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The Best Things in Life Are Free

  • September 14 2006, 1:00am EDT

DM Review welcomes Mark Madsen, president of Third Nature consulting and market research firm, as our newest online columnist. Look for his column the first week of each odd-numbered month.

"At my lemonade stand I used to give the first glass away free and charge five dollars for the second glass. The refill contained the antidote." - Emo Phillips

"The margins are zero, but we'll make it up in volume." - comment on the free release of Internet Explorer

We all know that business intelligence (BI) software costs an arm and a leg and maybe an ear for good measure. That must mean it's terribly expensive to make this kind of software, so there's no way to make money by giving away the product. I think this is true in the way that bumblebees can't fly is true: they don't know they can't fly so they do.1

I hear the criticism that because a business model predicated on giving away software isn't viable, it's not worth evaluating open source BI tools. This would be a rational decision if the initial premise were true. Like most things, the truth depends the assumptions you make.

To get to the bottom of the argument, look at an anonymous healthy BI software company. Company X is a fairly typical BI provider that makes most of its revenues through the standard means of licenses and support, with a little services thrown in on the side. Figure 1 shows their revenue breakdown by percent and by dollars.

Figure 1: Company X 2005 Annual Revenue by Category, taken from their 10K filings

The big question is, "What would they look like if they were an open source company who gave away the product instead of selling it?" To work this out it's necessary to compile the results from their annual report to show the current revenues and expenses and what they might be under some realistic open source assumptions.

The first thing to go is the license revenue, because we're now giving it all away for free. The loss of almost half the corporate revenue hurt, but that's not the only cut to revenue. If you want to be realistic, you also need to take a whack at support. Most big corporations want support. Because licenses are cheaper, one thing to assume is that people will be willing to pay less for support so let's drop the price for the full-on corporate support by 20 percent.

To make matters worse, support is really two needs: maintenance (patches, upgrades and certifying that they work) and support (someone to call when something goes wrong). Maybe you think you can save money by not having support, relying instead on the community and your own staff. You just want basic software maintenance, so let's drop the price on that to 50 percent of what you were previously paying for support.

And then there are the cheapskates who only bought support because they had no alternative. Now they don't need to pay you anything. The downside for these companies is that they have to apply patches themselves, stay up to date on versions and are self-supporting. Assume that maybe 20 percent of the companies won't pay a dime, so chop 20 percent out of the total support dollars to account for these misers.

All this takes the original $320 million support revenue to $166 million. Services shouldn't be affected because people still need training, installation and configuration help. After all, the product isn't any different than it was before. This transforms the former $825 million juggernaut into a puny $308 million weakling.

Figure 2: Company X Revenues and Restatement as an Open Source Company

That's the bad news. The good news is that there are adjustments to expenses that will offset some of the revenue reductions. The biggest win for an open source company is the huge number called "selling, general and administrative expenses." Optimists drop this to zero. I'm being a little more realistic in assuming that you still have general and administrative expenses, so I settled on five percent of revenues. This shows that sales and marketing is a pricy hidden assumption built into the cost of enterprise software companies.

Interest income and expense is assumed to be the same percentage-wise, but because revenues are so much smaller, those numbers drop as well - but that has no major effect. The same applies to taxes. R&D expense dropped slightly because we can take into account community contributed features and bug fixes. I chose an optimistic 20 percent.

Surprise! Using these generally reasonable assumptions, net income goes from 16 percent to 30 percent meaning we're more profitable than we were before. From an economist's perspective what we just did was a great success - we made the software company more efficient and produce the exact same software for a lot less money.

The problem for many software companies is that free and open source is not some special characteristic of software. It's a development and deployment model and it stems from both ideology (e.g., the Free Software Foundation) and the economics of commoditization, with the economic factor being the bigger force. Because the economics of commodities are driving the industry, you can expect to see the market share of mature software businesses erode as open source expands.

The bad news is we have less than half the revenues we used to. The economic reality is that we need to lay off sales, marketing and a lot of administrative staff. Nobody said this was going to be a great thing.

What we just walked through is the pure software company model. If you wanted to be the Cognos or Business Objects of the open source BI world, it might look like this. My next column will try to answer the question "How can we make more money?" Until then, have that first glass of lemonade.


1. I know, I know. The "science proved bumblebees can't fly" story is an urban legend dating back to at least the 1930s. It is true only if you apply fixed-wing aerodynamics to the problem. In other words, if you use the wrong theories.

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