Changing Economics

Dec. 21, 2004
New rules and new players promise to put the economics of software on the radar screens of many executives this year.

The common practice of treating software as an expense is going the way of the dodo. Under new guidelines issued by the Financial Accounting Standards Board and the American Institute of Certified Public Accountants (AICPA), companies must capitalize many of the expenditures associated with software, whether purchased or developed in-house. The change comes at a time when some software makers are starting to offer their wares for rent or purchase under what promises to be more equitable terms. The new accounting guidelines, which apply only to software used internally, are designed to clear up common inconsistencies over the way companies account for purchases of software packages or investments in internally developed systems. A standard approach is needed, explains Dan Noll of the AICPA, because "as the dollars have gotten bigger, the impact of having companies account for their software expenditures differently has become a critical issue." So critical, in fact, that the Securities & Exchange Commission weighed in on the issue, requesting that the AICPA's Accounting Standards Executive Committee come up with a position statement. The result is a set of new accounting rules for software that will take effect as early as Dec. 15, although the date can vary depending on when a given company begins its next fiscal year. Some costs incurred during internal software development, such as those in the preliminary project stage and those associated with training and data conversion, should continue to be expensed. But external direct costs -- such as those incurred for acquiring or developing software for internal use (including most payroll-related costs) -- must be capitalized under the new rules. The upshot is that software now will be treated like most other assets. Some say the change adds greater legitimacy to the overall role information technology plays in a company's operations. However, the purpose of the new rules is to ensure that the millions of dollars companies spend don't cause accounting nightmares. "If you're acquiring a company that has spent heavily on a new system," Noll says, "this can make it easier to see just what's been allocated." Despite the change, software remains far more intangible than plants or equipment, even if it now will be funded, in part, from the same kitty. While acknowledging the difficulty of drawing firm boundaries between what should and should not be capitalized, the Statement of Position is fairly comprehensive and will no doubt make investors and others breathe a little easier, knowing that there is one less place on the balance sheet to hide ambiguity. The most notable effect for companies implementing the new rules is that major software initiatives now will have to compete alongside the firm's plant-and-equipment needs for those scarce capital-investment funds. That means IS executives and others may have to make a strong case for return on investment. "Luckily for us, we've been capitalizing certain costs anyway," says Bill Howard, vice president of information systems at Inland Steel Industries Inc., Chicago. "But it will be a dilemma for those who haven't done that. I think it will force some needed discipline. If a project can't win funding on its merits, it should go by the wayside." Joe Fontanilles, finance manager in the global-technology-solutions unit at PricewaterhouseCoopers in Floral Park, N.Y., says that companies such as his, which assign finance people to work directly within IT units, may have an advantage. "I know that accounting people are aware of this change," he says, "but whether these new rules have been communicated to people on the IT side is an open question.'' Another question is who will bear the burden of justifying expensive software projects? "If you're overhauling an order-entry system," says Ron Shevlin, a senior analyst at Forrester Research Inc., Cambridge, Mass., "where is the impact going to be felt? In IT? No, in the order-entry department, so they are the ones who will have to justify it." Fontanilles adds that the rules will likely force IT departments to take a long-term view of software projects and lead to more rigorous analysis of what contributes to the bottom line. "Before, you might have spent money on a project and the only goal you had was, 'This will help us close our general ledger a little earlier each quarter,'" he says. "Now you'll have to ask yourself just what that means, what the real value is over the long haul." Rent it instead? These accounting changes come, however, just as companies are being offered the option of renting software rather than buying. A new concept-dubbed "rentable applications" by some or the value-added offering of "applications services providers" by others-is simple: Rent the software you need, and let someone else worry about all the issues associated with owning it. If you haven't heard about this, you're not alone. The companies offering it are either small or still waiting for the paint to dry in their new offices. But the idea has so much appeal that Forrester Research predicts that the market for rentable applications will grow from nothing today to $6 billion by 2001. Other estimates are triple that. Among those leading the charge is USinternetworking Inc. (USi), Annapolis, Md. Flush with seed money and with US West as a minority stakeholder, USi is building a network of data centers around the globe and will provide what Michael Harper, vice president of product marketing, calls "Internet-enabled business processes" to midsized companies in virtually all industries. Customers can choose a variety of packages from PeopleSoft Inc. (human resources, financials), Siebel Systems Inc. (sales-force automation), BroadVision Inc.