Total cost of ownership (TCO) measures the ongoing expense of owning and maintaining software within a business. It is a key component of the i in return on investment (ROI). Naturally, the chief executive officer (CEO) and chief financial officer (CFO) care about ROI, but is TCO a measurement of complexity? Is TCO a measure of agility or the lack of agility? Does a higher TCO mean a company is less able to "turn on a dime" to meet customer and market demands?
An August 2006 Aberdeen Group report on enterprise resource planning (ERP) in manufacturing tells us that TCO is the number two selection criterion for ERP software selections behind functionality. While TCO has always been considered a key criterion for software selection for small to mid-sized companies, the report shows that it is even more important in large (with revenues over $1 billion) companies.
Looking at the two variables that rank first (functionality) and second (TCO) in software selection, we see that they relate directly to ROI. TCO is a measurement of investment—the ongoing investment required to own, maintain, and operate the solution. Functionality is not a measure of return, but it is an indicator of the potential. Without the right functionality, the software cannot have a positive impact on the business—and without that impact, it cannot generate a positive ROI.
TCO includes a number of different costs. External costs include checks written for software, hardware, and external services. However, while most companies understand these external costs, the internal costs are often not fully understood. The internal costs are often buried in a general information technology (IT) budget, and considered as the cost of doing business.
A Meta Group study decomposed the elements of TCO. The study found that internal costs, made up of staff expenses, account for 42 percent of total costs, while external services typically account for an additional 28 percent. In total, people account for 70 percent of TCO.
||% of TCO
|Implementation internal staff
|Post-implementation internal staff (two years)
Source: Meta Group
TCO—A Measure of Simplicity
With 70 percent of TCO going for people, one must ask, what tasks are these people performing? They are working to keep the system running. They are helping end users. They are tracking and fixing bugs (yes bugs do exist—either in the software or in how the software was implemented). They are installing new releases, and building and maintaining interfaces. Hopefully, these people are also changing the way the software works within the business to meet the ever-changing needs of the business. The business will change, in small ways and large ways, everyday. A system that falls behind the way the business needs it to work eventually becomes a liability instead of the asset that was hoped for.
These tasks take time. The more complex the tasks, the more time they take. Therefore, as the people cost makes up 70 percent of TCO, we see that TCO is a measure of complexity. We can conclude that the greater the TCO, the greater the complexity of the software.
Experience tells us that, although exceptions do exist, the larger the company, the more complex it is, and therefore the greater we should expect the TCO to be. This is true, but we should consider the cost per user as well as total cost. The Aberdeen Group study provided the cost per user. It shows that the cost per user actually declines as company revenue grows. Smaller companies actually spend more for systems than larger companies when the cost per user is considered.
So Why Should the CEO and CFO Care?
TCO is a measure of complexity, and the opposite of complexity is simplicity. With almost everything in life, complexity is bad and simplicity is good. In software, complexity means both higher costs and less ability to keep the system up to meeting the ever-changing needs of the business.
No business stays the same. Challenges include customers demanding new ways of doing business. Challenges include governments setting new regulations. Challenges include companies changing to gain competitive advantage or to neutralize a competitive threat. As is often said, the only constant in business is change. When systems are complex, it means that the company is less able to respond to these challenges. Greater complexity means that the business will continue to change, and systems will fail to stay up to the needs of the business. Systems are often an obstacle to change. The CEO and CFO care because they direct changes in strategy, tactics, and business processes to meet these challenges. Today, the CEO and CFO expect the company to be agile to meet these challenges. TCO is a measure of a company's agility.
A direct benefit of a lower TCO is the pure economic benefit of lowered expenses. When TCO is lower, more money goes to the Bottom Line: a dollar saved in TCO means that dollar is available to go directly to the bottom line. Actually, that dollar can usually be used more effectively elsewhere in the business, for a purpose that offers a higher impact on the bottom line. Would a company rather pay for the care and feeding of its ERP system, or put that money into research and development (R&D) or marketing or additional sales resources?
About the Author
Olin Thompson, vice-president of industry strategy with Lawson Software, is a frequent contributor to TEC of articles of general interest to ERP and manufacturing management. He has over twenty-five years of experience as an executive in the software industry, and has been called the "father of process ERP." He is a frequent author and award-winning speaker on such topics as gaining value from ERP, supply chain planning (SCP), e-commerce, and the impact of technology on industry. He can be reached at Olin.Thompson@us.lawson.com.