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TCO, ROI and the Difference Between Price and Cost

By Curt Finch
Nov 23, 2010 5:00 AM PT

Total cost of ownership is a financial estimate that helps enterprise managers determine direct and indirect costs of a system. TCO goes beyond the initial purchase price or implementation cost to consider the full cost of an asset over its useful life.

TCO, ROI and the Difference Between Price and Cost

TCO and ROI, or return on investment, are frequently confused and misused, but they actually must be used together to properly evaluate customer relationship management projects. Don't pay too much attention to costs and too little to benefits. Rather, forecast and compare costs over the life of a project. A proper TCO analysis often shows there is a large difference between the price of something and its long-term cost.

For example, let's say you buy a car that's inexpensive but it breaks down constantly. When you take it to get fixed, you find that the repair shop is far away and the parts are costly. It also loses value faster than other cars that cost more when it comes time to sell. Your time is also valuable, and all of the trips to the repair shop should be taken into consideration, too.

So, let's do the math.

Car A

Initial cost: US$10,000
5 years of repairs, plus normal maintenance: $7,500
Value after five years when you sell it: $1,000

Car B

Initial cost: $20,000
Five years of repairs, plus normal maintenance: $2,000
Value after five years when you sell it: $10,000

The five-year TCO of Car A is $16,500, whereas the five-year TCO of Car B is $12,000. Even though Car B was more expensive up front, it costs less in the long run.  

How TCO Is Calculated and Used to Make Decisions

My company uses a CRM tool that tracks leads, sales and customer support issues. It's been used in the company for a very long time and is deeply embedded in our company's operations. However, the usability and performance are quite poor, and the monthly cost is exorbitant. There are plenty of competitors to this CRM system, and the time has come to consider other options.

In order to make this decision, the TCO of each of the potential solutions must be understood. The future costs need to be considered for a set period of time. Let's consider four options:

Option 1 -- Stick with the existing vendor and stop whining
Option 2 -- Build a solution internally, perhaps using open source tools (e.g. SugarCRM) embedded in the solution
Option 3 -- Choose a huge mega-vendor like Microsoft
Option 4 -- Choose a small vendor that will pay closer attention to our needs
This scenario presumes that these options exist and are somewhat rational. Since this is purely hypothetical, let's pretend they do.

How would these solutions compare over a five-year time frame?

Each of these options has different costs for hardware, backups and operating system software. Software installed by your IT staff in your own company's environment will have all of these costs. On the other hand, solutions provided directly to your browser from the vendor's system (Software as a Service, also known as "SaaS" or "cloud" solutions) usually only have a monthly fee, and any Web browser will work with the software.

Vendor risk is another factor. Will your chosen technology vendor still be supporting the product in a few years? Large vendors obsolete technology platforms all the time, and this is always a risk. If a system is built internally, the expert who understands the software better than anyone else is employed by your company. What if that person leaves?

Let's take backup and disaster recovery, for example. In option 1, there isn't as much worry about disaster recovery because the vendor offers the CRM system on a SaaS basis. Customers don't have to conduct backups because they trust the vendor to do this. Most SaaS vendors are pretty good about doing this, and their SAS70 certification should explain the procedures they follow to the customer.

Be Aware of Vendors' Hidden Agendas

All managers need to have some system of TCO in place when making decisions on choosing solutions. Vendors will try to manipulate and obfuscate the true TCO of their solution and it will be different for each installation. Customers must be sure that THEY own the definition and calculation of TCO and don't allow the vendor to drive the agenda.

For example, some of the costs, like risk and opportunity, are nebulous and hard to define. Vendors will try to make other vendors' solutions look risky. Large companies like to say that dealing with small companies is riskier, but this is not necessarily the case. Large firms can evaporate overnight (think Wachovia, Lehman Brothers). Additionally, large vendors may not view you as large enough of a client to matter if they ignore your needs. This scenario sheds a positive light on option 4 -- choosing a small vendor. 

Opportunity cost (e.g. if we build this ourselves, will we be gaining new opportunities in the marketplace from doing this or will it distract us?) needs to be assigned a dollar value, which is difficult to do. But you must come up with some estimate of opportunity cost for each solution being considered.

In the long run, you're the boss. It's all up to you. You get to define the costs and make sure they are a good representation of the issues your business faces. Don't let a vendor's salesperson take over the process from you. But don't throw the baby out with the bathwater -- vendors do know the weaknesses of their competitors and can be very useful in this regard.  

As you can see, each solution will have different benefits, risks and costs. Only when a thorough analysis is conducted can you compare the TCO across possible solutions.

Putting the TCO Calculation Into Practice

The purpose of TCO for CRM projects is to provide a complete scope of project costs, including those costs for technology, processes and people. Given that CRM technology costs include a great deal more than just the purchase price of the system, one good method for CRM-project TCO calculations is to be meticulous about collecting all the appropriate and associated costs for the project. Another good option is to take a baseline measurement of all pre-project costs for each option, before selecting one, to have a point of comparison.

Consider this list of costs and risks that are frequently overlooked and could differ substantially for the four options described above. Obviously, you can't do this analysis in a time crunch for more than a very few possible solutions.

Software Cost
License cost + base/server cost
Client side cost (if any)
Purchasing process (how many vendors?)
Operating Costs
IT staff
Management time
Floor space
Outage costs
Back-up/Recovery cost
Annual cost
Server cost
Other product costs that are required, like a database, Web-server, etc. (Even if you already have these things, you might need more, or to keep or support them longer.)
Risk cost
Opportunity cost
ROI, in contrast, is the complete financial analysis of the CRM project's costs and benefits -- not just a list of projected benefits or a simple payback calculation.

Essentially, any benefit could be part of the analysis, including intangible or soft-dollar benefits. In calculating CRM benefits, consider improvements in efficiency and effectiveness, as well as cost savings. If your project has them, predict improvements in intangibles, such as strengthening customer loyalty and increasing brand recognition.

Remember, however, to use both TCO and ROI to evaluate your CRM project, and not to focus too much or too little on either the costs or benefits side.

Happy planning!

Curt Finch is CEO of Journyx, a provider of Web-based time tracking, project accounting and resource management software designed to guide customers to per-person, per-project profitability. Finch is an avid speaker and author of All Your Money Won't Another Minute Buy: Valuing Time as a Business Resource. He is also a blogger for Inc. You can follow him on Twitter @clf99 or send him an email at curt@journyx.com.

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