Supply & Demand: Software PricingBy Jeffrey Rothfeder | Posted 02-01-2004
Supply & Demand: Software Pricing
ATA Holdings Corp. navigated the new rules of engagement with software vendors for the first time nearly two-and-a-half years ago. The Indianapolis-based parent company of discount ATA Airlines Inc. was in the midst of the post-Sept. 11 air-travel crisis, when air travel dropped off a cliff. That's when management decided that a reborn Internet site was essential to lead the carrier out of the wilderness. Before then, ATA had a negligible e-commerce presence: an outsourced Web site that was neither attractive nor reliable. Their plan was to bring control of the site in-house and remake it into a profit centerall in a matter of months.
It was a tall order, recalls Bob Lewandowski, ATA's director of e-business. The biggest problem was gauging capacity and guaranteeing virtually no site slowdowns or downtime. "The Web site was going to be such an important part of our distribution channel that we couldn't afford to not be open and ready for all customers at all times," Lewandowski says, "or we lose the sale."
ATA was using Oracle software to develop and run the site, but when Lewandowski's team began test runs, the software would spike to 100 percent usage and lock up. In the old relationship between software buyers and sellers, to troubleshoot the Oracle program, ATA would have had to pony up tens of thousands of dollars to obtain several perpetual licenses for a new software-management program. Then the company would have had to spend months installing the program on its internal systems and working out the kinks. By the time the Web site was up and running, months would have been wasted and a lot of commercial opportunity would have passed irretrievably.
But Lewandowski had better options: He cut a three-month subscription deal with Mercury Interactive Corp., a maker of business-technology-optimization software, to deliver a program via the Web that could simulate 10,000 users and determine how to tweak the Oracle software to handle the load. Moreover, the Mercury software would continually monitor ATA's Internet site and benchmark its performance every few minutes.
With no internal setup required, Lewandowski was able to see and quickly identify some of the data-indexing and pooling fixes he could apply to increase the capacity of the Oracle software. And, although purchasing software by subscription costs more over the long term than buying a perpetual license, the upfront fees for ATA's initial Mercury contract were just a fraction of what he would have had to pay if a perpetual license had been the only alternative. (Since then Lewandowski has signed up for two more one-year subscriptions.
ATA's site went live in May 2002. It has become the airline's most profitable channel, with 100 percent revenue growth each of the past two years, and it often racks up $100,000 in sales in an hour. Along with a lucrative Pentagon contract to ferry soldiers and supplies to and from Iraq, ATA credits its Web site for the company's recent turnaround: The carrier posted total operating earnings of $86.9 million for the first three quarters of 2003, compared with losses of $108.9 million during the same period the year before.
"We were successful because I had a number of software-delivery and purchasing choices to pick from and a software company that was bending over backwards to work with me," Lewandowski says. "That's a far cry from the way it used to be with software vendors. This time I had leverage."
Such a statement was unimaginable just five years ago, when software companies were king. With demand at its peak, thanks to a seemingly unquenchable thirst for ERP and CRM applicationsnot to mention the need for programs to address Y2K fears and drive dot-com dreamssoftware vendors were able to dictate the terms of purchase. But as the economy slowed, so did software sales. Worldwide, annual software-industry revenue fell 2.5 percent between 2000 and 2002, after years of double-digit growth, according to the Software & Information Industry Association. As IT budgets shrank, many CIOs began focusing more on integrating recent software acquisitions (too often still not living up to expectations) rather than on making big new purchases. To entice customers in this strapped business environment, vendors of every stripefrom the more conservative standbys such as IBM Corp., Siebel Systems Inc. and Oracle Corp., to more freewheeling players such as Salesforce.com Inc. and Computer Associates International Inc.are offering ever more creative and customized pricing and delivery choices.
In today's market, the perpetual license, still the dominant approach for purchasing software, is inexorably giving way to yearly or even monthly subscriptions and more radical fee plans, in which, for instance, companies pay for software based on how much they use, just as they would purchase electricity from a utility. Meanwhile, traditional arrangements based on one name, or one box, per license have already been overtaken by concurrent licensing in which companies buy, say, 50 licenses and divvy them up among users as needed from one moment to the next. And more and more companies are acquiring their programs from vendors who manage and maintain the software on their own computers and deliver it via the Web.
