TCO or ROI or Value - Which Can Justify SaaS?
Steven Forth is a Managing Partner at Ibbaka. See his Skill Profile on Ibbaka Talio.
How does one make the business case for a SaaS purchase or renewal?
There are 3 common approaches:
TCO (Total Cost of Ownership),
ROI (Return on Investment), and
Value.
Which of these makes the strongest case? Value.
At present, it appears that ROI is the most common approach. Below are the results of a poll from April 8 across the Design Thinking, Professional Pricing Society, Product Development and Management Association, and Software as a Service - SaaS groups on Linkedin. N = 57 at the time of publication.
A reliance on basic ROI calculators is suboptimal. Value models are needed to really drive sales and renewals.
Total Cost of Ownership or TCO
This metric was popular when most software was sold into cost centers. TCO models take into account all of the costs of owning and operating a software system and not just the price. The goal was to get buyers to take a more holistic view of the purchase. In addition to the cost of the software, TCO models included things like
The servers and other hardware needed (less relevant for cloud software)
Energy and network costs
The salaries of the people operating and maintaining the software
Training for the people using the software
Integration implementation and support
TCO was a step forward in that it recognized that the software application was part of a larger system, one that included both people and other systems. The limitation was the focus on cost. No one buys software to increase their cost. There is some business objective at stake. And an investment in software is made to get some sort of return.
Return on Investment (ROI)
As software or IT came to represent a larger and larger share of operating costs the finance department became more and more involved in software purchases. The head of finance, the Chief Financial Officer or CFO, was used to making large investment decisions. The accepted tools for this are Return on Investment (ROI) and Net Present Value (NPV).
ROI generates a number, given the amount invested, how much will the company earn throughout the investment. It is generally presented as a percent. A percent is convenient for finance as it allows them to stack rank investments in order of return. There is a finite amount of capital available and the CFO needs to allocate it where it will have the most impact. To simplify things, many finance departments set a hurdle rate, a minimum ROI that investments must meet to even be considered.
Net Present Value takes the ROI for each time period and adjusts it using a discount rate. The discount rate integrates two things: the time value of money (all things being equal we would rather have the money now rather than at some point in the future) and risk (the world could. change and the expected return may not be realized).
The problem with ROI is that it is a black box. The calculations of ROI are often obscure and the results are presented as one number. This is useful when one needs to compare very different investments. It generally does not help when comparing two similar solutions to a business challenge. For that, a more sophisticated approach is needed.
Value
Value is the most holistic approach to justifying a purchase or renewal. There are three dimensions to value, emotional, community, and economic. Here we will focus on economic value as it is the dimension most directly comparable to TCO and ROI.
In the classic book, The Strategy and Tactics of Pricing, Tom Nagle and his co-authors have proposed the Economic Value Estimation or EVE approach to estimating the economic value of a solution.
This approach is much more powerful than a direct ROI calculation, as
It takes the competitive alternative into account
It forces one to understand the impact of the solution on the customer’s Profit and Loss statement
Value is presented at a granular level (at the level of Value Drivers)
Being able to talk about value at a granular level is important as different stakeholders are concerned with different aspects of value. The Chief Revenue Officer is concerned with increasing revenue, the Chief Operating Officer is often most concerned with operating costs, while the Chief Financial Officer is especially interested in operating capital, capital investment, and reducing risk. Innovation groups are often accountable for increasing options.
Value models by themselves are not enough. They need to be used across the value cycle.
The Value Model is the foundation of Value Understanding. Without a value model, value understanding is just hand waving.
The Value Model guides value creation. Product and solution leadership should reference the value model when making investment decisions.
The Value Model is generally too technical a tool to use in value communication. But it can be translated into a value story. This is one of the things that the Ibbaka Valio platform does.
During delivery, the implementation and then the customer success team need to make sure the value promised is being delivered.
That value is then documented, again the value model provides the framework for doing this.
And then that value documentation can be used to justify the price during the renewal process.
Having documented value is one of the best ways to reduce churn.
