Cloud Accounting Software: Justifying the ROI

July 25th, 2013 by

Cloud accounting software is quickly attracting the attention of firms searching for new accounting software or ERP software. While Cloud accounting software hasn’t reached 50% market share, most people see that happening within the next few years. Does this mean firms must include Cloud accounting software products when evaluating their options? No, but the prudent CFO or IT manager (actually both need to agree) should at least consider the possibility.

Cloud Accounting SoftwareRegardless of which deployment option is selected (Cloud accounting software or on-premise accounting software), the software selection process is the same and must follow a step-by-step approach. Actually you might want to utilize The Accounting Library, our software selection tool to identify best suited products that might be of interest. You can utilize four different approaches, but maybe all you want to do is identify Cloud accounting software products. That’s one of our supported methodologies.

The decision process steps below represent a brief review of the tasks that need to be accomplished to ensure project success when you are searching for Cloud accounting software. Since the objective of this article isn’t understanding the software selection process in detail, we are just going to list many of the most important steps and discuss them in a other articles.

Remember, our objective is understanding how to compare the cost of Cloud accounting software against the cost of an on-premise system.

  • Build a consensus that accounting/ERP software options need to be explored.
  • Appoint Project Manager
  • Appoint software selection champions
  • Acquire software selection knowledge
  • Identify typical opportunities for improvement
  • Understand deployment options (Cloud, Hosted, On-Premise)
  • Appoint selection committee
  • Identify initial list of potential software products.
  • Identify and broadly assess local ERP/accounting software providers
  • Identify specific opportunities for accounting software or ERP software improvement
  • Sell the project
  • Identify, assess and reduce the impact of potential impediments to project success
  • Justify the investment
  • Obtain buy-in and support
  • Organize your firm for success
  • Define functional requirements
  • Define Business Intelligence (BI) requirements
  • Define business management requirements (e.g. Exception Management and Performance Metrics)
  • Evaluate and eliminate unsuited products
  • Evaluate products face-to-face
  • Identify and compare product strengths and weaknesses
  • Calculate ROI
  • Conduct final product evaluation
  • Make final purchase decision

Justify the Investment / Calculate Project ROI

Notice in the accounting software selection checklist above that I have suggested that you should calculate an ROI twice. If you are evaluating Cloud accounting software or on-premise software options, you do need to evaluate the cost/return twice. It makes no sense to invest hundreds of hours (if not more) in this project, only to discover that the cost/benefit ratio is unacceptable.

If you are interested in replacing your current business management software, you need to research product options (including Cloud accounting software), define the expected benefits and estimate the total cost of the project. This is just a preliminary step to make sure the project has merit.

Once you have justified the potential investment and expected benefits, you can move forward into a much more detailed analysis of your firm. This analysis will cover all of the bases: business processes that need to be improved, required business management software functionality, Business Intelligence and Cloud accounting software requirements.

Once you have completed your requirements analysis and have identified several best suited products, you will need to create some rational method of determining which products yield the best return. That’s where it gets a bit complicated.

On-premise accounting software loads costs on the front end, particularly software cost and implementation. Cloud accounting software spreads the cost out over a number of years. Obviously the allure of Cloud accounting software is this absence of front cost loading. Companies that know they need to upgrade their business management software, but are cash strapped find this option to be quite attractive.

Cost / Benefit of Cloud Accounting Software

The fact that the cost of Cloud accounting software isn’t front loaded doesn’t necessarily mean that it’s the best investment in all cases. As we all know leasing any high value equipment is more expensive over an extended time period, at least in terms of total cash flow.

Leasing software is no different. Cloud accounting software isn’t front loaded, but the total cash outflow over an extended time period may be greater than an on-premise equivalent. That’s why you need to calculate the total cost of each option (on-premise vs. Cloud accounting software) and recognize the timing of the cash outflow.

Before we discuss how you can compare these two options (basically creating an analysis that allows you to compare apples to apples), recognize the fact that Cloud accounting software offers several non-monetary benefits that might play a significant role in the final product evaluation.

  • Updating tax tables and other regulatory tables is eliminated
  • Product updates are handled by the vendor
  • Network maintenance and updates is easier
  • Anywhere / anytime access

Obviously the most attractive benefit of Cloud accounting software is the concept of anywhere / anytime access. Keep in mind the fact that there are several types of Cloud accounting software and on-premise deployment can actually be farmed out to third parties (hopefully they are experts in the products they support).

Many Cloud accounting products do indeed offer a very wide choice of accounting software functionality, but they cannot be everything to every firm. That’s why there are “private clouds” that offer a true cloud experience, but firm specific functionality. As is the case for on-premise accounting software, there are hundreds of third party products that provide functionality that you might need.

Comparing the Cost of Cloud Accounting Software

If you are evaluating on-premise accounting software as well as Cloud accounting software, and presuming that both options give you the exact same level of functionality and reporting (BI), how can you calculate an accurate cost and ROI that takes into consideration when the costs are incurred? This comparison will not be valid unless the functionality of each option is the same.

The concept of Net Present Value gives you the tool you need to calculate the cost for each option. The cash outflow for an on-premise accounting software product will be front loaded, particularly the cost of the software itself as well implementation. The cost of Cloud accounting software will be more evenly spread over a number of years, but will tend to be more expensive in future years. Using Net Present Value will enable you to calculate what each option will cost (and return) in today’s dollars.