By choosing well from among the available payment and purchasing schemes, organizations can generate real savings. An example is the Jet Propulsion Laboratory at the National Aeronautics and Space Administration, which relies on a popular computer-aided engineering (CAE) tool for aerospace design. With about 600 potential users, JPL would have to pay more than $1.1 million to obtain perpetual licenses of the $1,900 software for each of them; then there's another $600,000 over a five-year period to license the roughly 300 additional users who might get involved in JPL projects for a short time, or who are replacing departing JPL staff. "Nearly $2 million for one program over five years is a big expenditure, but that amount highlights a key problem with perpetual licenses: They become orphaned and lost in the system," says Charles White, a system engineer at Northrop Grumman Corp., currently on contract to JPL in the computer-aided engineering office. "It's hard to keep track of which user holds which license if you have many different kinds of software. So when people leave, the software is often abandoned and unusedand the money we paid for the license is wasted."
Six years ago, in an effort to gain control over these expenses, JPL shifted its CAE software account to concurrent licensing, thus eliminating per-user contracts. Under the concurrent approach, the cost per license was $7,600four times that of a per-user licensebut the agency only needed to purchase 100 copies of the CAE software, the maximum number of people running it at any given time. All told, JPL, one of the first organizations to demand concurrent licensing, slashed its CAE software outlays more than 50 percent, and expects to reap further savings in the coming years. "In aerospace, we have a programming talent pool and once upon a time we never bought third-party products; we wrote our own software," White says. "If software again costs more to purchase than to build, we'll just go back to making it ourselves. For their survival, software companies realize it's a good idea to cooperate with us."
Only now are more mainstream buyers getting the same privileged treatment. Among companies with more than 1,000 employees, nearly 30 percent of the software bought in April 2003 was purchased with concurrent licenses, compared to about 20 percent for the per-user approach, according to IDC. (The rest of the software was acquired through various forms of subscriptions.)
"Software is a mature industry with considerable cost pressures," says Ken Berryman, a principal at McKinsey & Co.'s Silicon Valley office. "On the user side, this has resulted in increased demands for transparency, a reduction in pricing complexity and more scrutiny of total cost of ownership. For software companies, it has meant a more solutions-oriented approach. The way this significant transformation unwinds in the next 18 months will set the pace for how software will be priced and delivered in the foreseeable future."
The most radical change in pricing has been the tilt toward subscription plans and away from perpetual licenses. Customers pay for software licenses by the month, quarter, year or longer and can cancel or renew at the end of their term. In the third quarter of 2003, 46 percent of new orders at Mercury Interactive were subscription-based, compared with just 28 percent in the same period the year before. And even established software companies such as Oracle, which, in the past, quietly offered subscriptions only to large clients, have softened their stance in response to customer demand. "We've had some form of subscription pricing [for many years], but now it comes up more often," said Jacqueline Woods, Oracle's vice president for global pricing and licensing strategy, at a software conference in mid-2003.
Customers are drawn to software subscriptions because these plans limit large upfront expenditures and don't lock them into costly long-term relationships with vendors. But there is one caveat: Software purchased in any way other than as a perpetual license is viewed as a business cost, as opposed to a depreciable capital expense, and must be accounted for on profit-and-loss statements. For projects with big price tags and high consultant fees, many companies prefer the depreciation route; if taken as an expense, the software costs would weigh on earnings. For more routine software initiatives, however, company executives say that the accounting difference is negligible and more than made up for by the benefits of subscriptions.
For instance, in subscription arrangements, software vendors typically provide updates as part of the plan, so companies don't have to worry about whether or not they should purchase new versions of software to replace a large number of perpetual licenses. In addition, many CIOs feel that, because they re-evaluate their use of the software every time they renew, it is fairly easy to monitor how many software subscriptions they've purchased and whether it meets their organization's needs, which, of course, mitigates the expensive problem of orphaned perpetual licenses. Perhaps most important, and something that even vendors admit, is that subscriptions force them to pay more attention to customer needs on a daily basisin maintaining the software and making sure it keeps up with the state of the art, for instancebecause they can lose customers at any time.
