The prevailing mandate for both buyers and vendors is that any IT business investment must be justified by quantifiable delivered value; not just once but continually as a key measure of investment “success.” This trend is a key driver of change in the software industry. According to an IDC study, “72 percent of software vendors and 70 percent of software buyers strongly believe that the software industry must place a greater focus on clearly establishing the business value of software.” [“Future of Software Licensing”, IDC, March 2004]

Success of a software solution (whether sold as a product or service) is now directly tethered to the vendor’s ability to communicate and prove the value delivered by that solution to targeted buyers. If the vendor can’t do this, the customer will discontinue subscription. In addition, software vendors need to create new revenue streams that capitalize on new software delivery and licensing methods and customers’ appetite for outsourced services.

It wasn’t too long ago that the promising Application Service Provider (ASP) of the Dot Com boom days fell off its pedestal to become a pariah of the investment sector. Well, ASPs have reemerged onto the scene again, now operating under the handle of “hosted or managed services.” Hosted services deliver the same level of software capability and performance as an on-premises solution, but with centralized offsite management of application maintenance, upgrade management and infrastructure provisioning. Relieved of the ongoing drain of dedicating IT resources to software lifecycle management and customization, buyers are gravitating to this new view of software as a service. In this new realm, a software vendor transforms into a type of outsourcer, offering access to its solution via the Internet through a browser interface. Where software was once purchased as a licensed product, application services are now retained on a subscription basis – typically on a sliding-scale according to metrics that gauge the size of the buyer’s organization (e.g. number of employees, number of transactions).

Once a software vendor crosses the threshold into the service world, a palette of opportunity emerges. Software vendors are naturally extending their offerings to include outsourced managed infrastructure services and data center services. The secondary leap into non-technical administration and professional services becomes just a small step on the continuum. The net result is that the distinction between software vendors, hosted services and service outsourcers is blurring.

The acceptance of “software as a service” by the enterprise community has overcome the former objections and risks surrounding the concept of application outsourcing. Formerly, enterprises’ concern over information security, integrity and availability alone would have scuttled any hope of entering into an off-premise relationship. However, the struggle to survive in a lagging economy over the past four years has tempered these concerns, putting cost reduction at the top of enterprise priority list. More than ever, enterprises are centered on business process efficiency and establishing performance metrics to benchmark and track against.

This shift has dramatically changed the dynamic of the software selling process. Enterprises seek solutions that will have measurable positive impact on operating costs and improve the effectiveness of their business processes. Enterprises measure this bottom line impact in terms of increased revenue, customer retention, reduced and avoided costs, increased business opportunity and reduced risk and liability. This focus elevates the buyer’s purchase decision criteria up a notch, making preferences for solution delivery method – on-premise software, hosted solution, outsourced service – far less of a consideration. Simply stated, enterprises evaluate solution investments on the basis of which solution will require the lowest investment for the greatest return. Not surprisingly, this change in buying criteria has increased the appetite for offshore outsourcing. Offshore services further impact the software cost structure by leveraging technically proficient, low cost labor pool in such world locals as China, India, Eastern Europe, etc. But this is another story in itself… (so stay tuned to a follow-on Gantry Group newsletter on the ROI of Offshore Outsourcing).

One of the attractive attributes of subscription-based pricing for buyers, is that it’s a “pay as you go plan”, requiring far less of an upfront investment. However, the software vendor willingly sacrifices revenue that could have been won as a lump sum in a perpetual license sale in the hopes of making more money through a long-term recurring subscription.

On the other hand, as a result of having “less skin in the game”, a customer is far more likely to revisit their buying decision after subscribing to the solution. “Switch and cut bait” is much more economically feasible for the customer in the subscription scenario. As a result the software vendor has a far less captive customer base, setting a new sales imperative for the software vendor: the need to continuously “resell” the customer. Renewal of the subscription contract period is a time for quantitative reassessment by the customer. Customers ask, “Have we received value from this solution? Did the value delivery from the solution meet our expectations? Have we met our business performance goals through the use of this solution? Is there another vendor that can deliver better value?” A software vendor must be ready to have a consultative value assessment session with the customer to better ensure subscription renewal. The software vendor needs to quantify the bottom line value that its solution has specifically delivered to the customer’s organization and the impact that it has had on the customer’s relevant business processes. This sales step is critical if a software vendor hopes to tap the upside of a recurring revenue stream.

So why stop with just software… why not add computer hardware into the mix! Sounds far fetched? Well, the new subscription model is not just a phenomenon within the software sector; it has transformed the computer hardware sector as well. Enterprises don’t want to own hardware, they want to lease it. The hardware giants – IBM, Sun, Hewlett Packard – don’t disappoint. These companies are now selling “cycles” not iron. Utility thinking has arrived for computer hardware manufacturers. Enterprises are sold computing cycles similar to the way power companies produce and deliver electricity to homes [“Computing Farms”, Red Herring, February 3, 2004]. Taking your pick of the latest lingo - utility computing, adaptive enterprise or on-demand computing – the Internet serves as the communications vehicle for processing enterprise computing task requests to and from big server computing farms, owned and operated by large computer vendors [“Computing Farms”, Red Herring, February 3, 2004]. And it’s not just the hardware that is being sold by the cycle – software solutions are bundled in as well.

The motivations for adoption of the utility computing model are similar to those for the hosted software model discussed above: an intense desire to reduce expense and financial overhead, while increasing business efficiency. Enterprises that invested heavily in computer equipment and server farms are realizing that utilization of all that power is far from optimized. In many cases only a fraction of the installed capacity was being used. By renting cycles, enterprises pay only for what they need, substantially lowering capital expense. Reminiscent of the old computing time-sharing days of the 1970s, utility computing harness the Internet and promises to transform the computer hardware sector into an outsourced, service business.

Some say that utility computing is just “the latest attempt at selling hosted applications.” [“Virtual Utility”, Red Herring, February 4, 2004] However technology has rapidly moved forward to make the forecasted success of this business model more believable. For example, server virtualization (which makes unused parts of many computers function as one computer) now makes it easier for customers to share a data center’s computing resources to suit each customer’s needs. [“Virtual Utility”, Red Herring, February 4, 2004] IDC estimates that worldwide utility computing will grow from $1 billion in 2003 to $4.6 billion by 2007.

While utility computing is a far more ambitious model that a hosted software solution or outsourced service, only time will reveal true enterprise adoption and its overall success. However, the fact that this business model is being trialed by so many successful computer firms speaks to the enterprise market’s ongoing need to reduce operational costs and manage business processes company-wide. Enterprises are receptive to these new software and computer hardware purchasing models because of their overriding focus on value delivery and return on their investment.

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