Chambers: Cisco needs to change software pricing model

Cisco Systems CEO John Chambers said this week that Cisco needs to change the way it charges for software bundled into its networking hardware, and contended that Cisco is probably not charging enough.

"We need to evolve our software strategy," he said. "We have a good value proposition because we [bundle] hardware, software and ASICs [Application Specific Integrated Circuits]. Do we charge as much as we should, or as much as we could? Probably not."

In comments to reporters at Cisco Networkers 2006 in Las Vegas, Chambers said Cisco should begin considering charging separately for some of the software now bundled into its hardware. He offered no details about specific plans or strategies, however.

In reaction, several customers at Networkers said they were surprised by Chambers comments and wanted more details. But some wondered whether Cisco's overall prices for what many already consider the most expensive networking gear and annual support services on the market would rise further.

"My skeptical side wonders if this is a way to raise prices. But on the other hand, I wonder if there is some opportunity here that I don't know about," said Robert Fort, director of IT at Virgin Entertainment Group in Los Angeles. Virgin Entertainment uses nearly 500 Voice over Internet Protocol (VoIP) phones and related gear in 15 retail stores and its headquarters. That hardware cost about US$1 million.

"We've done very well, but Cisco is the Cadillac of networking," Fort said, adding that he and Cisco customers sense that paying premium prices for equipment and services results in a lower total cost of ownership.

David Langford, vice president of technology at Smart City Holdings, a communications provider to convention centers, said he would oppose separate charges for Cisco's operating system software.

Having software bundled with hardware makes budgeting and accounting for networking projects easier, Langford said. "It depends on how they do it, but on the surface, I'm against it." In general, he said Cisco is "expensive, but worth it."

Chambers' comments came after a question from a reporter during a roundtable discussion. Chambers was asked initially whether Cisco charges too much for its products and services, given some critical comments from customers at the conference.

In response, Chambers said customers have benefited for years from increases in product performance, then added, "One thing we haven't done well [is] we haven't charged for software with ongoing fees."

Cisco currently bundles its proprietary operating system software, called IOS, on all its routers and switches and many other products, allowing customers to download upgrades for free, subject to participating in a variety of technical support services plans that customers pay for to cover replacement of broken hardware and services calls, said Zeus Kerravala, an analyst at Yankee Group.

Cisco also markets many other types of software for collaboration applications, for example, and for network and security management. Some of the applications are charged on an annual license basis, similar to the way a typical software company charges.

Chambers said Cisco lumps software into maintenance costs, which causes confusion, and argued that Cisco should show customers more precisely what they are paying for. "There will be some elements of our software strategy that will be bundled forever," he added. "There will be others that will evolve out and will allow customers to choose what they want or don't want."

He also said it is ironic that while half of Cisco's engineers design software, the company sells software as if it were hardware. "All the major software companies in the world charge major amounts for upgrades and regular things and customers don't even blink about that in terms of the upgrades," he said.

Kerravala contended that Cisco should charge separately for software, arguing that Cisco is "leaving money on the table." For some customers who have not carefully monitored software upgrades with IOS and are behind on upgrades, overall costs could go up. But at some large Cisco shops, costs could drop, he said.

Kerravala said one of his former employers paid for the most expensive annual services plan when it might not have needed to, in hopes of keeping up with all kinds of patches and upgrades to software as well as to have a quick response for a repair. In that case, the customer might not need so many services and could lower its costs by paying for software upgrades only. Kerravala said he could not comment on what the company is planning to do, but said Cisco had hired a pricing expert a year ago to help develop a software pricing strategy.

Wu Zhou, an analyst at IDC who studies services, speculated that Chambers may be pushing Cisco to become more of a software provider instead of a hardware provider, similar to how Cisco competitor Avaya recently created a new software-based pricing model. Such an approach makes sense for companies selling data and voice network convergence products because of the complexities in setting up VoIP and the reliance of such systems on software, she said.

Cisco's services business is a "very profitable" part of its overall business, even under the current structure of allowing customers to get software upgrades packaged with maintenance services, Zhou noted. Cisco has been able to leverage what it learns from one customer's problems to share with other customers, which has helped lower costs, she said.

Overall, Cisco services accounted for 16 percent of revenues in the third quarter of 2006, with the gross margin of profit on services for the quarter at nearly 68 percent, according to a Cisco spokeswoman. With revenues of US$7.3 billion for the third quarter, services accounted for more than US$1 billion in revenue.

Several Cisco customers said they try to lower or eliminate annual costs paid for maintenance services by buying spare IP telephones and other gear, rather than pay an expensive annual service fee on the gear. That way, they have equipment to substitute in the event of a failure.

David Siles, CTO at Kane County said he has in the past purchased spare Cisco routers rather than pay US$200,000 in annual services fees on the ones he already has. "They could do better on their services costs," he said.

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