1 Introduction
The Information Technology (IT) industry has experienced immense growth in the last couple of decades. It has changed the working methods in almost all other sectors in the economy and achieved an increasing economic importance. The software industry is a critical sub set within this Information Technology industry.
The United States has been the world leader in the software industry since its inception. The United States is the largest single software market representing total revenues of $100.6 billion in 2010 accounting for more than 40% of global software market revenue of $265.4 billion in the same year (Datamonitor 2011). The largest software companies in the United States are Microsoft, IBM and Oracle. Together they form the top 3 software firms in the world and out of the Top100 software companies in the world, 63 companies are US based (Software Top100 2011). The U.S software firms dominate the worldwide software market such that sixty cents of every dollar spent on software worldwide goes to US-based companies (Holleyman 2011).
2 Background
Originated with the entrepreneurial computer software companies of the 1950s and 1960s, US software sector grew dramatically through the 1970s and 1980s with the rise of personal computer. By the 1990s, internet revolution, there was also an increased demand for large system integrators , which sought to offer more complete solutions to large corporations running large computers. Most successful firms developed specialized capabilities that enabled them to prosper within their sector and by the 21st century software industry has become a market force rivaling that of the computer hardware companies.
Software market consists of customized software and packaged software. Customized software, also known as Business software is designed or modified for a specific end-user like large public agencies or private businesses and frequently installed by the vendor, who may provide extensive pre and after sale technical support. Packaged software are shrink wrapped software products sold vua retail distribution channels. These are also known as Mass Market software with minimal additional technical support.
Softwares products are always delivered within the frame of consultancy. Despite the fact that "packaged software" products more closely resemble a good in their methods of distribution and reproduction Software is classified as a "business service" (Stienmueller 1995). Software companies provide “solutions” which involves some combination of custom developed software, packaged off the- shelf software bundled with hardware products. A sale will include consulting, systems design, systems integration, contract programming and maintenance. Note that, the Software sector includes only the firms whose core business is producing and selling software i.e, their revenue is derived from the selling of software products. Firms like Apple or Sony who develop software products for their own electronic products are not included in this sector. Also not included in this sector are the entertainment software and gaming firms like Electronic Arts or Zynga.
3 Industry Structure
There are several types of businesses within the software industry. According to Campbell- Kelly (2003), a software industry can be classified into three sub-sectors based on their business models:
- Software contractors/consultants
- Producers of customized software products
- Producers of the packaged software products
All the above sub-sectors are dominated by US companies. Within one sub-sector companies compete against each other; outside of these sub-sectors there is hardly any competition because of different markets and capabilities. Each of these sub-sectors has its own business characteristics.
Software contractors/consultants :
Software contractors provide customization, installation, integration and maintenance of other firms' products, along with consulting and other services. They compete on economies of scope, cost estimation and project management. Some of the key players are IBM corporation and Accenture.
Producers of customized software products :
Producers of customized or Business software products target large businesses in retail, banking, manufacturing industries and also various government agencies. They compete on economies of scale, corporate marketing skills and and after sales support. The lead US company in this sub-sectors is Oracle Corporation.
Producers of the packaged software products :
And the producers of packages software products compete on economies of scale, marketing capabilities, and user friendliness. Some of he key players in this sub-sector are Microsoft Corporation, Adobe Systems and Symantec.
Almost all software product firms eventually provide some services and drift towards the hybrid business model. It is easy for software firms to transition from the product business model to the hybrid one because they already have a client base to whom they can market.
3.1 Cost Characteristics
The software industry is a highly competitive industry characterized by rapid technological change and high degree of uncertainty. As the knowledge and skills become outdated quickly, it is absolutely necessary for the firms to employ the latest technologies in their products. As a result, software companies tend to spend huge amounts of money on research and development and equally huge amount marketing them. Business Software Alliance’s publicly traded member companies spent nearly $43 billion on R&D in 2008, equal to 7.1% of their collective revenues (BSA 2010). The Software product development is associated with high fixed cost, but very low marginal costs. Although the software industry's R&D costs and marketing costs are very high, its operating costs are relatively low as the software is reproducible at very low costs relative to the costs of its creation. By producing multiple copies of the same software product at a very low marginal costs, software product firms can gain an economy of scale that enables them to increase revenues without substantially increasing their costs, thereby becoming very profitable within a short period of time. This is one of the reasons why companies like Microsoft and Oracle have billions of dollars in revenue and market capitalization in a relatively short period.
Another peculiar characteristic of the software industry is that software must be supported,
maintained and upgraded. Software companies will typically sign a multi-year support contracts with
its customer to support and maintain the software which they sell. It is not common for the cost of
maintenance to exceed the cost of software, and can be as high as twice or three times the purchase
price over the life of the software. Software firms thus have an established client base who provide it
with a recurring revenue stream from maintenance fees, updates, customization and other services.
Support fees are largely profit, once the product is stable. Since the support revenue stream is based
on multi-year contracts it is a very stable source of income.
3.2 Demand characteristics
The software industry is cyclical, meaning that its earnings track both the ups and downs of the business cycle with their profits benefiting from economic upturns but suffer in a downturn (Sloman, Hinde & Garatt 2010). The software industry follows the business cycle closely because the sector primarily caters to large corporations. The investment decisions of the large firms are susceptible to the global economy,during economic downturn large companies will cut back on their Information Technology spending which software sector is part of. A lack of disposable income in households will also affect sales of personal computers which in turn affects packaged software sales.
The stock prices of the large software companies has followed the broader market index, like S&P 500. When the market was yielding steady returns between 2004 and 2007, the software companies also had a steady growth. During the 2008 recession period, prices in these companies dipped. As financial institutions are by far the largest customer segment for the software industry, the credit crisis impacted software companies. After the initial decline in 2008 and 2009, the software industry is back in the upward.
3.3 Competition
The entry and exit cost for a software company is low. In principle software can be developed in small room with just a personal computer. However it is very difficult for a start-up software company to compete against large and stable software giants. These established firms work in an oligopoly structure where significant barriers come from having already locked-in bulk of the market. For example, Oracle and SAP can be considered an oligopoly in business software segment, whereas Microsoft has a virtual monopoly in personal computer software segment. These large companies create barriers to entry by “Proprietary product technology” and “Locked-In Customers”.
Proprietary product technology :
The successfully software firms differentiate their products by using innovative
technologies and/or techniques. These know-hows are either hard to replicate or are protected
by Intellectual Property and patents secrecy. Patents have a significant effect on competition
as the larger software companies stockpile patents, both as revenue earners, and as a defense
against other companies offering similar technology.
Locked-In Customers:
It is very expensive and exponentially difficult for customers to switch from one software provider to another software provider. Switching costs’ are the psychological, physical, and economic costs that consumers face in switching between technologies (Hyun & Pae, 2005).These software switching can be so complex and time consuming that switching suppliers is virtually unthinkable. The large software companies with their established brand make it hard for competitors due to their economies of scale and ability to spend more on marketing, to attract and lock-in new customers on multi-year support contracts.