Armanino Blog

TCO: Accounting for Cloud Computing Costs

November 06, 2011

Total Cost of Ownership (TCO) analysis is a management accounting tool used for determining both the direct and indirect costs of a product or system. Because the cost structures of on-premises applications and Software as a Service (SaaS) differ so much, TCO analysis is needed to establish a comparable cost basis.

If you are about to undertake a TCO analysis, a good place to start is with Daniel Druker's post on the subject. Druker, an Intacct SVP, details the cost factors that you need to include for the SaaS model. I assume you are already familiar with the cost factors for applications installed on-premises.

In Druker 's view, "an overall TCO analysis that makes true apples to apples comparison of SaaS / Cloud vs on-premises applications should include a thorough analysis of costs and return across at least three components - Capital expenditure, IT operations and Departmental /Business operations. The TCO model should extend over the total expected lifecycle of the applications - I'd suggest 7 to 9 years in the world of financial applications - and break the overall lifecycle into three sections - initial deployment, ongoing operations and upgrade/replacement in year 3-5."

He also advocates including others areas of analysis - reduced risk of project failure, faster time to value, greater flexibility, and superior operating capabilities - which contribute to ROI estimates. A Forrester Research note on "Comparing the ROI of SaaS Versus On-Premise Using Forrester's TEI Approach" makes a similar point. "Conduct a retrospective analysis on previous implementations to identify the proper factors for areas like benefits, risks , and flexibility. In the absence of such data, apply reasonable benchmarks based on company size and industry."

There are a few rules of thumb for company size. As early as 2005, the Yankee Group titled its analysis "TCO of On-Demand Applications Is Significantly Better for SMBs and Mid-Market Enterprises." Five years later, in "For Cloud, Age and Size Do Matter," it drew the same conclusion but refined its analysis with data from enterprise surveys.

Large enterprises that license hundreds of seats have another wrinkle to consider. R "Ray" Wang, the Forrester analyst quoted above, advises distinguishing between centralized and remote users rather than plugging in a number for total hands-on users for the applications you analyze. "In general, as the number of users increases, on-premise models increase in financial attractiveness. However, enterprises operating in multiple geographies with 25% or more users in remote locations benefit more from SaaS options," Wang notes.

Every company is unique. Your TCO analysis will look different from anyone else's TCO analysis. What everybody will notice, however, is that cloud computing transforms the IT cost footprint. When the Yankee Group did its apples to apples TCO analysis of mid-market offerings, the license fee of the on-premise package accounted for only 26% of the TCO. The remaining 74% went for the infrastructure, maintenance, patches, IT resources, upgrades and training. Like an iceberg, the majority of the costs - both sunk and prospective - are underwater.

By contrast, in the SaaS model, the license fee represents 65% of the the total TCO; the remaining 35% goes to consulting, training and IT resources. That is because the cloud vendor assumes the infrastructure and other costs that burden on-premise applications. The vendor's infrastructure and other costs are spread out over an expanding universe of users of its application, so each customer pays only a small portion of it as part of their license fee.

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