Overview: Understanding the software industry cost structure

Software industry cost structure

In the software industry, although competition prevails, many companies offer niche products and services. As a result, they don’t compete with each other directly. For example:

• SAP AG (SAP) develops databases and business software
• Oracle (ORCL) supplies software for enterprise information management
• Salesforce.com (CRM) provides CRM software on demand
• Redhat (RHT) develops and provides open source software and  services
• Symantec Corp. (SYMC) provides security, storage, and systems management solutions

The companies still have one thing in common. The majority of their operating expenditure consists of research and development (or R&D) costs and marketing spending. With the emergence and adoption of cloud computing and open source software, companies are finding it very difficult to maintain high margins, which were once associated with the industry. Every year, software companies revise their R&D spending budget in order to keep up with the competition and innovate new products and technologies.

Symantec leads in R&D investment

The previous chart shows how much leading players have spent in marketing and R&D in 2013. Symantec seems to make huge investments in R&D compared to its peers. In regards to marketing spending, the company is way ahead of the market leader—Microsoft (MSFT). Compared to its peers, IBM has low allocation for R&D as well as marketing expenditure. It’s the only company among the leading players that spent more on R&D than marketing activities.

High R&D and marketing expenses impact industry’s cost structure 

Let’s understand how this all fits in the cost structure of “software companies,” whose major operating expenses include R&D costs, sales and marketing activities, and support costs.

R&D costs typically form 10%–20% of the revenues for software companies. However, not all of this goes into innovation. A large portion of it’s spent in testing various configurations of operating systems (or OS) instead of developing new functionality. Industry experts think that even less than 5% of R&D budget is spent on innovation. This expenditure gives an insight into the revenues expected in future. It hints at the company’s market share and profitability.

Sales and marketing costs

Due to increased competition, companies have huge marketing expenditure, which even surpasses R&D spending most of the time. This expense category contributes the most to operating expenditure of software companies. It varies depending on the product or services that a company is engaged in. On average, companies spend 15%–25% of their revenues in sales and marketing activities. However, there are exceptions like Symantec (SYMC) which has consistently spent ~40% of its revenues in sales and marketing.

Support costs include the costs associated with the help desk and customer support. They’re responsible for handling customer queries and directing them in how to set up and operate the application.

By investing more in R&D and marketing, companies aim to differentiate their products that are hard to replicate or protected by intellectual property rights or patents. Patents serves as armor for the software companies. Small companies and start-ups find the patents hard to penetrate.

Establishing a strong customer base makes switching costs very high and adds to the challenges of start-ups. Also, because the market is highly concentrated, it contributes significantly to creating strong barriers to entry. As a result, patents, high switching costs, and the concentration of the software market create significant barriers.