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Eye on ROI:
The Software "R(OI)evolution"

online columnist The Gantry Group     Column published in DMReview.com
August 26, 2004
 
  By The Gantry Group

So much attention is being paid to the ebb and flow of the economy these days that many are not fully aware that the software industry is in the midst of a major sea change. In particular, software licensing and delivery has entered a stage of metamorphosis, as companies move from perpetual, on-premise licensing models to hosted, subscription-based (i.e., recurring) models. The impact of this shift in both pricing model and software delivery is far reaching, affecting the way enterprises buy and pay for software solutions and, importantly, how they measure and track the economic justification (ROI) of their investment.

It's difficult to pin down just what software is these days - is it a discrete technology product? Or is a hosted managed service - an ASP - or simply the infrastructure that drives an outsourcer's delivery of a managed business process? In today's market the answer is, of course, all of the above! But this is important to understand if you are conducting an ROI analysis to compare the economic value of a licensed application versus a hosted, off-premise solution.

Shifting Sands

The traditional software licensing model, where a company pays a one-time, upfront fee for a perpetual license to the software, is quickly being eroded by the annual subscription model. IDC estimates that 25 percent of software sales are sold using subscription licenses today. IDC forecasts strong adoption of the subscription model, with more than 43 percent of software vendors and 26 percent of customers believing that the majority of worldwide software revenue will be derived from subscription-based software by 2010 - this dramatic change catalyzed by "financial motivations, industry dynamics and customer demands."1

Key benefits of the subscription model for software - for both software vendors and customers - are the promises of simplicity and economic justification. From the software vendor's view, a subscription model brings the advantage of a recurring and more predictable revenue stream that overcomes the "one-off" enterprise sale. The subscription model typically bundles everything into a single annual fee, including rights to software use, automatic software updates, maintenance and technical support.

Enterprises see a number of advantages to this model, including the elimination of upfront costs, a predictable software cost structure, a more predictable software life cycle and the freedom to reevaluate the solution decision at almost any time. Subscriptions are simply more compatible with enterprises' desire to manage cash flow, while avoiding the complexities of software license management and enforcement of company-wide compliance. Another "plus" is the basic fact that subscription pricing can make sophisticated technology accessible to smaller companies that could never before afford it.

Today, the prevailing mandate for both buyers and vendors is that any IT business investment must be justified by quantifiable delivered value in a required timeframe. Value must be delivered not just once but continually as a key measure of investment "success." Enterprises' desire to track software impact against their business performance goals is a key driver of change in the software industry. According to an IDC study, "72 percent of software vendors and 70 percent of software buyers strongly believe that the software industry must place a greater focus on clearly establishing the business value of software."2

Success of a software solution - whether sold as a product or service - is now directly tethered to the vendor's ability to communicate and prove the economic value delivered by that solution to targeted buyers. If the vendor can't do this, the customer will discontinue subscription and switch to another provider. As a derivative of subscription pricing, enterprises are less likely to be held captive by vendors.

What Does This All Mean for Enterprises?

While in the past concerns about information and data security, reliability and system integrity represented insurmountable barriers to application outsourcing, in today's environment other advantages have all but overcome most of these objections. As enterprises are under pressure to survive in a stalled (or slowly recovering) economy, which is nonetheless increasingly regulated, issues around net cost reductions and economic value now figure prominently in IT purchase decisions. Now focused on improving business process efficiency and establishing ROI performance metrics to benchmark and track success, enterprises have new criteria for selection of technology. Today the advances in security technology and Internet resiliency have largely calmed prior concerns, while the compelling economics of shared services - or outsourcing - are driving growing adoption of subscription software contracts.

One might even say that the IT technology market is shifting from a seller's to a buyer's market. Companies now seek solutions that will have measurable economic impact on operating costs and improve the effectiveness of their business processes. Enterprises measure this bottom-line impact in terms of increased revenue, customer retention, reduced and avoided costs, increased business opportunity and reduced risk and liability. This focus elevates the buyer's purchase decision criteria up a notch, making preferences for solution delivery method - on-premise software, hosted solution, outsourced service - far less of a consideration. Simply stated, enterprises evaluate solution investments on the basis of which solution will require the lowest investment for the greatest return. If an outsourced solution can't deliver the promised value, it may very well be replaced at the end of the subscription contract.

