You won’t have a modern understanding of the internet using vocabulary from the 80s. The same goes with cell phones, music players, televisions, video games, home video players…the list goes on.
So, why do we use outdated language to understand modern software business plans?
Total cost of ownership (TCO) has been a helpful metric for many years, providing a detailed estimate of how much software costs to create and maintain. However, context is important. The phrase came into existence before software was ever sold as a service.
Instead of considering the TCO, SaaS businesses can think about the total cost of service (TCOS) to get a better idea of what to charge, and how much their product will cost consumers over the lifetime of their relationship with the product.
Total cost of service versus total cost of ownership
In 2015, IT expert Bill Kirwin gave a speech in which he effectively minted the concept of TCOS. “Total cost of services refers to full lifecycle cost of the entirety of activities–driven by market forces and directed by policies organized with supporting processes and procedures, as well as any secondary effects–that are performed by an organization or part of an organization to source, plan, provision, operate, control and refresh IT services offered to consumers of those services.”
The total cost of ownership framework that has been in the driver’s seat for decades when it comes to calculating expenses is thought by some to be outdated. TCO refers to how much SaaS solutions will cost, both in terms of their sticker price, and any maintenance they might require.
The phrase was introduced in the late 80s as a way to help businesses with their financial management as they considered buying a product. The problem? The SaaS industry has shifted significantly since then. Considering the term emerged in an era where phrases like ‘social media marketing’ didn’t even exist yet, it’s no wonder why.
SaaS products are now a service rather than something a customer owns outright. This new business model makes total cost of ownership seem imprecise.
Instead, SaaS companies can consider the cost of their product not necessarily as something that will end when the software is outdated, but as something that can extend almost indefinitely through multiple subscription cycles.
When a SaaS business factors in the total cost of service, it can account for price uplifts and other things that wouldn’t otherwise be taken into account.
Myth: TCOS in SaaS is negligible
The total cost of ownership for on-premise software in which maintenance from the software provider is regularly required tends to be around 22% of the annual licensing cost. That’s a significant number in its own right.
It’s also a little different than the number you might get when you factor in your TCOS.
When a software company calculates its TCO, the assumption that the business relationship will end is baked into the calculations. With SaaS, relationships can, and hopefully will last for much longer.
Businesses that calculate TCO may think of the number in terms of a full customer life cycle. Instead, with TCOS, they could break costs down from year to year.
- TCOS for one year is X.
- Year two: Y.
- And so on, giving both the customer and the business a clear idea of cost versus value.
Naturally, things are different for a traditional business selling physical goods. Owernship costs of a car, for example, are very flexible and subject to many variables. SaaS businesses, on the other hand, have a clearer idea of expenses, both for the customer and for themselves.
Why TCOS is important
Ok. So TCOS is slightly different than TCO. If that news doesn’t make its way onto the front page of the New York Times, quell your surprise. It may seem like a negligible distinction, but for the SaaS business model, it is important to factor in.
For one thing, there’s the obvious consideration that TCO simply isn’t as accurate as it used to be. SaaS solutions can stick around for many lifecycles. As long as the product remains useful and the customer is satisfied, the relationship is indefinite.
Several important benefits emerge for SaaS businesses that can accurately factor their TCOS.
1. A better value proposition
SaaS products have to strike a balance between turning a profit and providing a high margin of value for the customer. Naturally, since the SaaS industry is built on repeat business, customer satisfaction is non-negotiable.
TCOS may help you to more accurately account for the customer’s value experience beginning in software development and extending to the sales cycle. It can also help you more easily demonstrate this value.
Customer loyalty thrives on transparency. By being able to tell a potential client that your product costs X now, and may cost Y in the future, you help them visualize and plan for a long and mutually satisfying relationship.
Currently, 40% of SaaS businesses take a value-based approach to setting their prices.
2. Pricing that turns you a profit
Understanding TCOS also helps the software company make pricing decisions that are more likely to help them turn a profit. A typical SaaS pricing strategy involves low subscription rates (relative to the cost of development, sales, CX, etc.) that are offered to the customer under the hope and assumption that a profit will be established by long-term contracts with many customers.
Naturally, this means that when a large customer leaves before the business has retrieved its customer acquisition cost, the company hemorrhages money.
TCOS can help businesses better understand not just what the customer is experiencing, but also what the cost of the customer lifecycle is for the business. Using this information, they can:
- look for ways to reduce their own costs and
- craft pricing strategies with improved margins to lower the risk of financial loss.
Automated billing platforms can help you run billing scenarios that help you ensure a profit. For example, billing software can provide A/B testing—a process in which the same product is priced differently based on unique marketing scenarios. Having the ability to test different pricing points and strategies can help you get ever-closer to the elusive ‘perfect pricing strategy’, in a relatively low-risk way.
Calculating total cost of services
Total cost of service is calculated by factoring in all of the expenses it takes to bring your product to market. This includes product development, ops/support, sales/marketing, and so on. Then, you add on whichever pricing strategy you feel will best turn your business a profit.
Naturally, pricing is a complex process and we have plenty of articles on the subject if you’d like to dive into the details. Whatever strategy you use, factor it into the equation. For example, if you use a cost-plus pricing strategy, calculate your expenses, and then tack on the profit margin that you are trying to achieve.
This will give you the total cost of service for the customer.
An updated concept
Total cost of service doesn’t revolutionize the way people think about software pricing. It updates it. The world of software moves pretty fast. It’s important to change with it. Looking at TCOS is a smarter way to do something you were already doing anyway.
It’s helpful for the customer. Integral for the pricing strategy. And crucial for the business that wants to change the way they think about pricing.