Build vs Buy TCO: How to Calculate Total Cost of Ownership
This guide explains how to calculate the total cost of ownership (TCO) when deciding whether to build a software solution in-house or buy an off-the-shelf product. You’ll learn to identify all cost categories, assign realistic values, and compare the two options over a multi-year horizon. Before starting, gather your organization’s budget data, current staffing costs, and any vendor quotes you have.
What You’ll Need
- Vendor quotes or pricing pages for the buy option (license, subscription, support).
- Internal salary and overhead rates for developers, testers, and support staff.
- Infrastructure cost estimates (cloud, hardware, hosting) or your current per-server costs.
- An estimated time horizon (typically 3–5 years) for the comparison.
- A spreadsheet or calculator for summing costs.
Step-by-Step
- Define the scope and time horizon. Decide what the solution must do and how long you expect to use it. A common horizon is 3–5 years because that aligns with typical software lifecycles.
- List all cost categories for the build option. Include initial development (design, coding, testing), ongoing maintenance (bug fixes, updates), infrastructure (servers, cloud, storage), personnel (developers, project managers, support staff), and training for your team.
- List all cost categories for the buy option. Include license or subscription fees, implementation and integration costs, annual maintenance/support fees, hardware or infrastructure if required, and training for users.
- Assign monetary values to each cost. Use real quotes, salary averages, and infrastructure pricing. For internal labor, use fully loaded cost (salary + benefits + overhead). For example, a developer earning $80,000 might cost $110,000 fully loaded.
- Estimate recurring costs per year. For build: maintenance (often 15–25% of initial development cost annually), infrastructure scaling, and ongoing staff. For buy: annual maintenance (often 15–20% of license fee) and any subscription renewals.
- Calculate the total cost for each year. For each year in the horizon, sum the initial and recurring costs. For build, year 1 includes development; years 2+ include maintenance. For buy, year 1 includes license + implementation; years 2+ include maintenance.
- Sum the yearly totals to get TCO. Add up all years for each option. This gives you the total cost of ownership over the chosen horizon.
- Compare the two totals. The lower TCO is usually the financially better choice, but also consider qualitative factors like control, customization, and vendor lock-in.
- Run a sensitivity analysis. Adjust key assumptions (e.g., development time, maintenance percentage) to see how the TCO changes. This helps you understand the risk of each option.
Common Mistakes
- Omitting hidden costs. For build, forgetting ongoing security updates, documentation, or developer turnover. For buy, missing integration costs, data migration, or per-user fees.
- Using a too-short horizon. A 1-year view often makes buy look cheaper, but over 5 years build can be more cost-effective. Always use at least 3 years.
- Ignoring opportunity cost. The time your team spends building could be used on other projects. Factor in the value of that lost work.
- Not adjusting for inflation or discounting. Future costs are worth less today. Use a discount rate (e.g., 5–10%) to bring future costs to present value for a fair comparison.
- Using list prices without negotiation. Vendors often discount. Always use the actual negotiated price, not the sticker price.
Tips
- Create a spreadsheet with columns for each year. This makes it easy to adjust assumptions and see the impact.
- Use a “fully loaded� cost for internal staff. Include benefits, taxes, office space, and equipment. A common multiplier is 1.3–1.5× base salary.
- Include training and change management. Both build and buy require user training; don’t forget this cost.
- Consider the cost of capital. If you spend money now on build, that money can’t be used elsewhere. Discount future costs to reflect this.
- Document your assumptions. This helps you revisit the decision later and justify it to stakeholders.
Troubleshooting
If your TCO numbers seem unrealistic, check your cost estimates. Are you using fully loaded salaries? Did you include all infrastructure costs? Compare with industry benchmarks if possible.
If the buy option looks too cheap, verify that you included all per-user fees, overage charges, and mandatory support contracts. Some vendors charge extra for integrations, APIs, or premium support.
If the build option looks too expensive, you may be overestimating development time. Break the project into smaller phases and estimate each. Also consider using open-source components to reduce development cost.
If you’re unsure about the discount rate, use a range (e.g., 5% and 10%) and see if the conclusion changes. If it does, the decision is sensitive to that assumption—flag it for decision-makers.
Frequently Asked Questions
What is the typical maintenance cost for a build solution?
Maintenance typically runs 15–25% of the initial development cost per year. This covers bug fixes, updates, and minor enhancements.
How do I account for the cost of my own developers’ time?
Use their fully loaded cost (salary + benefits + overhead). Multiply the number of hours by the hourly rate. For example, a $100,000 salary with 1.4 multiplier gives $140,000 per year, or about $67 per hour for 2,080 hours.
Should I include the cost of migrating data?
Yes, data migration is a real cost for both build and buy. Include the time to extract, transform, and load data, plus any tools needed.
Is it better to build if we have a unique need?
Not necessarily. Sometimes a buy option can be customized. If the need is truly unique and core to your business, build may be justified, but only after a thorough TCO analysis.
How often should I re-evaluate the build vs buy decision?
Re-evaluate whenever there’s a major change—new vendor pricing, a significant internal project, or a change in business requirements. Also, review annually as part of budget planning.
What is the payback period for build vs buy?
The payback period is when the cumulative cost of build becomes less than buy. Calculate it by comparing the yearly totals. If build has higher upfront costs but lower recurring costs, the payback period is the year when the cumulative build cost falls below the cumulative buy cost.
Related
Method: the standard formula for this calculation, rounded as each result states. See how the calculators work or report an error.