Mostly Harmless, Part XXI
Every solution costs more than the sticker price. But how much more? In this post, we’ll outline how to cost the various solutions as well as a methodology for calculating the expected value.
First of all there’s the cost of the license, which can be significant. If the system is enterprise, and especially if it’s an installed solution, this can be a very significant up-front cost in the six figure range. Then there’s the maintenance, which is required for support and mandatory for some solutions, and built into the price of on-demand/SaaS solutions. This can be as high as 22% a year for some solutions. Then there’s the installation and integration costs. Even a SaaS solution will require some setup, and the e-Procurement system will need to be integrated with accounting systems, sourcing systems, payment systems, and other enterprise (resource planning) systems in order for the organization to extract maximum value for the system.
Then there’s training costs. Even though a good system will be extremely easy to use and self-explanatory where basic functions are concerned, some training will still be required. This is especially true for the administrators, who have to maintain the system, and analysts, who have to analyze processes, performance, and spending. In addition to training costs, there will be support costs. Administrators will have to be employed to continually maintain the system (data) and train new users. If the system is installed, they will also have to do patches and upgrades in addition to maintaining system data and (business) processes.
If the organization is looking for an installed or hosted ASP solution, there will also be hardware costs, database costs, application server costs, and middleware costs. These costs can easily dwarf the system costs if the organization doesn’t already have any of these solutions. And even if the organization has some of these solutions in place, there will likely be additional license fees. Finally, there will likely be additional IT (support) costs to maintain the hardware, which will have to be upgraded on a regular basis, and the supporting software.
When all is said in done, the cost of a solution can end up being 10 times the sticker price, so it’s important to understand the total cost of ownership before choosing a solution. This is not to say that a solution with a seven figure total cost of ownership is expensive. It might be, it might not. It all depends upon how much it costs relative to other solutions being evaluated, how many users will use the system, how much it will increase organizational efficiency, and what ROI the organization expects to see.
Fortunately, the calculation of expected value is quite straightforward once the TCO is known. It’s simply a matter of computing the ROI according to the following formula:
(savings expected from increased efficiency +savings expected from maverick spend reductions +savings expected from newly identified opportunities) /total expected cost
While some of these numbers may appear hard to calculate, they are easy to estimate and what is really important is order of magnitude. For example:
- if the organization expects to increase efficiency 200%, that’s a 65% workforce reduction against current workload; if the organization currently requires 20 people to handle tactical procurement tasks, at an average salary of 62K, that’s a reduction of 13 people or about 800K per year
- if the organization currently has a maverick spend rate of 30% and expects, using third party benchmarks, to reduce that by 66%, that’s an 20% reduction in maverick spend; if maverick spend, on average, costs the organization 5% of spend on average, if the organization spends 100M annually, that’s a projected savings of 1% (20% of 5%), or 1 M in one-time savings
- if the organization expects that an e-Procurement system will identify additional savings opportunities on 20% of spend annually and that the average savings that will be obtained will be 10%, then the organization would expect to save 2% of spend, or 2M annually
All told, if the organization expects to use the system for five years, it would expect to save 15M over five years (5*800K + 1M + 5*2M). If the total cost of ownership of the system was determined to be 3M for five years, then the organization would expect to see an ROI of 5X, which should be a buy decision. Of course, if the calculations worked out that the organization only expected to save 5 M, and the ROI was only 1.6, the decision should be to find a more cost effective solution.
For more details on cost calculations, and a starting spreadsheet, see Sourcing Innovation’s post on Uncovering the True Cost of On-Premise Sourcing & Procurement Software in the archives.
Next Post: Procurement Models