(e-commerce), and others, paying a monthly fee. The software will run on USi's machines, but customers will have their own dedicated servers accessible by private or public lines. "Customers are looking for three things," Harper says. "Lower total-cost-of-ownership, fast implementation, and reliability. We can give them all three. We can provide, for example, a state-of-the-art data center and network that a midsized company could never afford on its own." Although USi has yet to announce any customers, other companies are playing in a similar space, albeit on a smaller scale. World Technology Services LLC (WTS), Seattle, for example, offers software made by J.D. Edwards & Co. priced on a per-user, per-month basis. "There is no capital investment upfront, no backups to do, no maintenance," says Tom Hughes, WTS president. "Not to mention that when you rent you need less staff, and that's a big motivator in today's climate." While USi intends to offer what it views as "best-of-breed" of many different kinds of software, along with implementation services and other forms of consulting, WTS intends to remain essentially a data center for hire, running J.D. Edwards. "We know the software very well," Hughes says. "In fact, we helped design some of it." WTS has more than a dozen customers now, including E. Kent Halvorson Inc., a construction company in Redmond, Wash. Brian Lawrence, the company's CFO, says he likes the rentable applications model because "we're growing fast and have outstripped software that runs on PCs or servers. But we don't have the money to buy a mainframe package outright, so this is the perfect solution." Halvorson pays a monthly fee based on transaction volume and the number of concurrent users. "If we want to add more users, all it takes is a phone call," Lawrence says. He sees other benefits as well. "WTS has a lot of experience in the construction industry, and they offer some great enhancements to the basic product that focus on things like job forecasting, which is a key requirement in our business." That ability to provide doses of customization may become a key differentiator between companies, if the notion of rentable applications does take off. USi, for example, believes that it must avoid writing any custom code in order to provide low monthly usage rates. Smaller companies such as WTS may choose to concentrate on certain vertical industries where they can bring specific expertise to bear and perhaps modify some products for each customer. While USi is targeting midsized companies today (which it defines as $100 million to $1.5 billion in revenue) analysts believe that the rentable-applications model will appeal to large companies as well. "There's absolutely no reason that this approach can't be scaled up," says Judy Hodges, an analyst with International Data Corp. (IDC), Framingham, Mass. "This approach differs from outsourcing in at least one important way-these vendors are buying licenses from software vendors at deep discounts and passing savings on to customers. That has a lot of appeal." Aside from its economic appeal, the model may get a boost because some very big players are already circling. IBM Corp., for example, also offers a per-user/per-month deal with J.D. Edwards software. "They certainly have everything it takes to get fully into this market,' says USi's Harper, "although so far they don't seem focused on it." Major consulting organizations, not to mention other large outsourcing vendors, also could hang out the "software for rent" shingle at any time-although they'll no doubt dress up the term a little. "I don't like the word 'rent,'" says Dick LeFebvre, director of IT for auto-parts maker Simpson Industries Inc., Plymouth, Mich. "But the idea behind it is the right one: Just pay a monthly fee for software and have no worries about installing it, operating it, or upgrading it. That sounds great to me." Same software, different price For those who decide that buying is still the way to go, there may be new flexibility on pricing. PeopleSoft, for instance, has moved away from the standard pricing models, which are usually based on numbers of users, or number and types of servers, and instead offers extended-enterprise pricing. Traditional pricing models are difficult to administer. Someone, for example, may have to name every user entitled to access a given piece of software. As more employees use software via the Web or company intranets-but often as only a small part of their job-per-user licensing becomes unworkable. Sales and maintenance cycles also stretch as the actual degree of usage is negotiated and then measured each year. Enter a new model, in which customers pay for software based on its value to the organization, in many cases choosing which metric they prefer to pay by. For example, a manufacturing company might pay based on revenue growth; beyond the initial price, the vendor will charge an additional 10% each time revenue grows by 20%. A financial-service company might prefer to pay based on assets under management. Specific terms are negotiated with each customer, but the overall idea-paying based on business value, rather than technology infrastructure or a clearly defined list of users-is the same and seems to be extremely popular: PeopleSoft's revenues grew 76% between 1996 and 1997. "One major benefit of this pricing approach," says IDC's Hodges, "is that it lets you accurately project your cost of ownership over a five-year stretch, based on your own growth projections, not on your projections about your technology upgrades." To date, few other vendors have rushed in to emulate PeopleSoft's pricing approach, but its success is such that imitation would seem to be inevitable. "Many customers are almost shocked by this approach," Hodges says, "but once they kick the tires they clearly like it."

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