Managing 3rd Party Software Costs

“Our products are getting more integrated with software from other vendors.” 

I hear this comment more and more often as I interact with application producers (software vendors and intelligent device manufacturers).  It takes on many forms: 

  • A feature licensed from a 3rd party software supplier that is sold as a value added feature to the base product
  • A module or piece of software code from the supplier embedded into the core software vendor’s product
  • Hardware vendors embedding 3rd party software to provide specific capabilities that enhance and differentiate their hardware

Essentially, in each of these scenarios, there is a value provided from the 3rd party supplier to the application producers selling the final product.  While the supplier wants to maximize the revenue from the intellectual property, the seller of the final product wants to minimize costs.  Managing this conundrum requires delicate balancing.

Tightrope

How have companies traditionally managed 3rd party software costs?

  • A blanket agreement with payment terms that are not tied to volume 
  • A trust model where the customer provides a report back to the vendor on the volume, and payment owed is calculated based on that
  • Hardware manufacturers provide a single piece of hardware with all features loaded, irrespective of whether the features are required or used by the customer

What are the drawbacks of this traditional approach?

  • Inaccurate
  • Manual intensive
  • Error prone
  • Not scalable
  • Not in line with value exchanged
  • Leave money on the table or overpay depending on the side of the equation

What are some approaches of doing this better? 

One approach is to use software licensing to track activations of the modules and pay only on end user activated features / modules. Another approach is to provide good, better, best kind of options catering to different market segments with the same code but enabling only the relevant features.  This not only reduces 3rd party software costs but also provides the ability to target different customer segments with different price points.  Additionally, this approach benefits hardware companies by reducing their supply chain costs through a single hardware base.   A third approach to solve the problem is using a pure usage-based licensing model, where payments for 3rd party software are based on actual usage.  

Why should companies care?

Highlighting two examples from my recent discussions:

  • A large device manufacturer indicated that they saved ~ $100 MM in the first year purely through timing of cash outflow by paying vendors only after activation.
  • Another medium sized hardware company in the video broadcasting business was loading all software features into their hardware and incurring costs on all of the software irrespective of whether the customer used it or not.  This company was making payments to about 30 software vendors.  It saw a huge potential in the ability to license the 3rd party software (or at least the important / expensive ones), thus providing the ability to track and report software activations. They expected this could reduce their 3rd party software costs by 20%. 

These are just two examples.  With the increasing trend towards dependency on partners to develop a “whole product”, 3rd party software costs will only continue to rise.   Hence companies need a more accurate and scalable way to manage them.

What have been your experiences in managing 3rd party software costs?  What approaches have you followed?

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