Is SaaS Still Purchased the Way Vanderbilt and Hill Bought Railroad Track?

This post was originally published on Spend Matters.

Procurement, as it is traditionally understood, was born during the second industrial revolution, thanks to the electrification of industry, the growth of railways and telegraphic communication. An early “manifesto” for the procurement function by Marshall Monroe Kirkman spoke of, “The intelligence and fidelity exercised in the purchase, care and use of railway supplies influences directly the cost of construction and operating and affect the reputations of officers and the profits of owners.”

Kind of quaint, isn’t it? It’s the world of the great railroad tycoons Cornelius Vanderbilt and James J. Hill.

Little changed until the early 2000s and the first attempts to computerize certain aspects of procurement with, for example, online auctions. Fundamentally though, things stayed the same. Even today, procurement tech companies still seek to optimize the old paradigm of “buying more for less” without challenging it.

And the old paradigm works well for the old categories of spend. You buy direct materials like railroad track as and when you need them. And even if you have leftover stock, it’s still usable. Likewise, when you buy outsourced indirect services such as maintenance, repair and operations (MRO) you basically only pay for what you get. The same is true of capital expenditure, e.g., the storage facilities you need to keep the coal that fuels your locomotives. It’s highly visible, so you can see what you’ve paid for and it’s easy to amortize the costs.

What all of these have in common is transparent pricing models and clear outcomes, including measurable return on investment.

But today, alongside the fourth industrial revolution, we have a fourth type of procurement that sits apart from the traditional direct, indirect and capex categories: software, particularly software-as-a-service (SaaS), such as SalesForce, Slack, Adobe etc. The big difference is that SaaS is intangible, invisible. In fact, the only place where you can be sure of noticing this category of spend is the dent it puts in your finances, after the fact. No wonder that the senior director of IT sourcing at a Fortune 500 retailer called software “the silent killer of your company’s budget.”

The dent software puts in company finances is growing at an alarming rate, made all the bigger by the changes brought about by the pandemic. In 2022, companies are spending 50% more on SaaS than they did just two years ago. However, according to G2 Track, more than $40 billion is spent on unused SaaS tools each year on average. An average of 40% of all SaaS licenses go unused in any 30-day period, which means that companies are overpaying by 30% for software as a service.

This would be almost unimaginable in any traditional direct or indirect category of spend. A procurement manager in an automotive manufacturer would surely be fired if they were paying a 30% excess for sheet metal. Likewise, no company could tolerate paying vast sums for advertising airtime, 40% of which was unused.

Think that’s bad? That’s only the tip of the iceberg! There are also high soft costs involved in SaaS procurement – costs that cannot easily be brought under control with conventional “source-to-pay” procurement technology. Let’s compare traditional direct materials procurement with SaaS procurement to understand why.

Direct materials are static, software is dynamic.‍

When you manufacture a physical product, the requirement for direct materials is linear and predictable so you can buy just in time or keep inventory to match the speed of production. The number of user licenses you need are constantly in flux, as are software, prices, features and renewal cycles.

Category management is simple with direct materials but almost impossible with SaaS.

The products and pricing from competing suppliers of direct materials are comparable, so it is relatively easy for procurement officers to keep up, even if they are not category specialists. With software, there is huge variation between product offerings. Vendors have access to information that buyers don’t; such information asymmetry puts vendors at an advantage. This may not be such a problem for large enterprises with extensive procurement departments and broad-ranging category expertise, but it’s an impossible situation for medium-sized companies with limited resources. Even specialist analyst firms like Gartner and IDC – who sell market intelligence to buyers – struggle to make direct comparisons.

With direct materials, decision-making is simple. With software, it’s a team sport.

So long as they buy goods that meet certain quality standards, a company can leave the procurement team to negotiate directly with suppliers or to source using online auctions. But with software there are several diverse stakeholders (IT, IT security, heads of department, procurement, finance, maybe legal…) who will all stick their oar into the decision-making process.

These factors mean that the time and opportunity-cost spent on software procurement may greatly outweigh your outlay on the software itself. In many cases heads of department, growing weary of the slow decision-making process, sidestep it entirely, leading to “maverick spend” which is not only inefficient and wasteful but also risky.

How to approach SaaS procurement today

Today, companies have on average 100 different software contracts (and in some cases, many more). To buy SaaS effectively today requires a three-pronged strategy.

First, you need market intelligence that is both broad and deep, keeping track of developments (e.g., new software versions, new market entrants and changes in pricing structures) in real time. This extends to pricing benchmarks derived from interactions with hundreds of vendors over thousands of negotiations.

Second, you need the right tools that are adapted to the specific requirements when buying SaaS: flexible and user-friendly workflows to facilitate efficient collaboration and approval processes; a centralized repository for all contracts; and capabilities to measure SaaS platform usage and effectiveness, which put pricing and SLA negotiations on a factual basis.

Third, you need the right knowledge and people skills: deep domain expertise in different types and categories of software; strong, mutually respectful and productive relationships with the vendors; and not least, expertise in negotiations supported by a strong playbook for achieving the best outcomes – from both economic and strategic perspectives – in this unique and challenging area of procurement.

Without these three elements, software costs will grow over time as the industrial and business landscape is increasingly shaped by new cloud-based intelligent systems. But with these three elements in place, a company is equipped to achieve software procurement excellence. In many sectors dependence on software investment is growing at a remarkable rate. Take manufacturing: according to research by McKinsey, “In the automotive sector alone, software and electronics expenditures are expected to almost double in ten years, from $238 billion in 2020 to $469 billion by 2030.” There are huge potential savings to be made here with the right approach to software procurement. The report concludes: “And in a range of sectors around the world, organizations have shown improvements in performance per unit of cost of 10, 20, or even 30% – generating real competitive advantage as the importance of software keeps growing.”

The world of business is changing all the time, and today it’s changing faster than ever. Of course, some things don’t change. The railroad tycoon James J. Hill, who built the first transcontinental railroad with private capital, the Great Northern Railway, said:

“If you want to know whether you are destined to be a success or a failure in life, you can easily find out. The test is simple, and it is infallible: Are you able to save money?”

There’s a huge difference between buying physical products like rails, rolling stock, locomotives and fuel and buying something as intangible as software as a service. But you can still save a pile of money if you buy it right, and that could make all the difference between success and failure.