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Hosted Software Is Shifting Ground

Hosted software is shifting the dynamics of vendor pricing models and disrupting the industry's control over how customers spend. See how midmarket CIOs are navigating this new landscape.

Years after most companies kissed their COBOL-based systems goodbye, C&H Sugar Co. was still entering data on green screens. By 2002, the $400 million refinery needed a modern-day enterprise resource planning (ERP) system that would enable it to integrate warehouse, order-entry and other systems to create real-time tracking of its sugar shipments. But running these critical applications 24x7 was out of its reach.

Vendor Vetting, Tough Negotiating Make ERP Affordable

Hosted software was the only approach that made any sense when C&H Sugar decided to implement an ERP system. The $400 million sugar processor knew that when it upgraded its systems from ancient green screens to SAP's mySAP.com Solution Suite, including warehouse, order-entry, human resources and other modules, it couldn't handle the job in-house.

Twenty-four hours a day, 10 out of every 14 days, the company refines and ships sugar to industrial and consumer customers, filling 26 different-sized packages -- small boxes on a supermarket shelf, 2,500-pound industrial containers and everything in between -- for a total of 700,000 pounds a year. That meant it would need a continuously operating system. But its 125-year-old brick building wouldn't support the infrastructure required for such an operation, nor could the company's 17-person IT staff. "We just didn't have the right staff to afford a 24x7 operation," says CIO Gary Walden.

Walden worked closely with controller Stephen Cottrell and a steering committee of top managers to vet vendors and negotiate contracts. The company began with 11 vendors and quickly whittled the group down to three, which it then pitted against one another. When it finally selected SAP, it worked hard to simplify the contract. "We spent a lot of time negotiating," Walden says. In the end, C&H spent $5 million to $6 million on the project. It pays 17% of that amount in yearly maintenance.

Once it had selected SAP, C&H began looking at companies to host the application. One important factor was making sure potential partners were financially stable because there had been so much bankruptcy in the ASP market. After considering various options, it chose Hewlett-Packard, which is SAP's hosting partner. It uses HP's Atlanta data center.

Walden says the project would have cost twice as much to bring in-house as it did to undertake using a hoster. (SAP's current hosted arrangement wasn't available at the time of C&H's project.) C&H was also able to negotiate with HP for the future use of applications such as a business warehouse, plant maintenance, CRM and advanced planning modules. It will pay for those applications and the hosting service as they come online.

Despite the desire to use a service provider, many of the business managers were concerned about application response times, especially because the data center was located across the country. However, C&H negotiated a service-level agreement with SAP that's based on uptime and response time. SAP faces penalties if those requirements aren't met. In addition, C&H leased a T1 line.

Involving so many managers in the process helped to allay their fears, Cottrell says. "It was important to involve business users in the decision so that they became comfortable with the decisions we were making." -- J.R.

"It was easy to make the business case that we shouldn't support that kind of application locally," CIO Gary Walden says. His 17-person IT operation didn't have the necessary skills, and the company's facilities didn't have generators or other pieces of infrastructure needed for continuous operations.

So once Walden, with a steering committee of top-level managers and controller Stephen Cottrell, spent between $5 million and $6 million to purchase nine modules of SAP AG software, the company went shopping for a third party to host and maintain it. In the end, Crockett, Calif.-based C&H signed on with an SAP partner, a Hewlett-Packard Co. data center in Atlanta, to which it pays a per-user monthly fee.

Today, SAP, like an increasing number of purveyors of corporate software and point products, offers that hosted model itself, charging as little as $325 per user per month.

Call it a disruptive technology: Hosted software is changing the dynamics of the software industry. Vendors avoid it at their peril -- and many hope to use it for competitive advantage as they wrestle for new customers in the largely untapped midmarket. For companies like C&H Sugar, making the leap to on-demand software means more choices, no upfront fees and, often, cheaper prices than investments in traditional perpetual licensing. That old model involves not only a hefty fee upfront, but also annual maintenance fees often approaching 20%.

Indeed, even the software giants that have relied on the perpetual model are coming to terms with the sea change. Oracle Corp., for instance, now offers much of its software as an on-demand service and last fall brought in a top HP executive to run its on-demand division. Siebel Systems Inc., in the customer relationship management (CRM) market, launched a hosted service in 2003; SAP launched its hosted service last year.

CRM, in fact, is a leader in the hosted space, largely because the application doesn't require integration with legacy systems. The loudest voice behind hosted software may be Marc Benioff, CEO of CRM provider Salesforce.com Inc. in San Francisco. Benioff, a former Oracle executive, is rarely seen without one of his company's anti-software buttons tacked to his lapel. He's not opposed to software itself, just the expense and complication of companies having to deploy it.

