Before we discuss the components of vendor pricing we shoulddwell for a moment on value rather than cost. To value something isto estimate it's monetary worth.

As any of you who have been active in the vendor marketplaceknow, vendors and their products are not the same so understandingwhat you are getting for your dollar is as important as how manydollars are required to pay for it.

In comparing vendors it is necessary to compare several aspectsof their offerings before you can determine the best deal for yourorganization. An obvious example is functional footprint; if onevendor's solution includes a viable print solution but another doesnot then you need to factor that into the price comparison.

Similarly, if vendor A requires that you buy and install athird-party product—say an rdbms—in order to run their software,but vendor B does not this fact needs to be accounted for in theprice comparison.

There also is the more nebulous issue of how much yourorganization values one function over another. Vendor A may have amore functionally-mature billing system than vendor B, but if yourorganization does only simple, direct billing and therefore doesnot need all that additional functionality the distinction may beirrelevant.

So, before you consider the actual pricing that each vendor isoffering construct a framework for how you value what is beingoffered. And a final comment for now on value as opposed to price:Market results show consistently that carriers do not buy on pricealone. The least expensive vendor does not always win, and thenotion of the "best price" does not necessarily equate to thelowest price; rather it equates to a combination of understoodcosts, estimated value, and perceived risk. Carriers will pay morefor added value and they will pay more for lower risk.

That said, it is of course important to understand the cost ofpurchasing and installing vendor software. Software costs havethree or four components depending on whether or not the businessdeal involves an ASP arrangement.

License Pricing

The license price is the cost a carrier pays to a vendor for therights to use a defined set of software for a defined purpose for adefined period of time. The defined purpose is usually moreconcerned with what the carrier cannot do, rather than what it cando. For example, the defined purpose will usually exclude the useof the software for anything other than the carrier's coreinsurance business and also may exclude the processing of businessfrom acquired carriers.

The usage language may be broadly written,granting the carrier an enterprise license, but may includeadditional costs as the written premium processed on the systemincreases. The language may be price sensitive to the introductionof new lines of business and/or new states.

Two important features to understand are: Does the license grantaccess to the source code? Is there a license term or is itperpetual? The provision of source code is obviously important ifthe carrier intends to take over maintenance of the system andbecome independent of the vendor.

This is a common feature of legacy "package" environments wherein-house staff has so heavily modified the system that takingvendor maintenance releases becomes extremely difficult. However,with modern configurable software, access to the source code isless of an issue. Configurable systems include a toolkit which isused for maintenance and enhancement of the application. It isaccess to this rather than the underlying source code in which thetool kit is written that is important.

On the issue of term, it is important to know if the carrier isbeing granted a permanent license to use the software or whether anew license term will be required in the future, which carries anew license fee.

Maintenance Pricing

The most common arrangement in software pricing in our marketremains the license fee/maintenance fee model. A maintenance feegives the carrier access to ongoing software updates, enhancements,bug fixes, and certain defined levels of support. In this model themaintenance fee usually costs about 20 percent of the license feeand runs for five years.

It is important to know what happens at the end of the initialfive-year term. In many contracts the carrier can choose tonon-renew the maintenance agreement and continue in-house support.Part of this decision is the perceived value of the agreement.

Carriers have commonly complained that the cost of maintenancebought them limited value in terms of added system capabilities.The carrier should understand what is included in maintenance andwhat is not. For instance, one area of contention is compliancechanges, which may or may not be included in the maintenance cost.Secondly, the carrier needs to understand how and when specificenhancements areagreed and scheduled into releases.

Services Pricing

Often the largest cost component of a major system acquisitionis implementation services. It also is the most difficult toestimate in a reliable way for obvious reasons.

The license fee is for something that already exists (wesincerely hope), and the maintenance fee is pretty much a functionof the license fee. But the implementation cost is based on projectestimates for something that has yet to be done, and whichtherefore carries significant risk.

At its simplest, the implementation cost estimate is anestimated number of service hours multiplied by an hourly rate. Thehourly rate is the only concrete number we are dealing with at thispoint in time and many carriers focus significant energy onnegotiating this number down.  Doing this before anoverall estimate has been provided is somewhat self-defeating andallows the vendor to give on hourly rate only to make up thedifference on hours.

Also, these costs are seldom fixed price. Rather, they areestimates that, while they may be written as "not to exceed withoutwritten permission" will still be exceeded should they proveinadequate. The reassurance afforded by a fixed price contract isalso somewhat illusory.

Two facts about fixed price are: The vendor will pad the numbersbecause the perceived risk has shifted to their side of the ledger,so the initial costs may be greater; second, and more important, ifthe fixed price proves inadequate the vendor will return lookingfor additional money.

Should this situation deteriorate into legal action the carrierhad better have a tightly defined set of agreed deliverables, alongwith a demonstrable track record of keeping their end of the dealin terms of delivering requirements, testing, etc. in a timelymanner, and without changing the scope. Otherwise it's hard to holdthe vendor to a fixed price deal.

Maybe the best insurance in terms of holding to theimplementation cost estimate is to focus hard on the vendor'simplementation track record and their knowledge of your businessduring the selection process, rather than trying to negotiate termsthat appear to shift risk to the vendor and away from thecarrier.

ASP Services

But what if an outsourcing deal is part of the mix? How doesthis affect the pricing structure and overall cost?

There is no one single answer to this question. A vendor mayblend the license and maintenance fees into the monthly processingfee, or keep them separate. The monthly processing fee willprobably be a function of the breadth of services being providedand the volume of business being transacted on the system.

Volume may be measured in various ways, the most simple of whichis, again, written premium processed, but it may be calculated onrecord counts or even on certain transaction counts. An ASP dealwill also involve certain minimums to cover the vendor's set-upcosts.

These minimums may apply one time to the system start up or mayalso apply to new states and/or products. Again, read the fineprintand build a spreadsheet that predicts costs in various growthscenarios.

There is no overall rule of thumb as to how much a givensoftware acquisition and implementation will or should cost for agiven shape and size of carrier. The carrier can, however, getprepared and educated relatively early in the selection process byasking for standard terms and conditions and for initialimplementation costs.

Any vendor on a shortlist of three to five should be prepared tofurnish these initial estimates and also to explain how theirpricing structure works. This allows the carrier to begin toestimate an overall cost and also to compare how the vendors differin their pricing approach.

The carrier should understand that what they get initially isthe "list price" for each type of cost. Vendors will oftennegotiate significantly lower prices in order to win a client, butas we noted earlier it is incumbent upon the carrier to make surethat they are really being offered a discount, and not merely adisguised cost shift.

As always the important phrase is "buyer beware."

The content of "Shop Talk" is the responsibility of theauthor. Views and opinions are those of the author and do notnecessarily represent those of Tech Decisions.