The Business Model of “Software-As-A-Service”
Dan Ma
School of Information Systems, Singapore Management University
Singapore 178902
madan@smu.edu.sg
Abstract
The emergence of the Software-as-a-Service (SaaS)
business model has attracted great attentions from both
researchers and practitioners. SaaS vendors deliver on-
demand information processing services to users, and
thus offer computing utility rather than the standalone
software itself. In this work, I propose an analytical
model to study the competition between the SaaS and the
traditional COTS (Commercial off-the-shelf) solutions for
software applications. I show that when software
applications become open, modulated, and standardized,
the SaaS business model will take a significant market
share. In addition, under certain market conditions,
offering users an easy exit option through the software
contract will help to increase the SaaS vendors’
competitive ability.
1. Introduction
In a recent memo, Bill Gates proclaimed that the
emergence and rise of the Software-As-A-Service (SaaS)
business model will be the “next sea-change” in
computing [6]. Under the SaaS, the software system and
users’ data are stored off-site in a central location run by
the vendor. The vendor delivers the bundle of IT
infrastructure, software applications, and services to users
through a network. Users pay a fee per transaction.
According to AMR Research, the SaaS market is
growing more than 20% a year, compared with single-
digit growth in traditional software [5]. The SaaS has
become an attractive alternative to the traditional COTS
(commercial off-the-shelf) software solution.1 In a web
survey by ThinkStrategies, one-third of 118 respondents
were already using SaaS, and another third were
considering using one within the following 12 months [3].
In many cases, the SaaS may prove cheaper than owning
and maintaining an in-house IT system. Users expect to
save money on support and upgrade costs, IT
infrastructure, IT personnel, and implementation [5].
1
A COTS product is a commercial software application that “is
designed to be easily installed and to interoperate with existing system
components.” Almost all software bought by the average computer user
fits into the COTS category: operating systems, office product suites,
word processing, and e-mail programs are among the myriad examples.
See http://whatis.techtarget.com for more information.
2007 IEEE International Conference on Services Computing (SCC 2007)
0-7695-2925-9/07
Authorized$25.00
licensed©use
2007
limited to: b-on: Universidade Catolica Portuguesa. Downloaded on June 06,2024 at 15:41:08 UTC from IEEE Xplore. Restrictions apply.
Especially for small and medium businesses with limited
IT resources and constrained budgets, the SaaS constitutes
an affordable way to access software applications [2].
In this study, I propose a model to examine the
competition between a SaaS and COTS software. The two
competing software vendors are differentiated in multiple
ways. First, they deliver different products: an easy-to-be-
customized software application (from the COTS) versus
a bundle of standard software and services (from the
SaaS). Second, they adopt distinct pricing modes: an
outright purchase (the COTS) versus a “per transaction”
fee structure (the SaaS). Third, they employ different
delivery methods: software installed on a user’s in-house
server (the COTS) versus an interface delivered over the
Internet remotely (the SaaS). Software users have
different cost structures and bear different risks in dealing
with each business arrangement.
Modeling details are presented in Section 2. The last
section presents the major findings as well as discusses
their business implications.
2. The Model
Consider the software market with three parties:
software users (i.e., firms in need of software
applications), the COTS vendor, and the SaaS vendor.
Users have heterogeneous demand for the software in
terms of their expected usage volume, which are assumed
to be uniformly distributed over [0, 1]. For each
individual user i, its actual usage is a random variable
[ ]
distributed over d i − θ , d i − θ , where θ measures the
demand volatility level.
The COTS vendor sells packaged software
applications to users and charges a one time upfront fee.
The source code of the application is modified to fit the
user’s specific business needs, to assure a good
integration with the user’s existing IT system. The vendor
bears an operating cost C and receives a one-time
payment P from the user. The COTS users themselves
must provide in-house IT services to maintain and support
the software, which is denoted by c (i.e., the service costs
per transaction). Each transaction creates a value of u.
Under the SaaS model, the vendor bears an initial
setup cost S to start the business with a user, and service
cost c per transaction to serve the user. Users pay a price
 pa per transaction. Due to the “one to many” business
structure, the SaaS software is not well-customized, and
each transaction gives the user a total value of u-t. The
parameter t measures the user’s unfit costs. The exact
value of the unfit costs is unknown by the user ex ante
since software applications are experience goods. It can
be low ( t = tL ) or high ( t = tH ), each equal probability,
and will be revealed to users only after they try and use
the SaaS applications. Once users learn the exact value of
these costs, they may consider exiting the SaaS by paying
an exiting cost E.