Nick Gall, principal analyst for technology research services at Meta Group Inc. in Stamford, Conn., credits Benioff with leading the hosted software charge. "Software as a Service in the Salesforce.com model is one of the biggest long-term disruptors," Gall says. Market projections bear that out. Framingham, Mass.-based research firm IDC expects usage of hosted software to grow by 25% a year, from $3.7 billion last year to $9 billion in 2008. By then, IDC predicts, subscription-based licenses (which include both hosted and on-premise software) will account for 34% of all software license revenue, bringing in a total of $38 billion industrywide.

Subscriptions make sense for industries whose software needs -- particularly with desktop and security applications -- change from year to year. Microsoft Corp. has created special subscription programs in education and government, for example, where the number of PCs and related software grows and contracts periodically. Microsoft also offers subscriptions on many products, including Office, Microsoft CRM and SQL Server. "A subscription licensing model helps ensure that they are covered, but not over-licensed," says Cori Hartje, a Microsoft marketing executive. Oracle and SAP also offer subscription-based pricing, and Sun Microsystems Inc. charges a flat subscriber fee of $140 per user for its Java Enterprise System. Computer Associates International Inc. already reports that about 15% of its customers are taking advantage of nontraditional metrics for buying software.

Observers say the subscription model is cheaper than traditional perpetual licenses at the outset, but those savings can peter out after a few years. In the end, a subscription can be more expensive than a perpetual license, especially if the vendor doesn't frequently update the product. "Subscription pricing has you paying full price for software every three or four years, which is actually faster than Microsoft is updating much of its software," notes Paul DeGroot, an analyst with Directions on Microsoft, a Kirkland, Wash.-based research firm that focuses exclusively on Microsoft.

Nevertheless, many businesses prefer subscription pricing to perpetual licenses. "Businesses are trading higher long-term costs for flexibility" and lower startup costs, says Amy Konary, director of software pricing and licensing at IDC. Tactical applications, compared with long-term strategic software such as supply chain management, are particularly well-suited for subscription and/or hosted models because they can be deployed relatively quickly, she says.

New Wave Complexity

Of course, there are risks in riding the new wave. Choosing the wrong model or pricing metric can land a business with unpredictable bills -- and perhaps even higher costs than before. Models with complex metrics can be hard to understand and make costs tough to predict over the long term, says Jim Shepard, a senior vice president at Boston-based research firm AMR Research Inc.

Businesses that opt for a usage-based model need to make sure they have a solid understanding of their usage pattern before entering into a deal, advises IDC's Konary. For example, sales reps can fluctuate greatly in their usage of sales force automation tools, leading to unpleasant spikes in monthly software "utility" bills. "With software you deploy throughout an enterprise around the world, how do you control that?" she asks. "It could be a management nightmare."

Alex Lang knows what that's like. As administration manager and security officer at $750 million Oceaneering International Inc. in Houston, Lang keeps an eye on contracts that not only use different models and metrics but also vary from country to country. He's in a constant scramble to ensure that his contracts are up to date and that he's not overpaying for licenses he won't use. He's often mired in legalese. "It is horrible," he says.

Access and, critically, security are other aspects of the hosted model that IT executives must consider before signing on the dotted line. Austin Energy, a $1 billion municipal utility in Texas, chose a hosted system for its billing software (see "Texas Utility Gets Extra Benefit: Data Analysis") but kept its financial system on site. CIO Andres Carvallo says the organization's chief financial officer didn't want to find out that the Internet connection was down and that he was suddenly left without access to financial data.

Better Foundations, Avid Adherents

These approaches, like the hosted pay-as-you-go model, aren't actually new. The model took root in the 1970s, underwent a hiatus when distributed computing became popular, then re-emerged in the late 1990s with application service providers (ASPs), many of which failed miserably. This time, Web-based interfaces are more mature, and their Java 2 Platform, Enterprise Edition-based code helps with better response time. These advances mean more businesses are more willing to accept hosted software this time around, says Fred Hoch, a vice president at the Software and Information Industry Association, a vendor trade organization.

Utility Gets Extra Benefit: Data Insights

When Austin Energy purchased a hosted billing system, the $1 billion municipal utility in Texas gained an unexpected dividend. Andres Carvallo, Austin's CIO, says the company learned how to become more customer-centric. Part of that was thanks to the software itself. But the biggest benefit came from an unlikely source: the software's pricing model.

In 1999, Austin Energy's self-developed billing software had reached its limits. The company had grown and was looking for software that could handle more transactions. But rather than deploy software on site, Carvallo decided to use a hosted service from Dallas-based Alliance Data Systems (ADS) Corp.

Austin Energy pays for the billing service by the transaction (a completed activity such as mailing a bill).

