Tuesday, July 13, 2010

Why TCO Models Fail

by David Gross

For years, data center and telecom suppliers have presented TCO models to customers promising a full range of financial benefits, from lower operating costs to more revenue to reduced capex. But they're not taken very seriously. Understanding that these payback scenarios are often created by engineers with limited financial knowledge, some companies will venture out to a large consulting firm that itself has limited product knowledge in order to validate some of their claims. But the result is the same, a McKinsey or Bain mark on a spreadsheet does little to add credibility to numbers that no financial analyst with budget responsibility can take seriously.

The reason these business cases fail include:
  • Scattered Financial Benefits – most financially worthwhile products cut capex, increase productivity, or add to revenue, but not all three
  • Automatic Layoffs at Installation – operations staff are often modeled to disappear after a new router or switch is installed, this of course never happens in practice, a more sensible way to present this is to demonstrate that your product can improve productivity, not that it cuts opex
  • No Time Value of Money - many engineers and product managers will say “ROI” 100 times without ever showing an IRR, or Internal Rate of Return, on the capital outlay of buying their product. A 15% “ROI” is pretty good if it occurs over 8 months and will beat just about any buyer's cost of capital, but it is dreadful if it occurs over 3 years - the IRR at 8 months is about 23%, while at 3 years it's about 4%.

In addition to ignoring these financial realities, many business cases get tossed in the trash because they show no understanding of operational realities. This often occurs with the clever models put together by MBA consulting firms with little industry experience.  I once saw a business case that showed new revenue amazingly appearing with the purchase of a new switch. What was not shown was any recognition of time needed to sell the 150 gigabit+ capacity within the switch, to negotiate large bandwidth purchases, network planning, circuit ordering, credit checks, or any of the typical issues that come up with major network capacity issues. Adding in reasonable operating expectations for filling capacity threw the IRR under many companies' cost of capital, and made buying the switch a bad deal – per the supplier's own business case.

Having survived two bruising recessions in the last decade, purchasing managers will not go to bat for a vendor that cannot show the financial depth that the finance department needs, or operational understanding that puts credibility behind any financial projections. With so many cost-of-ownership and payback models ending up as a big waste of time and effort, smart hardware suppliers need to reconsider how they present the financial justification for buying their equipment.

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