Comparing Total Cost of Ownership of Rented and Bought Enterprise Software

We are often asked this question by potential customers who want to know what renting enterprise software means for their organization from a financial perspective.

This question can’t be answered without understanding a couple of things:(1) the enterprise software upgrade cycle and (2) the typical business model used by today’s enterprise software vendors.

(1) Enterprise Software Upgrade Cycle

Enterprise software has a finite life span after which the software needs to be upgraded or cross-graded to the most current version. Most enterprise  system vendors provide a version increment every 3 years. Some system vendors upgrade their software more frequent and others less frequent, but 3 years is about the expected timeframe for a major version change to come around. It is important for a customer to stay up-to-date with these upgrades so that the company has access to technical support and to make sure that incompatibilities don’t arise between the enterprise software and other components and software across the company’s IT infrastructure. A failure to stay up-to-date can cause costly technical faults, system failure and cause end users to go unsupported – not to mention the very real likelihood that upgrading might be impossible if the upgrade path stays broken for too long.

(2) Enterprise Software Vendors’ Typical Business Model

Software vendors sell enterprise software that typically has an annual maintenance fee of around 15% of the initial purchase price of the software. Some vendors might charge only 10% and some might charge as much 30% – so, 15% is just a typical amount. The purchase price is usually paid up-front and the price of maintenance is paid annually in advance. The annual maintenance fee typically covers technical support and access to patches and fixes for the current version of the enterprise software. Often the annual maintenance fees don’t include customisations or specialised consulting services.

Increasingly though as enterprise software matures and becomes more ‘configurable’ and the need for customised development to modify the enterprise software decreases, there is a commensurate increase in the  software’s complexity. The need for consultation and specialised advice in order to work out how best to implement customisations in the software increases as the software’s complexity increases. It appears that the decrease in need for customisation is replaced by an increase in the need for consultation, training and expert advice in order to implement modern enterprise software successfully.

Comparing Renting and Buying Using A Simple Model

Keeping in mind the information discussed above, the total cost of owning enterprise software is not a straightforward calculation—we can’t just assume that the “sticker price” multiplied by the number of end users equals the entire cost of rolling out a new system.

The customer should ideally understand the total cost equation over at least a 3-year period and should account for customisations, consultation time, report writing and other auxiliary services that typically go along with the planning, implementation, utilization and maintenance of an enterprise software system.

Considering all factors, a 200-user enterprise system may cost $400,000 to purchase (@ $2,000 per user) plus an additional $60,000 per year for annual maintenance and additional consulting and training services (15% of the purchase price). The reality is that these consulting and training amounts are usually much, much higher (in some cases the cost of these services can be in multiples of the purchase price of the software). But, for now, let’s just use these numbers to illustrate the outright software purchase business model. So over the lifespan of the software the customer is up for a total investment of:

Now, let’s look at an equivalent software rental model.

Please note a few things about the software rental model.

• Software renting does not mean that the product resides on the Internet, nor does it mean that the software is licensed to your enterprise in a way that is different to that of purchased software. The customer who rents software still owns a license to operate the rented software and this ‘ownership’ means the software vendor is prepared to let the customer pay for the license as your company consumes the software’s value over time.

• In purchasing software, the customer pays for the software’s full value up-front and then uses up that value as the software ages through its life cycle. Up-front payment models place the burden of risk on the customer and recouping the upfront investment will take many years. If the customer does not choose wisely, the repercussions can be significant and serious.

• There are some obvious benefits to companies that decide to rent software. The company avoids the massive ‘sunk cost’ that occurs when software is purchased. Renting enterprise software means that the total cost of ownership is spread out evenly over multiple years and is therefore more closely matched to the way in which value is derived by the customer from the software. The reasoning is that, by using the software for a month, you should only have to pay for a month.

• The rented enterprise software should have a low ‘switch’ cost–a customer should be able to stop paying at any time and move to another system without a large financial or resource penalty for doing so. Customers who rent software typically can’t afford to wait out long implementation periods or development of additional modules or a consultant’s customised outputs. With rented software, if the product fails to deliver, it is simply turned off and the customer stops paying and picks another supplier. The vendors for rented software must work to deliver real benefits to customers or risk losing clients because of a low ‘switch’ cost.

