Calculating Total Cost of Ownership for Software
As more and more businesses rely on software solutions to streamline their organizational processes and drive growth, it is important to understand the costs associated with implementing and maintaining these systems. Although the upfront purchase or licensing cost may seem like the most significant expense, it is just the tip of the iceberg. The Total Cost of Ownership (TCO) allows business owners to see beyond this initial cost and make an informed decision that is based on accurate data.
In this article, we will delve into calculating TCO for software, describing the challenges that may go along with the project and outlining the practices that help overcome those. We will also explore some tips from our own experience that will help conduct the most successful TCO calculation.
Why Calculate the Total Cost of Ownership for Software?
Purchasing software is a big decision for businesses that requires a lot of research and prior budget preparations. Although it can be helpful to look at the initial price when thinking of buying an asset, it is only a small percentage of what should be considered.
Calculating the Total Cost of Ownership (TCO) is a tool that helps demonstrate a clear picture of a software’s value. Consisting of both the purchase price and operating costs, it can facilitate decision-making by helping to present a long-term vision of an asset’s usability on a spreadsheet.
Moreover, TCO is beneficial for planning the budget, assessing return on investment, managing risks, maximizing the value of technology investments, and planning for the entire lifecycle of an asset or investment. Knowing how to calculate the total cost of ownership for software allows businesses to comprehensively understand the financial implications and select software that aligns with their budget and offers the best value for money result.
TCO Analysis for Software
To calculate the Total Cost of Ownership for software, it is essential to consider the formula with three variables: initial cost, operating costs, and retirement costs.
Initial cost, or Acquisition cost, includes the purchase price of the asset, as well as any development, installation, deployment, and implementation expenses that are required to make it operational. For example, the licensing and software fees, training employees or assisting users in adaptation for software costs, budget incurred for integrating the new asset or system into the existing infrastructure, a price for quality assurance activities, etc.
Operating costs are the ongoing expenses associated with owning, operating, maintaining, and continuously improving an asset or system throughout its lifecycle. These costs typically occur after the initial software acquisition and continue for the duration of the asset’s use. Here are some of the cost examples that can be considered operational:
- Maintenance and Repairs. Costs associated with regular maintenance activities, servicing, and repairs to keep the asset or system in optimal working condition. This includes the cost of spare parts, labor, and any external service contracts.
- Energy Consumption. Electricity, fuel, or other energy sources required to power and operate the asset.
- Consumables and Supplies. Costs of consumable items or supplies needed for the asset’s operation, such as ink cartridges, lubricants, cleaning materials, or other components that may need replacement over time.
- Technical Support. For example, helpdesk support or customer support contracts provided by the asset’s manufacturer or third-party vendors.
- Upgrades and Enhancements. This can include software upgrades, hardware replacements, or adding new functionalities.
- Downtime and Productivity Loss. The financial impact of any unplanned downtime or disruptions caused by equipment failures, maintenance activities, or other issues that result in a loss of productivity or revenue.
- Compliance and Regulatory Cost. Expenses related to ensuring compliance with industry standards, regulations, or legal requirements. This may involve conducting audits, implementing security measures, or obtaining certifications.
Retirement costs, or disposal costs, are the expenses associated with retiring or disposing of an asset or system at the end of its useful life. These occur when the asset is no longer operational, outdated, or no longer meets the organization’s needs. Retirement costs could include:
- Decommissioning. Expenses related to safely decommissioning and removing the asset or system from its operational environment. This can involve disconnecting utilities, dismantling or uninstalling equipment, and disposing of hazardous materials or components.
- Data or Information Security. This may involve data wiping, data destruction, or hiring specialized services to ensure compliance with data privacy regulations.
- Disposal or Recycling. Expenses related to properly disposing of or recycling the asset or system in an environmentally responsible manner.
- Equipment Replacement. Costs associated with replacing the retired asset or system with a new one that meets the organization’s current needs. This includes the purchase cost of the replacement equipment, installation, and any associated integration or customization expenses.