It's that per-transaction model that has brought it some of the biggest benefits. Because the utility asked ADS to track transactions by department -- electricity, water and waste -- the company now better understands how the system is used. "The company realized that the way we were investing money in terms of infrastructure was not necessarily aligned for the best interest of the customer," Carvallo says. "Now we are able to put the customer at the center of every decision."

The hosted system still requires some in-house management. A staff of five monitors and manages it. In addition, the staff can analyze how many calls each agent handles and view transactions by geography, transaction type, time of day or any number of criteria. "We can analyze data that we never could before," he says.

That's a level of understanding Carvallo says he would never have been able to achieve by deploying similar software on site or using a different billing model with a hosted service. "The hard work of creating [the] granularity is done by the vendor, not by me," he explains. And he would never have obtained approval for staff just to analyze the data. "Everyone would look at me and ask why I wanted to hire 10 people to do financial analysis on our own software." -- J.R.

Cliff Bell, CIO of Phoenix Technologies Ltd., an $86 million software company in Milpitas, Calif., is one adherent. His company tried and failed twice to implement an on-premise CRM system. "We spent lots of money and didn't get anywhere," Bell says.

This time Bell was looking for something that would be quick to implement and wouldn't require a huge investment in software, consultants or servers. He chose Salesforce.com, which charges a monthly fee of up to $125 per user but no large licensing fee up front. "The fact there were no start-up costs was huge," Bell says. About 200 of the company's roughly 500 employees use the application, costing the firm about one-fifth the implementation and maintenance cost of an on-premise CRM system, he says.

For his part, C&H Sugar's Cottrell says he would have gladly taken SAP's hosted option with per-user pricing were it available two years ago when his project began. "If we can avoid a capital investment and spread the payment out over a longer time, from a cash flow management perspective, that is beneficial," he says.

Others have been pleasantly surprised by added value, not just cost savings. Austin Energy pays for its hosted billing application per transaction. The hoster tracks each transaction back to its department of origin -- electric, water or waste. That task serves up data that CIO Carvallo would have had to hire analysts to find. "Now we can come in and analyze the touch points of customer interaction and how the data flows to understand what the customer really needs," Carvallo says.

Other Disruptive Influences

Customer needs and a competitive market aren't the only drivers of the hosted pricing and delivery model. There's another technological disruptor: Linux. It offers performance and friendly prices not seen with traditional workhorse servers. Harris Interactive Inc., a market research firm in Rochester, N.Y., with $150 million in annual revenue, switched from Unix to Linux and realized gains of five times the performance, plus savings of $100,000 a year, CIO Peter Milla says. He uses Red Hat Inc. for Linux updates and service, paying an annual subscription fee of $750 per server. He also can choose his own subscription term. "The accountants were doing backflips," he says.

Changes in hardware are also driving how software is priced.

The $1 billion Southern Farm Bureau Casualty Insurance Co. in Ridgeland, Miss., has been working with IBM to find new metrics for its mainframe operating system.

Only 30 of the company's 5,000 employees use the mainframe OS, so Kenneth McCardle, associate vice president of information systems, didn't want to pay per user. He was also wary of paying for capacity he wasn't using.

He worked out an initial pricing model with IBM where he put the OS on only three of the organization's 10 mainframe engines, so he was paying for and using a maximum of 300 million instructions per second (MIPS). However, he was capped at 300 MIPS and therefore couldn't use much of the capacity he owned.

With IBM's new zSeries processor, he was able to try a much more flexible approach. Employees use whatever capacity they need, whether it's one or 10 engines, and Southern Farm Bureau pays for only what it uses. IBM peeks into the system to track the usage but doesn't view any customer data, so the risk is minimal, McCardle says. And he saves an average of $18,000 a month.

Multi-core chips are also creating change in pricing strategies. Vendors that used to charge by the core are beginning to reconsider that approach. Microsoft now charges by the slot, allowing companies to take advantage of the increased performance of multi-core chips without any added expense. Oracle hasn't announced any change.

Down the Road

While on-demand, usage-based and subscription-based pricing are the exception today, that's changing. Already some businesses are looking for more places to implement them.

Phoenix Technologies' Bell uses not only Salesforce.com but also a hosted service to monitor and maintain his network. He's now considering outsourcing his email on a per-mailbox basis because the cost of filtering spam and enabling off-site access for mobile devices such as the BlackBerry has become prohibitive, he says. He's also interested in subscription-based pricing for antivirus software. "I would try hosting in every area of my organization," he says.

Not everyone is as gung-ho as Bell. Yet the industry is inexorably moving toward these flexible pricing and delivery models, says Alvin Park, research director at Gartner Inc. in Stamford, Conn. "This is fairly new, and there are not too many vendors doing this, but it will become more and more of an issue over the next couple of years," he says. "Over time, it will become the de facto standard."

This was last published in March 2005

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