3. Findings and Implications
The competition takes place in two stages: before and
after the exact value of unfit costs is learned by users.
Hence, the model can be solved backward.
Due to the space limit, I omit the detailed model
solving and derivations. Below, I present two major
findings. Their business implications are discussed as
well.
Proposition 1. As users’ unfit costs decrease, the
relative economic advantage of the SaaS business
model increases monotonically.
This result reveals the future evolution of the
software market. As unfit costs t decreases, the whole
software industry will be transited to the service-oriented
structure. The unfit costs present users’ extra efforts to
make different software applications run together
smoothly. The followings are several possible ways to
reduce such costs. On the software vendor’s side, they
should create applications that are most compatible with
other systems and programs, by writing the applications
using an open language (for example, XML), in a proper
modular structure, and with a loosely coupled interface
with other applications. All these strategies would help to
increase the application’s ability of being compatible with
other systems. For example, in January 2006,
Salesforce.com developed and launched AppExchange,
an online marketplace for on-demand business software.
It allows Salesforce.com and other software providers to
establish across-application integration and therefore
provides users seamless extension of their existing
systems [1] [4]. Users expect to have reduced unfit costs
because a uniform platform eases collaboration across
software applications. In addition, industry-wide adoption
of software standards and protocols, once achieved, will
also make the communications and cooperation across
different applications easier and thus would reduce users’
unfit costs.
Proposition 2. The SaaS vendor’s profit and the users’
exiting costs show a non-monotonic relation. As exiting
2007 IEEE International Conference on Services Computing (SCC 2007)
0-7695-2925-9/07
Authorized$25.00
licensed©use
2007
limited to: b-on: Universidade Catolica Portuguesa. Downloaded on June 06,2024 at 15:41:08 UTC from IEEE Xplore. Restrictions apply.
costs increase, the vendor’s profit increases first,
peaks in the middle, and decreases afterwards.
Exiting costs play two opposite roles in the
competition. On one hand, they increase the SaaS
vendor’s lock-in power and allow the vendor to extract
more surplus from existing users; on the other hand, they
reduce the attractiveness of the SaaS and may “scare
away” potential users at the beginning. Such double
effects result in the above non-monotonic relation.
This finding suggests that the SaaS vendors can
enhance their competitive advantage through appropriate
contract designs. Nowadays, many vendors deliberately
increase users’ switching barriers in order to obtain lock-
in advantages. For example, a typical SaaS software
contract in the healthcare industry requires users’ long
term commitment (3~5 years) and users’ early exit incurs
punishments on them (e.g., cancellation fees). However,
my finding here challenges these existing SaaS contracts.
I suggest, instead, that under certain market conditions the
vendor should cooperate and help their users to have easy
exits. The contract should be designed in the way that the
vendor does not charge users high cancellation fees,
assures users to get their data back intact once they decide
to exit the contract, and cooperates and guarantees the
data transition done in days or hours. The increased
attractiveness of such a contract allows SaaS vendors to
draw users who otherwise might opt for the COTS
software, and finally increases the SaaS’ profitability.
To conclude, the future prosperity of the SaaS
business model requires both technological and
managerial efforts. As the technologies further advance,
and as the vendors improve their understandings of the
economics of the competitive market, we expect to see
more software delivered as a service.
References
[1] Cowley, S., “Salesforce.com Makes Platform Move with
AppExchange”, InfoWorld, Sep 2005
[2] Garner, R., “Software for Hire”, CRN, Nov 1, 2004
[3] Kaplan, J., “Sorting Through Software As A Service”,
Network World, Nov 21, 2005
[4] Kuchinskas, S., “Salesforce Finally Ships AppExchange”,
Ecommerce, Jan 17, 2006
[5] Lacy, S., “The On-Demand Software Scrum”, Business
Week, April 17, 2006
[6] Niccolai, J., “Gates Memo Puts Services at the Heart of
Microsoft”, Network World, Nov 2005