- Transition Costs. Expenses incurred during the transition from the retired asset to the new one, such as the cost of training employees on the latest equipment, migrating data, updating processes, and implementing any necessary changes to the infrastructure.
- Disruption and Downtime. The financial impact of the temporary disruption or downtime during the retirement process, which can result in reduced productivity, potential revenue loss, or additional costs associated with contingency plans.
Challenges with TCO Calculations and How to Solve Them
The quality of Total Cost of Ownership calculations depends on different factors, such as data availability, the subjectivity of stakeholders, changing variables, and others. It might be challenging to plan how to calculate TCO for software if some costs are hard to determine, cost components are missing, and benefits are not included in the analysis.
While the initial price of an asset is mainly fixed and clear, calculating operational and retirement costs is challenging. With the passing of time, these types of costs fluctuate, making them hard to predict. For example, it is impossible to forecast security breaches and downtime. Inflation is also a significant factor in budget planning.
There isn’t much you can do about the influence of inflation, and it is not possible to predict future security issues. However, one tip is to include the inflation average for the country or countries where the business is registered. For security purposes, you could develop different case scenarios based on the scale and time of potential breaches and count the approximate cost of each.
Missing Cost Components
The bigger a project, the easier it is to miscalculate or miss some of the cost components and cause unexpected budget spending later. For example, the hidden costs of frequent downtime and missed opportunities are difficult to account for. It is also a common mistake to compare software with different functions or characteristics, which can be misleading.
The only advice here is to go over the project’s budget as much as needed to ensure the most accurate calculation – even if it is inexact. It would be genuinely beneficial to take your time and not spare the resources for double-checking.
Lack of Benefits Analysis
Similar to the cost-benefit analysis principle, it would be helpful to consider the benefits of either one or the other software while counting the Total Cost of Ownership. For example, if you have to compare the energy consumption costs of 2 different assets. Looking at a TCO result only, you might choose a cheaper option and be satisfied with it. If, however, the more expensive option has better benefits (e.g., it is more environmentally friendly), it is up to your company’s values to help make a reasonable decision.
[su_note note_color=”#F0F8FC” radius=”15″]Maven’s client Babypark, the largest children’s goods retail network in Europe, is an example of how the right choice of software can help reduce operational expenses.
Previously, Babypark cooperated with other service providers who transferred its website to the hosting without conducting a preliminary business analysis. Unfortunately, the hosting had an issue with resource underutilization. Only 10-20% of resources were actually mobilized, while the business paid a 100% price and couldn’t optimize the process.
When Babypark asked us to help solve the problem, Maven built a custom solution that ensured the best fit and value. We rebuilt the architecture, reorganized the workflow, and expanded the team.
The combination of infrastructure migration and application modernization resulted in BabyPark no longer needing to pay for a license or other extras from the 3d parties, stepping up the omnichannel game, having x30 faster info processes, and x24 more rapid item info updates from ERP.[/su_note]
Best Practices for TCO Analysis
The most important advice for performing TCO for software projects is to actually do it. Businesses are often inclined to make quicker solutions and neglect this framework, focusing only on the initial price and concentrating on other priorities. This is a highway to ill-considered decisions and budget drainings in the future.
During the process, we recommend paying attention to the timing, using the OpEx model, and approaching the list of flexible costs with a business model in mind.
Mind the Timing
All the costs are sensitive to the timing – especially operating ones. Inflation, market changes, and even political or government regulations can influence price fluctuations. Therefore, it is important to be as up-to-date as possible, calculating TCO closer to the date of software purchase.
Minding the right planning timeline is also essential. For example, if the new software usually becomes obsolete 5 years after the purchase, making a TCO for 10 years is not useful.
Use the Continuous Improvement Approach
Evaluating total cost of ownership for software platforms, many businesses focus on the Initial costs only, perceiving technical solutions as capital expenditure (CapEx), which you only pay for once and forget about afterward. It would be much more productive and healthy to adopt the continuous improvement (CI) approach, looking at Operating and Retirement costs too.
