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Life Cycle Cost

(September 30, 2004) You may remember the Defense Department pricing scandals of the late 1980s. Toilet seats sold for $800; screwdrivers could fetch $1,500. We had a ringside seat.

The problem was simple. DoD had extremely limited acquisition budgets during the early 1980s. To acquire the business, vendors underpriced their initial deliveries and planned to make up their money on the back end. In context, expensive spare parts prices made sense when you understood the deep discounts on the original purchase.

Although the business practice was sound and is time honored, it typically fails what we call "the Mike Wallace test". In other words, pricing initial acquisition low and making up the difference on the back end will always get you in trouble if someone just looks at the back end. Like credit pricing for those who can't get good credit, the approach lifts the overall cost but makes purchasing easy. Credit laws don't typically protect against consumer stupidity and, in fact, this scheme can be viewed as altruism of sorts.

In the early days of enterprise software delivery, this pricing approach was heavily used to speed the market's acceptance of a new product. Initial installations were priced low while the money was made up on customization charges and out-year transactions. While the Life Cycle Cost of the system went through the ceiling, initial acquisition became affordable.

Some of the players in the "we wannabe an enterprise company" Applicant Tracking Systems marketplace (including some notable existing enterprise firms) are starting to adopt this pricing method. Like the overpriced toilet seats and screwdrivers in the DoD, the risk is that it will be perceived as a license to print money. Here's how it works.

Imagine an RFQ for Applicant Tracking that gets three responses. Each, of course, represents the unique approach of the vendors. One emphasizes relationships, one emphasizes data quality, one emphasizes total solution. The prices cluster in two places: around $1.3M and $700K. The $700K price includes the processing of system email at a fixed cost per piece of mail (or resume or job). (We've seen one response that billed each email between the system and candidates at $1.75!!).

It really doesn't take long for a system to accumulate a lot of mail, particularly if it acknowledges the receipt of a resume. Over the course of a reasonable life, we'd estimate the real prices to be more like $4M for the cheap one and $2.5 for those that clustered at $1.3M. In other words, the cheap solution (as is always the case) is really the most expensive.

Ultimately, the military began soliciting bids that defined both the initial acquisition cost and a guarantee of total Life Cycle Cost. While it didn't solve the whole problem, it did introduce a contractual method to police abuse. The big risk in signing off on a low ball acquisition price is that you lose control of the back end.

We recommend that you do not make an acquisition without a careful examination of the total price of the relationship.

- John Sumser

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Materials written by John Sumser © TwoColorHat. All Rights Reserved.
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