The ROI of Subscription Pricing

One of the attractive attributes of subscription-based pricing for customers is that it is a "pay as you go plan," eliminating the need for large upfront payments. However, the software vendor willingly sacrifices revenue that could have been won as a lump sum in a perpetual license sale in the hopes of making more money through a long-term contract-based subscription. However, these long-term subscriptions are by no means a certainty.

As a result of having "less skin in the game," a customer is far more likely to revisit their buying decision after subscribing to the solution. "Switch and cut bait" is much more economically feasible for the customer in the subscription scenario than in the past. No longer the captive customer, enterprise sales must now be resold toward the end of every service contract.

Renewal of the subscription contract period is a time for quantitative reassessment by the enterprise. Prior to contract renewal questions to ask include: "Have we received value from this solution? Did the value delivery from the solution meet our expectations? Have we met our business performance goals through the use of this solution? Is there another vendor that can deliver better value?" A software vendor must be ready to have a consultative value assessment session with the customer to better ensure subscription renewal. The software vendor needs to quantify the bottom line value that its solution has specifically delivered to the customer's organization and the impact that it has had on the customer's relevant business processes. This sales step is critical if a software vendor hopes to tap the upside of a recurring revenue stream.

Expanding the Paradigm

So why stop with just software... why not add computer hardware into the mix! Sounds far fetched? Well, the new subscription model is not just a phenomenon within the software sector; it is transforming the computer hardware sector as well. Enterprises don't want to own hardware, they want to lease it - and even share it. The hardware giants - IBM, Sun, Hewlett Packard - don't disappoint. These companies have jumped onto the bandwagon to sell "cycles", not iron. "Utility thinking" has arrived for computer hardware manufacturers, as they dream up new ways to make their equipment pricing more palatable for anemic enterprise budgets and wedged cash flows. Enterprises are sold computing cycles similar to the way power companies produce and deliver electricity to homes.3 Taking your pick of the latest lingo - utility computing, adaptive enterprise, virtualized enterprise or on-demand computing - the Internet serves as the communications vehicle for processing enterprise computing task requests to and from big server computing farms, owned and operated by large computer vendors.4 And it's not just the hardware that is being sold by the cycle - software solutions are bundled in as well.

The motivations for adoption of the utility computing model are similar to those for the hosted software model discussed above: an intense desire to reduce expense and financial overhead, while increasing business process efficiency. Enterprises that invested heavily in computer equipment and server farms are realizing that utilization of all that power is far from optimized. In many cases only a fraction of the installed capacity was being used. By renting cycles, enterprises pay only for what they need, substantially lowering capital expense. Reminiscent of the old computing time-sharing days of the 1970s, utility computing harness the Internet and promises to transform the computer hardware sector into an outsourced, service business.

Some say that utility computing is just "the latest attempt at selling hosted applications."5 However technology has rapidly moved forward to make the forecasted success of this business model more believable. For example, technological breakthroughs like server virtualization allow unused resources of many computers function as one computer.6 Assured of data security, an enterprise can draw upon the resources of a centralized computing center according to its particular computing needs and appetite for cycles. IDC estimates that worldwide utility computing will grow from $1 billion in 2003 to $4.6 billion by 2007.7

While utility computing is a far more ambitious model that a hosted software solution or outsourced service, only time will reveal true enterprise adoption and its overall success. However, the fact that this business model is in trial mode with so many successful computer firms speaks to the enterprise market's ongoing need to reduce operational costs and manage business processes company-wide. Enterprises are receptive to these new software and computer hardware purchasing models because of their overriding focus on value delivery and ROI.

References:
1. "Future of Software Licensing." IDC, March 2004.
2. Ibid.
3. "Computing Farms." Red Herring: February 3, 2004.
4. Ibid.
5. "Virtual Utility." Red Herring: February 4, 2004.
6. Ibid.
7. Ibid.

...............................................................................

For more information on related topics visit the following related portals...
Outsourcing and ROI.

Dawna Paton and Dale Troppito are managing partners of the Gantry Group. Paton has helped guide the Gantry Group's rigorous ROI best practice models based on a 25-year career as chief executive officer, CFO, sales and marketing executive, and venture capitalist in high technology companies. You can reach her at dpaton@gantrygroup.com. Dale Troppito, company cofounder, believes that the technology leaders of the future will be those that understand the crucial role that a market-validated, value delivery strategy and compelling ROI play in shaping corporate competitiveness and customer satisfaction. You can reach her at dtroppito@gantrygroup.com.

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