Buying new software for your business can be a costly proposition. Both the dollars spent on the software, and the man hours spent on converting data, training end users and other tasks can quickly add up. Managers and CEOs alike will want to see good reasons for adopting a new software package. Therefore, justifying the cost of purchasing and implementing new business software is a key component in the software buying process.
Cost justification consists of identifying the total costs and benefits of implementing and using new software and then comparing those numbers to the costs and benefits of the current software system – or to the lack of any software at all. Also involved in this process is determining all of the stakeholders and how they’re affected and calculating the return on investment (ROI) of the software and how long it will take for the new system to pay for itself (the payback period).
Identify total cost of the software
The first step in cost justification is to identify the total cost involved in purchasing, implementing and maintaining a new software package over its lifetime, often referred to as Total Cost of Ownership (TCO). Crucial in this process is calculating the expenditures on software licenses, as well as the costs of training staff on the new system, installing the software, updating and maintaining the software, getting support for the software or spending time dealing with bugs, and maybe even upgrading hardware to run the software. For a more accurate estimate, make sure to discount future costs to their current value by using the risk free rate1 or an internal rate of return2.
Identify total cost savings and benefits of the new software
Estimate how much money the new software, once installed and running, can save or make for the period during which you use it. This calculation should be based on at least a couple of years’ use depending on how fast your business is growing. The faster the growth, the more likely you will outgrow a certain software in a shorter amount of time.
It’s important to look both at the potential cost savings and at the potential for additional revenue. For example, if a solution increases revenue because it cuts down on the time to process an order and allows more orders to be filled, that is a revenue benefit. If it also costs less to maintain per year than the old system, that is a cost savings. Both types of benefits should be fully accounted for in your estimates.
Many expected benefits are difficult to quantify. However, the attempt to do so will not only help you make a decision, but it will also help you to frame why you are buying the software in the first place – and help you maximize the benefits that you reap.
For example, one of the benefits of email marketing software is to help you maintain better touch with your customers. How does this translate into increasing your revenue? To determine this you could ascertain how many more customers you can reach with the software than without it and estimate how many of those can reasonably be expected to turn into repeat sales.
Comparing costs to benefits
After settling on estimates for the potential total costs and benefits of implementing new software, compare these numbers over the entire lifetime of the system to determine whether a purchase is justified. To do this, discount all future costs and benefits to their current value using the risk free rate or an internal rate of return and then subtract costs from benefits.
In addition, it can be helpful to include a return on investment (ROI) number in the cost justification paper. This number, once the total costs and benefits have been estimated, is fairly easy to find. ROI is a measure of the efficiency of an investment at generating returns, the higher the better. The formula for ROI is:
ROI = (Gain from Investment – Cost of Investment) / Cost of investment
Finally, including the payback period for the software is another useful metric to have when deciding whether or not to adopt new software. The payback period is the time it takes for the cost savings and additional revenue from new software to offset the initial cost.
Using the above tools and metrics is a helpful way for you to justify the purchase of a specific system to your users and stakeholders. Having the numbers to back up your claims will make your arguments all the more compelling.
- The risk free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time (from Investopedia.com).
- The internal rate of return is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero (from Investopedia.com).