Understanding Software Pricing Models

Posted by Patrick Heffron on Mon, Apr 15, 2013

    

Capital vs Operating Lease? Renting vs Own? Buy vs Lease?

These are decisions that can confuse even the most savvy business people - both in their professional and personal lives. And yet, when it comes to software purchasing it can get even more complicated! In my roles as a Chartered Accountant, CFO and COO for both large and small organizations, I've experienced them all. Below are some of the things that a buyer should consider when trying to decide between the two basic software pricing models - and for simplicity, we will refer to these two models as "perpetual" (including assurance) andUnderstanding pricing models for buying software "subscription".

Total Cost

A perpetual license almost always requires you to also pay an annual fee to receive the latest updates and access to support (aka "software assurance" or "maintenance"). Consider how important it to be on the latest versions of the software and/or have access to technical support? 

A subscription purchase usually includes software and software assurance costs bundled in as part of the annual/monthly fee—it's an "all-in" price, which is usually more comforting to the buyer.

Regardless, pick a time frame and then add up the total cost of both scenarios, make sure it is an apples-to-apples comparison. For most companies, a time frame of 3 years is appropriate. Beyond that time period there is too much uncertainty about what your needs may be. (If you are inclined to go longer, ask yourself if you would lease a car for 10 years?) 

Organization Objectives

In most large organizations decisions are influenced by the impact on measurement objectives. For example:

Capital vs Operating Budget

  • A perpetual license is usually considered a capital acquisition.
  • A subscription purchase is an operating expense.
  • Capital purchasing decisions are usually subjected to stringent and "corporate-level" business case reviews - which can take a long time, create a lot of work and have an uncertain outcome.
  • An organization may have more or less flexibility with one of these two budgets, which may have significant influence on the "affordability" of the initiative.

Cash

A perpetual software license requires a higher level of cash outlay up-front whereas the subscription model is a lower outlay (sometimes significantly lower.)

Profit & Loss

Even on an annual payment subscription, most organizations would set up the portion that will be "used" in future periods as a pre-paid expense, so that each month the P&L is only charged with 1/12 of the annual cost.

A perpetual license, in addition to impacting the capital budget, would result in a depreciation / amortization expense which may impact the P&L measurement for the organization. 

Tax Considerations

  • This will vary by country, but generally speaking an operating expense—which aligns with the subscription model—usually provides more favorable tax treatment because the entire cost of the expenditure is deductible as it is paid.

  • A capital expenditure is usually only deductible over a longer period of time, with further reductions in the year of acquisition.

  • Also consider whether there are tax incentive programs that would be more favorable for items with either an operating vs capital expenditure.

Uncertainty & Flexibility

Consider how fast and frequent technology changes. How many times have you felt stuck by prior commitments?

A purchase of technology under the subscription model typically offers more flexibility than the "sunk-cost" perpetual model. Consider for example: 

  • A customer could switch to a different solution with the same vendor—whether this is a complementary or alternative product
  • A customer could switch to the perpetual license after an initial period to confirm satisfaction with the solution and the provider
  • A customer could switch to anohter vendor for a competitive solution

Summary

A subscription pricing decision typically provides the following advantages:

  • Greater operational flexibilty
  • Less cost for changing technology in future years
  • Lower initial cost
  • Lower initial cash outlay
  • Favorable tax treatment

A perpetual license model may be more advantageous in situations where there is a high degree of certainty about the long-term technology platform and complementary applications / infrastructure.

 

Download this guide to Software Pricing Models

Topics: software pricing models, subscription software, cloud computing

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