Net Present Value = St=1..n  A/ (1+r)t

Where

A = Cash flow in the applicable year

r = Required rate of return

t = Year of cash flow

n = Applicable year

This equation seems complex, but it’s really quite straightforward. Take the cash flow in each year and discount it to reflect when the cash flow took place. A typical use of Net Present Value (NPV) is comparing the cost (and return) for two different projects. Normally these are two entirely different projects and the objective is determining which project makes better economic sense. You could argue the point that Cloud accounting software and on-premise accounting software are two different projects and you would be correct.

Example

Year 1 NPV:   A / (1 + r)1

Year 2 NPV:   A / (1 + r)2

Year 3 NPV:   A / (1 + r)3

Year 4 NPV:   A / (1 + r)4

Year 5 NPV:   A / (1 + r)5

Total                Net Present Value for the project (over the first five years)

  • This example uses a time frame of five years and that should be the minimum time frame for calculating the Net Present Value for a Cloud accounting software project. Actually the time period selected should be dependent on the “shape” of the cash flows for both projects. If there is a substantial benefit or cost in year six or seven of any project (including Cloud accounting software), then the time frame should be extended. Since an on-premise accounting software project is significantly front loaded, the selection of an appropriate time frame should be based on when the on-premise accounting software product might require a significant new investment. Certainly a minimum time frame for the Cloud accounting software ROI comparison should be five years.
  • N (applicable year) is just a notation and has no effect on the calculation.
  • R (required rate of return) has no significant effect as both projects are going to occur at the same time. Since the minimum rate of return for any business investment could be 5% or more, just select a reasonable rate of return that will be used for both calculations (Cloud accounting software or on-premise accounting software.
  • If you are interested, Wikipedia and Accounting for Management explain the concept of Net Present Value in more detail, particularly Wikipedia.

Include Costs and Benefits

While the comparison of an Cloud accounting software project against an equivalent on-premise accounting software project will depend for the most part on the software related costs for each option, please do not forget to examine other costs as well as benefits that might be received in different time periods.

Any accounting software selection project (Cloud or on-premise) must generate monetary benefits. Otherwise it is not a viable project. Either the project will enable employees to be more efficient or help them become more effective. The cash flow resulting in increases or decreases in balance sheet items should also be considered. As an example an Cloud accounting software project will help you reduce inventory or reduce Days Sales Outstanding (AR).

In any case you need to specify precisely every expected benefit, justify that benefit and for Net Present Value calculations define when those benefits will be received. If the benefits are going to be received in the same time period, then you don’t need to include them in the analysis.

If the benefits are going to be received in different time periods, even six months apart, then this difference needs to be recognized (e.g. 50% in year 1 and 50% in year 2). If as an example IT costs will be reduced in a Cloud accounting software scenario, then those benefits must be included in the analysis.

Since you should have analyzed every cost reduction or monetary benefit as an integral part of your analysis long before this, I would suggest that you create a spreadsheet table and list every single cost (software cost or monthly fee for Cloud accounting software) or monetary benefit within the time frame you have selected. It doesn’t really matter if the costs are identical; include them in the spreadsheet.

As I indicated above, pay close attention to the timing of the cost or benefit and place it into the appropriate year (or split it between years). Although the Cloud accounting software product should provide the same functionality as the on-premise accounting software project, it might not or vice versa. If as a result there should be a difference in monetary benefits, those cost or benefit items should be adjusted accordingly.

Final Net Present Value Analysis

Once you have identified each cost and benefit item and recorded them in a spreadsheet, create a second spreadsheet like the example below. This analysis does not have to identify each cost or benefit separately; just the total value and when the cost or benefit is to be recognized.

Once you have determined the Total Cash Flow for each time period as in the table below, apply the appropriate Net Present Value calculation to the Total Cash Flow.

If you do this analysis correctly, the benefits should outweigh the costs. Rather than working with negative numbers, the benefits should be recorded as positive numbers and the costs as negative numbers. If you are just recording benefits that are different, then the opposite numbering should be used.

The objective in either circumstance is determining a Total Net Present Value for each option over the time period you select.

As an example if The Total Cash Flow for Year 2 is $15,000 and you have selected 12% as the rate of return, the Net Present Value will be $11,957.

Year 2 = A / (1 + r)2 or $15,000 / (1 + .12)2.

Calculate the Total Net Present Value for each alternative (Cloud accounting software or on-premise accounting software) and compare the two.

Cloud Accounting Software

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Software Costs

Other Costs

Total Costs

Benefits

Total Cash Flow

NPV

On-Premise Accounting Software

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Software Costs

Other Costs

Total Costs

Benefits

Total Cash Flow

NPV

Summary

Cloud accounting software is becoming a major force in this industry. Make no mistake about this. For many small to medium sized firms the cost timing is alluring, but I think many of these firms are concerned about IT issues. IT costs are certainly something that might cause concern, but I think its more lack of IT expertise that is the bigger issue. Small to mid-sized firms want to concentrate in what they do best (actually that’s a mantra common to even larger firms) and IT is not their field of expertise.

Cloud accounting software is going to become more and more important, but in the meantime on-premise accounting software is still the market leader. If you want to consider Cloud accounting software, you should. It has a significant number of benefits.

However, this is still an investment whose ROI needs to be justified. Actually this analysis would also apply if you are evaluating two Cloud accounting software products or two on-premise accounting software products. You need to calculate an overall ROI and you need to recognize that both benefits and costs will be spread over time.

 

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