The subscription approach is winning over software vendors as well, because, as opposed to the choppy sales generated by one-time licensing, it gives them steady revenueand sometimes more of it. Subscriptions over a five-year period, for instance, are usually more expensive than perpetual programs, and, with customers at a premium, this is more and more critical.
"To sustain our business model, we have to have a constant stream of new customers and existing customers rolling out into new areas," says Kuljit Bawa, CEO of Americas for Staffware, a manufacturer of business-process-management software based in the U.K. Until recently, Staffware resisted offering a subscription-licensing program, but under a new arrangement with ADP Brokerage Services Group, Staffware's programs will be offered by the month, quarter or year. "Software companies estimate that they can forecast 52 percent of their revenue using the subscription model, compared to only 2 percent when they're solely selling perpetual licenses," says Bawa.
The ASP Is Back
The growing popularity of subscriptions for traditional software has created a tipping point for a software-delivery method that until recently was struggling for customer interest: Web-based, hosted applications, sometimes known as applications-service providers, or ASPs. Just a couple of years ago, customers ignored companies like Salesforce.com, which offers a Web-delivered CRM program, primarily because much of the software was not as fully developed as licensed software and did not integrate well with programs from other vendors. Also, there were fears that the Internet-delivery approach would be full of bugs, and that the companies providing these programs would be unreliable or suddenly disappear.
But, as large vendors began to switch over to the subscription approach, customers grew comfortable with the idea that they could successfully purchase software just as they do magazines, and they began to give ASPs a second look. One advantage is lower cost: ASPs typically charge less than $100 per user per month for a CRM or ERP program, compared to hundreds of thousands of dollars for an installed perpetual license. Another advantage is that installation and training are simple, usually taking days rather than months. And just as the interest in ASPs blossomed, the Web-based software providers that survived the dot-com bust were introducing some of their most reliable and feature-laden programs. Although not quite as powerful as the more expensive programs, they are easier to use. The merging of renewed customer interest with better products has resulted in one of the few growth sectors of the software industry.
This is illustrated by the rivalry between Salesforce.com and Siebel, the latter an old-school CRM provider. In 2002, Siebel's revenue dropped to $1.6 billion, down 22 percent compared with the year before, and fell still farther, to $1.3 billion, in 2003. Meanwhile, although its revenue is just 5 percent of Siebel's, Salesforce.com's sales nearly doubled in the nine-month period that ended Oct. 31, 2003, compared with the same period in 2002. These numbers are punctuated by an Aberdeen Group study conducted in 2003, in which CIOs were asked whether they would consider using an ASP as a CRM provider. In the first half of the year, about half the respondents said yes; in the second half, 85 percent responded affirmatively. Siebel has taken note of Salesforce.com's success. After deriding hosted applications as a misguided idea and shutting down a fledgling ASP two years ago, Siebel announced a joint venture with IBM in October to offer CRM programs via the Web at subscription rates of as low as $70 per month per user. Other established software companies, such as PeopleSoft Inc., Oracle and Hewlett-Packard Co., have also begun to sell enterprise software as ASPs.
Pay As You Go
It's just a small leap from hosted, subscription-based applications to software priced and delivered as a utilitythat is, to software distributed via the Web, but not as an ASP, and charged by usage, not by preset fees and a contractual arrangement. And, while this model is still one of the smallest of the many new alternatives to purchasing software, it is also one of the most intriguing. The value of utility computing, proponents say, can be demonstrated at companies with highly variable but temporary demands on technology. At retailers, for example, the six weeks at the end of the year represent a large proportion of their business. During this time, inventory and supply-chain networks are stressed to extremes, and it's impossible for these companies to know beforehand exactly how much additional computing capacity they will need.
