Examining The Shift To "On Demand" Applications

On demand solutions are growing in popularity and are trending to become the standard in areas that are mission critical/non core. Are you ready?

The enterprise software industry is currently experiencing a dramatic shift in how technology is delivered and sold. Customers are effecting this change by demanding fast and ongoing value. They are also reacting against the classic license and maintenance fee model, which has long been favored by enterprise software providers.

This has resulted in a new model — "on demand" — in which applications are priced and delivered in a manner similar to the way that gas, electricity and other utilities are delivered to consumers. The trend toward on demand is proliferating as companies begin to embrace the model and enterprise software vendors scramble to react. Within a few years, on demand will be the standard in many categories where enterprise software previously prevailed.

Customer Demand Has Driven Change

Until recently, customers had no alternative to the classic enterprise software approach and lacked the power to effect meaningful change. Over the last couple of years this situation has changed.

From 1995 to 2000, companies rushed to replace systems with enterprise-wide enterprise resource planning (ERP) applications to ensure they avoided business interruptions due to the year 2000 "bug." In the end, most companies had more software than they knew what to do with. This, combined with a down economy, led to weak demand for enterprise software since 2001.

Due to a brighter economic outlook, businesses are now beginning to consider new software investments, and they are seizing negotiation leverage from the vendor community, demanding a quicker return on their investment in an application. Vendors are being challenged by prospective customers to prove that they can provide a return on investment within a year of beginning a project. Customers are also now examining the total cost of owning an application when estimating the cost of the project, which includes implementation fees, upgrades and support services.

In October of 2003, Scott McNealy, CEO of Sun Microsystems, stated that the high-tech industry is over-charging by a factor of 10. Considering the license fee pricing model and risk/reward aspect of every project, he is correct in his statement. For example, if a company pays $5 million in license fees with annual maintenance fees at 18 percent per year, the total is $7.7 million over the course of three years with 65 percent of the total cost of the solution in license fees. Therefore, companies are being asked to invest millions of dollars in upfront fees, making it next to impossible to achieve a return on investment within a meaningful period of time.

There is also the assumption that customers will see value in their investments. Every project faces the risk of not meeting the expectations of its value due to a variety of unknowns, such as the rate of end-user acceptance or a shift in business priorities. Once risk is introduced to the investment/value equation, paying upfront makes even less sense.

Another trend affecting the enterprise software industry is that companies are increasing their focus on processes that are core to their business. Enterprise software tends to be invasive, and in most cases it takes years to fully install and integrate with other systems. In the process, scarce business and information technology (IT) resources are invested during the implementation, leaving some companies to ask whether or not it is really worth the effort.

Here, we can learn from the past. A decade ago, companies invested in costly software systems to process payroll. They needed complex systems to ensure that employees were paid correctly and in accordance with ever-changing regulations. Today, companies use payroll services and applications provided by such companies as ADP and Paychex. As a result, the companies were able to free up more money and human capital to focus on the areas that were more closely tied to their success as a business, such as manufacturing and customer-facing applications.

On Demand for Practitioners

Many businesses are now looking for delivery and payment models that are more in line with their demands relative to rapid return on investment (ROI) and low ongoing cost of ownership. One of the most popular new alternatives is the on demand model. On demand applications are priced using a utility-like model, with the costs spread over time based on usage. They are also accessible via the Internet, and upgrades, support and other operational services are included by default instead of being treated as extras.

The on demand model originally grew to prominence in the customer relationship management (CRM) space and has spread to other application categories, including payroll, expense reporting and spend management. This pattern is indicative of the fact that use of on demand solutions makes sense for supporting "mission critical/non-core" areas — the processes that need to occur in order to effectively run a business but are not directly related to a company's core business.

Because companies pay only for what they use and don't have to install software, there is no need to invest in internal or external resources to implement the application. Additionally, applications are deployed in weeks, not months or years, and ongoing ownership costs are typically five to 10 times less than the enterprise software option, according to a 2002 study from Industry Analysts.

A good example of this is the experience of Kennametal, a $1.8 billion manufacturer of tools and supplies for the metals industry. Kennametal wanted applications that would help the company to better control and manage its spending. The company was looking for a solution that would provide a positive ROI within a year, a low ongoing cost of ownership and ensured that scarce IT and business resources were not invested on a lengthy implementation project. The company spent two years reviewing solutions before it ultimately decided on an on demand service. The project was live within 45 days and delivered more than 150 percent ROI within one year. Just one manager from the company is running the project.

The Vendor Side of On Demand

As the on demand model gains momentum, old and new vendors may be required by default to adopt this way of doing business. Due to the fundamental differences between the license and on demand model, many of the larger software vendors will struggle to make the transition.

To understand the challenge, it is important to understand how software companies run their internal operations. High margins from upfront fees are dictated by how a vendor spends its income and how its employees are compensated. Most software companies spend more than 50 percent of their income on sales- and marketing-related expenses. Sales teams are paid on a commission rate based on quotas, and they are given an increased commission rate when they exceed their quota.

Marketing departments are provided with significant budgets that equate to 10 percent or more of annual revenue in order to woo new customers to pay for the company's products.

Once sales and marketing are underway, companies must invest in research and development (R&D) to continually develop new products and features. An average R&D budget costs 25 percent of revenue. Essentially, software companies have to have high margins for every new customer they sign simply in order to keep the business running.

In contrast, on demand providers' margins are earned over the lifetime of a contract rather than when a contract is signed. Sales teams are rewarded based on the customer's usage of the system over time rather than being paid based on upfront license fees. With the need to sustain ongoing value, an on demand vendor will spend proportionately more on R&D than it's software counterpart. These operational changes may take time for enterprise software vendors that have not traditionally provided on demand services.

The trend toward on demand applications represents a change in the enterprise software industry that has been brought about by customer demand for rapid and ongoing value and is a reaction against upfront license fees and lengthy implementations.

On demand solutions are growing in popularity and are trending to become the standard in areas that are mission critical/non core. As vendors rush to meet the demand for on demand solutions, potential buyers should push back on high upfront fees and make sure that the cost of the project is spread over the contract's lifetime.

Companies should also look out for any hidden extra costs and closely examine the services included in the offering to make sure that they understand what their responsibilities and true costs of ownership will be.

About the Author: Steve Savignano, the chairman and CEO of Ketera Technologies, has more than 20 years experience applying technology to deliver value across a number of different industries. Prior to Ketera, Steve served as a senior executive at a number of industry leading business application providers.

For more information about the issue of on demand, please read " Cutting Through the On Demand Hype," in the December/January 2004 issue of Supply & Demand Chain Executive.

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