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Why Do You Need to Calculate the Total Cost of Ownership of Software Acquisition?

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What is the true cost of software acquisition? This question is a cause for concern for almost every business that decided to purchase or develop a new system. And its importance does beyond the reflection “Can we afford such a substantial investment right now?” In the long run, it is the question of ROI and the value that software solutions deliver.

However, to get an insightful view of the success of your software purchase, you need to run a comprehensive assessment of the total cost of ownership (TCO). It is important to detect hidden costs and evaluate possible risks that can fluctuate TCO over time.

This article will cover how to calculate the total cost of ownership for custom software development, how to get results you can rely on, and how to leverage this data efficiently for better decision-making.

What is the Total Cost of Ownership (TCO)?

The total cost of ownership is a financial estimate that helps define the direct and indirect costs of purchasing and owning a product or service. TCO is widely used within different business spheres. In IT, the TCO of software calculates the sum of every possible expense associated with buying and owning this exact software solution. 

The list of aforementioned expenses might include:

The Importance of Total Cost of Ownership When Outsourcing Software Development

Many companies, when opting in for custom software development, are facing a few important choices. First, the company should determine if they want to build an in-house development team or outsource the development. For various reasons, a big percentage of businesses choose outsourcing, which creates a second dilemma: what outsourcing vendor to choose?

Though we strongly advise against making the price the determinant factor for any decision, business executives tend who don’t have a lot of experience with software development, tend to compare potential partners mainly on this ground. It might seem like a simple way to save money, but in fact, it is a path to inflated total costs and additional expenses you have not predicted. 

Low development rates, especially if they are above the market average, might say that the vendor sacrifices something in the process that other similar companies do not. It might be the seniority of the developers, the process reliability, etc. The low cost of the whole development achieved by a shorter deadline might say about a lack of attention to certain processes like quality assurance, software testing, etc. 

All of these aspects might mean that you risk receiving a software piece of lower quality. And the optimized cost you expected will turn into additional maintenance costs, which, in our experience, will significantly exceed the difference you wanted to save. 

Hence, when you are calculating how much money custom software is going to require, you need to consider all costs involved, not only the price your vendor charges for the development. 

At the same time, to leverage the full potential of TCO, you should consider it together with the other metrics — return on investment (ROI). ROI will show what output you can expect from the money you put into software development and help you to evaluate if this investment is going to be profitable.

For example, the total cost of ownership for a software piece of $1 million might not give a clear image (more likely, it will scare off the upper management or your investors). However, in combination with the data that the ROI of software will reach $10 million, it will give a totally different perspective on the rationality of software acquisition. 

TCO Analysis for Software

So, let’s dive into the process of actually calculating TCO for the new software piece your company decided to implement. To do that, you must consider four important variables. 

Initial Cost

Basically, it is the acquisition costs for the new software.

Software cost
The cost of the whole software development is provided by your vendor. Important note: if you purchase a ready-made solution under the subscription fee, it would be the most predictable expense item. With custom software, it might get a little bit more complicated. No cost estimation is 100% precise, so there is always a chance for discrepancies. During the development, the requirements might change, which will also impact actual costs. So, be aware that the total fee you will pay to your vendor might be higher than the one stated at the beginning.

Cloud
More and more businesses give up on-premise infrastructure and switch to the cloud. So, to support cloud-based solutions, you need to cover cloud service fees as well.

Data migration
Sometimes, companies need to migrate data from an old system to a new one to start using it. This expense should also be calculated.

Employee training
The solution will generate value if its users know how to get the maximum from it. Training employees is a key step to making them proficient users and overcoming their resistance to adapting to a new solution. So, it is another cost you need to consider.

Operating Costs

These costs cover the further steps of software lifecycle.

Maintenance and support costs
Every software piece needs to be supported and fixed, and it might be a significant expense item, so you don’t neglect it.

Software upgrade
It might happen that over the span of time, you will need to expand the functionality of your solution or reinvent certain parts of the solution, and you will need to cover the work of the development team.

Ongoing employee training costs
You need always to have a budget for new users’ training. There will always be new employees joining your company who would need assistance. Moreover, if you update your solution, you will also need to instruct your crew on how to use the new feature.

Downtime
Downtime might block operations within your company and bring productivity losses, which, in turn, leads to additional expenses.

Disaster recovery
It includes the cost of backups and the cost of the actual recovery after a crash.

Security
Security measures and solutions will demand a certain part of the budget, but by far, they will protect you from far bigger costs related to data breaches and reputational losses.

Retirement Costs

Even if you decide to retire an existing system, it doesn’t mean that it will just disappear and stop needing any type of support. You still need to ensure that the data stored in the system would be transferred to a safe location. At the same time, the old system can be repurposed and stay useful for your business.

Data export
When you are going to migrate data from the legacy solution to other systems, you still will need to spend money on the process, especially if you need to transform data.

System archiving
Sometimes, it would make sense to archive a solution to a read-only mode and use it as a knowledge base. However, you still will need to cover its support, though it would cost less than migrating data.

The Challenges with TCO Calculations

When you calculate TCO, you should be aware that there are some gaps that would decrease the accuracy of your analysis and devalue its importance. Hence, knowing the downfalls will help you to avoid them, or at least mitigate their impact.

Inflation

It might be really hard to predict the real level of inflation in our ever-changing world of constant crises. However, it doesn’t mean that you should just neglect this factor and calculate the overall TCO without inflation impact. Truth be told, if you take into account at least the inflation average for your country, you will be able to get a more realistic estimation than without any inflation adjustment at all.

Risks

Traditionally, risks are not considered in TCO analysis, but if you want to get a more realistic view, we suggest adding it. For every company, information technology risks will vary, possessing specific threats you should be ready to take care of. Run a detailed risk assessment, think through mitigation plans, and plan possible expenses.

Missing Cost Components

Every software development project is unique, and the more complex it is, the more the chances of missing some cost components while assessing it. So, carefully review the timeline of the project, its scope, and the involvement of other specialists to ensure that you haven’t forgotten about something that will suddenly pop up in the middle of the development and eat a big part of your budget. 

How to Optimize TCO Calculation & Leveraging?

So, how to make sure that the process of calculation TCO is efficient and that the data really helps you to make decisions? Here are a few tips we prepared for you that should help you to calculate total and long-term costs, as well as put them into use. 

In Conclusion

The total cost of ownership can help you achieve a lot when you are planning to acquire a custom software system. First, it is a powerful rationalizing tool you might use to convenience decision-makers to choose a certain solution. Second, in combination with other metrics, it can give you an insightful look into the value the implementation and ownership of the solution will bring you. Thirdly, it can help you to compare the offers of different vendors and select the one with lower long-time costs and higher value delivery over time. 

The impact of TCO metrics is clear, but don’t get hung up on it. Remember that this data will stay relevant when compared with other defining indicators.

FAQ

TCO stands for the total cost of ownership. In regard to software, it represents how much it will cost to acquire a solution, maintain it through its whole lifecycle, and retire when it becomes obsolete or outdated. TCO gives businesses a better view of the whole expenses they would experience when they purchase or develop a software piece.

A TCO calculator is a tool that helps you to calculate the total cost of ownership for a certain purchase. It works with a preset formula that includes different types of expenses you might have due to the acquisition of a new software system.

As for any other software solution, TCO for ERP represents the number of expenses the company will have when deciding to purchase or develop an ERP. For ready-made solutions and custom-developed, the TCO will be calculated differently. When you implement a ready-made ERP system, your upfront costs will include subscription and license fees and the fee for solution customization. With custom development, you will need to invest in the work of the development team and the development from scratch, which implies different types of expenses.

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