Amortizing the Costs of Software and Licensing Fees

One of questions I am sometimes asked as a Tech Advisor is “How do we amortize software development costs?”  Or “How are we going to recoup the costs of software development?”  The answer is, if the business is doing well, software development costs are typically paid off quickly.  As a prime example, you only have to look at the stock valuations of the big software companies in relation to size and cost of their workforces.

The big software companies are experts at developing software.  Companies that don’t specialize in software can do very well as long as they hire the right consultants and employees, or put together excellent teams of developers.

In simple terms, software developed “in-house” or by hired consultants is owned by the company.  This means that the total cost of development is a one-time expense.  Obviously, there are issues of hardware costs, hosting or cloud costs, operations, maintenance, upgrades, new features, and so on, which must be included in the budget.  Nevertheless, once developed, the software can simply be a part of operations.

It is often shocking to learn about the advanced age of major software systems in huge organizations.  The core code may be untouched for many years.  The hardware may be old as well, like old IBM systems that run reliably for years.  A major reason for the Y2K crisis was that the original developers couldn’t conceive that the software would last so long.  As the saying goes, “If it ain’t broke, don’t fix it.”  Another reason for software longevity is actually the lack of longevity of the original developers who really understand the software’s functionality, whether through retirement, changing jobs, or passing away.

Our contention, therefore, is that, as long as the business thrives, the software costs will be easily absorbed.  In fact, software can offer one of the most profound returns on investment that can be had.

There is a cautionary note we want to sound here.  Often software is sold based on a recurring licensing fee.  Depending on the size of the business, these fees may be relatively modest, easily absorbed in the costs of doing business – or they can become onerous, a drag on profitability, even viability.

Recently I learned about a mid-sized sales and distribution company whose operations were tied to a legacy ERP system.  For normal business to take place, they needed about 150 seat licenses, at a cost of $2,000 per seat annually.  Since they began with the system, technology has evolved.  Today there would be no need for 150 “seats.”  The operations performed could potentially be combined into a more modern architecture, such as service bus, which could potentially handle many workers, perhaps all 150, at a single connection point.  However, the ERP company would not willingly give up that $300,000 annually to provide such an interface.

In my experience, sometimes companies opt to purchase a platform with annual licensing fees, in order not to pay for custom development up front.  There are some advantages to this approach:

  • The platform will have “built-in” many of the capabilities that are planned for the system.
  • The initial cost will be lower with the platform.
  • Customization of the platform will be quick, so the system will come online more quickly.

The downside is of course that the licensing fees are ongoing.  The are other issues as well, however.  I recently spoke with the owner of a small business, who, years before, had opted for a platform solution, against my advice at the time.  Currently they were up against a wall.  The platform was software-as-a-service.  Their version was going to be discontinued shortly, forcing them to upgrade.  Unfortunately, all their customizations, built on the old platform, would be gone with the upgrade.  They were in a quandary.  My only advice was that they should try to engage the original developer to replicate the functionality of the earlier customizations on the latest platform version.  They were very concerned about the time, disruption, and costs involved.

Another issue for this company was their plans for the system.  Although this was a small business, the owners had excellent industry contacts.  Their initial vision was to build a system that they would own, and which could be marketed to other companies, putting them into the software business.  Since nothing in their vision had been done before, and it offered vast efficiency improvements over the way things were done in the industry, this plan did not seem totally farfetched.   What’s more, the cost of building custom could have been recouped in a few months, based on a modest assessment of the productivity increase.  However, once they decided to go with a platform with its own licensing fees, versions, and upgrades, they didn’t end up with a system that had any value outside their own office.

There is no easy answer when evaluating a system that involves licensing fees.  Consider, for example, that applications running in the cloud on AWS or Azure do involve fees.  However, the savings in infrastructure and the staff to maintain software applications often mean that these fees are a bargain.  Also, such fees are usage-scaled, so that the client pays for actual processing that goes on, rather than paying per seat – which, in these times, seems fairer.  Also, you can deploy in the cloud, but still own your application.  Should a company wish, it could move its cloud application to its own server farm.

Licensing fees are sometimes enforced with measures that may be viewed draconian.  Oracle has such a reputation, whether deserved or not.  At very least, for companies to follow the licensing requirements exactly may be quite burdensome.

Companies may need to buy software systems of platforms with rather heavy licensing fees.  In some cases there may be better alternatives.  Licensing fees are not always “bad,” but there may be some drawbacks that aren’t obvious to prospective licensees.

Copyright © 2018 Patrick D. Russell

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