Now that you understand some of the essentials, let’s go back to our $400,000 enterprise software system example above.

If a company rents out the same software, it might be charged a small implementation fee of a few thousand dollars to cover the time and resources to do the software installation along with a low, flat monthly fee for each named user being provided access to the software.

If there are 200 users (the number from our example above), an equivalent rental pricing might be a total of $10,000 per month (200 users @ $50 per user) or $120,000 per year. Over a three-years life span the cost of the system would be $360,000.

At first glance, there appears to be an obvious and significant saving of $220,000 and this is correct: $580,000 to buy versus $$360,000 to rent, save $220,000 by renting. But there are other significant savings to be made by renting software which are not altogether obvious.

Hidden Savings

The first partially hidden saving is due to the fact that there are no maintenance fees payable under a software rental agreement. Maintenance fees are built into the monthly rental fee. All technical support, patches, security fixes, bug fixes, and so forth, are covered in the monthly rental fee.

The next saving comes by way of avoiding a sunk cost. By purchasing software upfront and outright, the company sinks capital into a resource for which it must wait 3 years in order to get the full value of the software (on the basis that the software has a residual value of zero at the end of the three-year life span). By renting software however, the company spends $120,000 in year 1 and avoids sinking an additional $340,000 ($400,000 for the software and $60,000 for year one maintenance = $460,000). Assuming you were able to deploy the funds not sunk into software, you could gain $17,000 in interest, if that $340,000 were invested in a one-year term deposit at a reasonable interest rate of say 5%.

By renting the software, the company avoids the sinking more capital than it needs to, to get access to the enterprise software and can redeploy those savings elsewhere in the business (the use of a term deposit as an alternative investment was just for illustrative purposes as companies tend not to save money in term deposits but instead look for ways to deploy capital to grow their business!)

The same reasoning can be extended to the last 2 years of the software life cycle, resulting in even more gains.

Now if we consider that in the second year the customer will spend an additional $120,000 in rental fees (year 1 plus year 2), so the cash they would have on deposit is now reduced to a balance of $220,000 which can be left on deposit for a further one year earning and additional $11,000 for that second year in interest. Overall interest earned from funds not sunk into software provides an additional $28,000.

Granted, the model described above is over-simplified and the interest earned is a small percentage of the overall cost of the system (roughly 8%). The reality is that the sunk costs avoided are many times this and the alternative investment rates are not near as low as a cash rate. Enterprises typically don’t invest their capital in term deposits yielding 5% – they typically use it to expand their businesses and often can return more than 5% on their capital. For example, if a company were able to expand sales of its widgets–a core business operation–and return 20% on the capital deployed, then alternative uses of its capital could yield $112,000 in “interest” or return.

This model also assumes that investments are made annually and rental fees are paid annually in arrears. In fact, a typical rental fee is paid quarterly or monthly in advance, so the customer sinks even less of the company’s capital while renting – meaning, the customer is free to keep the business’s working capital around for a longer period before having to pay out some of the capital to cover software rental fees.

Conclusion

The bottom line is: renting software is the most cost effective way to access the value of enterprise software, even using a very conservative financial model that makes every attempt not to be biased in analysing the relative merits of both the rental and the purchase models. The above models showed that renting could cost as little as half of the total cost of ownership of purchasing software outright.

Renting enterprise software is increasingly becoming a critical consideration as modern enterprises strive to be more efficient in a globally competitive economic arena. It is often not a question of why to do it, but when can we start.

Tony Willenberg is the CEO of ICTD Corporation. He holds qualifications in information systems (MSc, BSc) and applied finance (MComm). Tony has produced white and blue papers for a number of organisations including the World Bank and various UN agencies. He has been engaged by both public and private sector organisations internationally. Tony serves on various ICT advisory and tender assessment panels for Australian state and federal government agencies and is a member of the One Laptop Per Child technical working group. His professional career has been documented by the Australian Computer Society and he is a member of both the IEEE and the ACM. He spends time equally between Singapore, Australia and the USA, is a regular speaker on the impacts and opportunities in ICT in emerging economies and has worked in more than 23 countries on strategic technology and technology policy initiatives.