.  Total license = 1,000,000.  30% maintenance for 10 years = 3,000,000.  Assume a free upgrade.  Total cost 4,000,000.

As one can see, you’d need a 30% maintenance fee to make up the loss in revenue over 10 years for a 75% discount.  This doesn’t even include the cost of money (NPV)!  In the other example a 60% discount would require a 15% maintenance fee to be equivalent.   Let’s examine the reality of fully loaded costs in the market for the client or True Cost of Ownership:

SCENARIO 2: True Cost of Ownership for 2 models shows Vendor R better for customer, Vendor W better for vendor

  • Vendor R’s make it up on maintenance strategy (i.e. big license discount/high rate of maintenance). 75% discount on license = 1000 per user.  Total license = 1,000,000.  22% maintenance for 10 years = 2,200,000.  Assume a free upgrade.  Total cost 3,200,000.  Vendor R makes less per 10 year period.
  • Vendor W’s upfront revenue maximization strategy. (i.e. modest license discount/ low rate of maintenance). 60% discount on license = 1600 per user.  Total license = 1,600,000.  17% maintenance for 10 years = 2,720,000.  Assume a free upgrade.  Total cost 4,320,000.  Vendor W makes more per 10 year period.

In the above example, it becomes apparent that going for the upfront license discount gives clients the better long term value.  Clients save about 1.1M just by getting a better license deal upfront.  From a vendor point of view, they lose 1.1M in a 10 year revenue stream.  Hence that’s why some vendors have had to jack up maintenance fees as they discount their licenses.   It’s too hard to make up incremental revenue.  Now let’s add SaaS to the equation.  For SaaS, assume 100/user/month or 1200/user/year with maintenance included:

SCENARIO 3: The SaaS factor highlights True Cost of Ownership point of view

  • Vendor S (i.e. typical SaaS subscription licensing approach). 20% discount on license = 960 per user per year or 9600 per user per 10 year period.  Total license and maintenance for 10 years = 9,600,000

Right off the back one could make a few erroneous conclusions.  SaaS appears to be 3 times more profitable for the vendor and or 3 times more expensive for the customer!  But, on premise doesn’t include the cost of implementation which could be up to 2 times the cost of the license fee and upgrades which often 1 to 2 times the original license to implement, test, and deploy.  That’s at least another 3 times the overall cost.  Adding up the final bill over 10 years at least for license, upgrade ,maintenance, and implementation:

SCENARIO 4: Comparing 2 common business models against the SaaS factor shows win-win with SaaS model

  • Vendor R’s make it up on maintenance strategy (i.e. big license discount/high rate of maintenance). Total license and maintenance cost 3,200,000.  Add 6,400,000 for implementation.  Add 3,200,000 for upgrade.  Estimated bill = 12,800,000
  • Vendor W’s upfront revenue maximization strategy. (i.e. modest license discount/ low rate of maintenance). Total license and maintenance cost 4,320,000.  Add 8,640,000 for implementation.  Add 4,320,000 for upgrade.  Estimated bill = 17,280,000

Once you take into account all costs to the customer, SaaS looks cheaper for clients and vendors make more.  This win-win is rare in the market but one reason why this model will continue to gain steam in the next 5 to 10 years. In fact this back of the envelope calculation shows a 3,200,000 to 7,680,000 savings.  Now, there are drawbacks such as the inability to customize, dependency on provider, and availability of end to end comparable suite solutions, so for a real ROI, check out the Forrester report on ROI of SaaS vs On Premise.

As these examples illustrate, customers should be comparing these final costs against all proposals.  Otherwise, customers can not compare among various offers and fully realize the true cost of ownership! True cost of ownership should be what’s compared and discussed.

The bottom line for end users – consider True Cost of Ownership when reexamining value in the vendor – customer relationship

Packaged apps (i.e. COTS for the public sector) promised overall cost savings and constant streams of innovation.  Clients went down this route to avoid the hassle of having to maintain and upgrade custom apps.  Yet, most clients don’t understand their cost basis. How can you calculate ROI? Calculating the true cost of ownership requires customers to account for all costs across the five phases of the software ownership life cycle (i.e. selection, implementation, utilization, maintenance, and retirement).  Users can then make apples to apples cost comparisons among custom development and other vendors products.

However, costs alone does not address the benefits different vendors provide.  Functionality still trumps costs in all surveys about buying decisions.  Some software vendors complete a bigger functional footprint, or provide better flexibility as some software is easier to use, or increase risk as some software is tougher to implement.  Hence the Forrester view on ROI makes sense and end users should evaluate these costs along with benefits, flexibility, and risk – Forrester’s Total Economic Impact model.  Customers should focus on value, which might mean a fair balance between cost and benefits and a bit more.  With that in mind, the key questions clients should keep asking are:

  • “Am I still saving money buying instead of building?”
  • “What value am I getting for my support and maintenance?”
  • “Have we achieved the cost savings and innovation that was promised?”
  • “Can we respond quickly enough to changing business conditions?”
  • “Is there enough of a competitive differentiator?”

Once that’s in place, vendor selection will be harmonized.  And, contract negotiations strategy can align with product adoption strategy.

The bottom line for vendors – communicate how your business model drives value to clients

Fairness aside,  maintenance and license fees will be the first two casualties of a downturn as companies look to strike down costs.  Most vendors face growing pressure from users who face tremendous pressures to remain solvent.  However, vendors who communicate the role of total account value (TAV) at the beginning of each sale will gain a new advantage in an educated customer.  As customers understand true cost of ownership, (i.e. the customer view of TAV), they can compare among comparable solutions and understand the value of their investment over a longer period of time.  This level of transparency provides assurance to the customer they received a fair deal.  That eliminates the hassle of trying to manage the perception of being cheated on over the course of the relationship.  It also makes it harder to complain about maintenance and seek third party maintenance options!

Walking through the scenarios, vendors can also alleviate client confusion and gain credibility by demonstrating:

  • Value – demonstrating comparable ROI among competitive products over 10 years.  Showing what percentage of the maintenance dollar goes back to product innovation.
  • Choice – providing options for clients to pay more upfront, less later; less upfront, more later; or a constant stream over a fixed period of time.  Helping show transparency in the product road map and development process.  Provide tiered maintenance options or embrace third party maintenance like options.
  • Predictability – keeping cost structures predictable over an average life cycle of the product (i.e. about 7 to 10 years).  Communicating and delivering on product roadmap promises.

Your POV

Ready to have a frank conversation with your vendor or client?  Have you figured out what the right ratio of reinvestment to profit should be?  Are you a vendor which has been showing how your solution demonstrates value? Posts are preferred or send me a private email to rwang0 at gmail dot com. Thanks and looking forward to your POV!

Copyright © 2009 R Wang. All rights reserved.

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