"That kind of company should not purchase additional computing capabilities up front for their peak periods. Instead, they should literally draw them in and pay for them as they're needed," says Jeff Smith, vice president of the On Demand Project Office for IBM Tivoli software, which, along with H-P and Sun Microsystems Inc., is among the biggest supporters of utility computing.
Despite the heavyweight backing, however, utility computing has been slow to be adopted, and it represents only about 5 percent to 10 percent of software sales, according to analysts. The reasons are mostly budgetary. Customers worry that it will be impossible to project full-year utility-computing costs because technology needs can be so unpredictable. The result: CIOs could face a paralyzing shortfall in computing resources if there were no money earmarked for unexpected needs. In addition, some technology chiefs fear that utility arrangements could stifle innovation, particularly if corporate bean counters closely monitor minute-by-minute software use and require justification for every additional expense.
"We're not interested in utility computing in our office," says JPL's White. "It's too hard for us to predict how much software time we need, and I don't want to spend an enormous amount of energy coming up with explanations every time we turn on a computer, or every time someone decides to be creative and uses more technology to explore a new design or a new way of doing something."
Given these doubts, the most prevalent utility-computing application in use so far appears to be process integrationprograms that optimize disparate hardware and software resources in a computing network in order to streamline it and make certain that it is being used efficiently. A key portion of IBM's On Demand initiative is focused on this problemit's an effort that has grown out of the need to rationalize the huge expenditures on IT that took place in the 1990s, and an attempt to gain a true return on investment from prior software purchases. To the degree that customers embrace this utility-computing application, it is because network optimization is not a core business operation, such as an ERP system. Thus, it is easily delivered as a Web- distributed overlay to existing technology. If usage exceeds the available budget, it could be turned off without compromising essential corporate systems.
Some large customers say they would be willing to consider utility computing for more critical applications if software providers offered a trial period, with a fixed rate for a short period of time, during which the vendor gathered data about software activity to help the company decide which pricing and delivery approach it should choose. Just as an energy company can give a consumer advice on how to conserve electricity based on an analysis of his daily usage, a vendor delivering software as a utility could provide usage metrics from many different data views. "Perhaps we'd pay a predetermined charge no matter how much we used for six months so I can compare the costs against normal licensing fees," Dan Griffith, Motorola Inc.'s senior engineering manager, said at a meeting of software companies last year. "I want tools available as neededI like that approachbut I need better reporting about our software usage so I can understand exactly how much it's all going to cost."
In fact, whether as an argument for considering utility computing or not, many customers are using their newly gained leverage to demand that kind of cost-based analysis from their software vendors, even those offering programs with traditional perpetual licenses. They feel they've purchased too many licenses and signed too many support contracts without knowing how much software they need, how many users they have at any given time, and how much maintenance they require. They argue that if software companies want to sell them additional programs, then they must become true partners, offering not only new products but also hard usage data to help them make better purchasing decisions.
Software vendors are not opposed to this idea. As revenue gets tighter, many of them are taking the possibility of misuse of software licenses, and the lack of compliance with software piracy rules, more and more seriously. As many as 10 percent of all end users are not conforming to licensing agreements, according to McKinsey's Berryman. That represents $19 billion in lost sales for software companies every year. More than 30 percent of respondents to an IDC survey in October 2002 blamed their noncompliance on the amount of software purchased, the frequency of staff changes, complex licensing rules and not enough staff to monitor software use. To recapture the revenue lost through noncompliance, many software companies are beginning to add to their programs tracking technology that can measure software use and produce detailed reports about individual activity. These reports will also provide what customers are now missing as they navigate new pricing and delivery programs: the ability to make purchasing decisions based on reliable information.
When this data is commonplace and available to end users, the pricing and delivery options that appear so radical now will seem tame compared to what customers will be demanding and what software companies will be forced to offer, says Stephen Graham, IDC group vice president of global software partnering and alliances: "The experience of other industries has been that the balance of power in a supplier relationship resides with the company that amasses information and then leverages its knowledge. Despite the structural problems and the changes that favor end users we've already seen in the software industry, vendors still have the balance of power. But not for long."
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