[su_quote cite=”Serhii Kopeikin, COO at Maven Solutions” url=”https://www.linkedin.com/in/serhii-kopeikin-b99b60a3″]It is an often-case scenario when the profit that could be received due to the continuous improvement approach exceeds the amount of budget saved by paying attention to the Initial costs only. The CI approach is better suited for long-term goals and objectives.[/su_quote]
Distributing the budget monthly, for example, instead of spending a fixed amount of money once and forgetting about it afterward, gives the internal IT team or a service provider the ability to make the most of the given resources while staying flexible to adjustments and choosing what works better regarding budget and workflow during a particular period of time.
Revise the Business Model
The success of TCO calculation lies in the correct and timely determination of costs that need to be included. And sometimes, paying attention to the technical indicators alone is not enough.
[su_quote cite=”Serhii Kopeikin, COO at Maven Solutions” url=”https://www.linkedin.com/in/serhii-kopeikin-b99b60a3″]It all comes down to the goals, priorities, culture, and model of the business. Imagine that some e-commerce company decided to improve its software to gain more clients. Its team conducted the TCO calculations, made a decision, and invested in the best possible choice. Now, they have a new system, which works great technically. However, with time passing by, the business still has the same number of clients or even fewer. Their primary goal isn’t achieved.
What the business’s team forgot is that a crucial part of their development is investing in advertising and SEO optimization, which requires a significant amount of budget that they now lack. Conducting the TCO, they didn’t include marketing in the list of operational costs, which was crucial for their specific business.[/su_quote]
It is important to thoroughly work on identifying the specific costs, especially operational and retirement ones, which suit your business model. You may even have to rethink your whole organizational structure and strategy.
Calculating the Total Cost of Ownership (TCO) for software is a vital practice that empowers businesses to make informed decisions and optimize their software investments. It can be challenging with hardly determined costs, missing cost components, and a lack of benefits analysis. To fully benefit from software total cost of ownership calculation, it is essential to mind the timing factor of your calculations, use the OpEx approach, and pay attention to the business model specifics.
If you want to step up the game with high-quality software and consider cooperating with external providers, Maven Solutions can be the partner you need. After 13+ years of experience in different niches (e.g., Travel, Fashion, Goods for children, Food, Logistics, and Branded products) and sizes (e.g., from startups to Fortune 500 and the Inc.5000), we are ready to share our expertise. Contact us to find out more.
How Do You Calculate the Total Cost of Software Ownership?
To calculate the Total Cost of Ownership (TCO), you need to add all the cost components associated with acquiring, operating, and retiring the software.
What Are the Components of Total Cost of Ownership for Technology Assets?
The Total Cost of Ownership (TCO) consists of various cost components. A common division for technology is Acquisition, Operating, and Retirement costs.
Who can be in Charge of Calculating the TCO of Company’s Software Ownership?
Calculating the Total Cost of Ownership (TCO) for software can involve various stakeholders within a company, depending on the organization’s structure and responsibilities. Usually, the executives and higher management are responsible for TCO development.
What are the Key Examples of Ownership for Software that Show When You Need Changes?
There are several key examples or indicators that may indicate the need for changes. These can vary depending on the specific context and objectives of the software. Some common situations where ownership changes may be necessary are lack of vendor support, changing business requirements, incompatibility with the technology stack, security vulnerabilities, and poor user satisfaction.
How to Reduce the Total Cost of Ownership for Software?
Some of the ways to reduce the Total Cost of Ownership for software are negotiating favorable licensing and maintenance agreements, optimizing infrastructure and resource utilization, establishing proactive maintenance practices to identify and address issues before they escalate, utilizing automation tools to reduce manual efforts, and regularly reviewing and optimizing license usage.
Why Is the Total Cost of Ownership Important?
TCO helps organizations forecast and plan their budgets more accurately, making informed decisions with insights into the long-term implications of asset ownership. This is especially important when software has been paid for, has been amortized, but the ongoing maintenance costs are on the rise, or the outdated software can no longer support necessary business processes effectively.