Cloud Computing

Financial traits of cloud computing



In these days most of the companies are under tremendous pressure to reduce IT operation costs, wherever possible. IT budgets are traditionally targets for cost reduction initiatives. Chief Information Officers (CIOs) are facing more pressures to reduce the cost and struggling with legacy IT infrastructures that are expensive to maintain and to reduce the go-to-market time to rapidly evolving business requirements.

Chief executives are asking CIO “unfair” questions such as “Why does it cost so much for us to deploy a server when external/public cloud service providers offer us a virtual machine for 2 cents an hour?” As external service providers set new cost and agility benchmarks and renewed interest in outsourcing looms, internal IT departments are seeking a path to achieve similar gains.

On the other hand the businesses scenario of today are also  seeing far higher levels of volatility in their computing needs – one only need look at the relative growth of both Twitter and Facebook to see that a traditional approach towards physical hardware cannot hope to keep up with scaling demand. The pressure to innovate and deliver cost leadership has been further amplified by developments in technology and business process.

Technologies those have affected the IT industry; as profoundly as cloud computing is one of them. The traditional way of building an IT environment is time consuming and costly affair, involving many infrastructure demands and long deployment cycles to deliver workloads to business. Certainly, cloud computing is causing a major paradigm shift in the IT industry.

The Basics of Cloud Computing:

For more details on the basics of cloud computing and it's advantages - please follow my previously released blogs.

Cloud computing is mainly a service delivery model or approach for enabling convenient, on-demand access to a shared pool of configurable computing resources (e.g. networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or less administrative interaction.

As a layman, its one way to think of cloud computing is to consider your experience with email. Your Office 365 email, it takes care of housing all of the necessary hardware and software to support your personal email account. When you want to access your email you open your web browser and log in. The most important part of the equation is having internet access. Your email is not housed on your physical computer; you access it through an internet connection. As customers they do not need to own any infrastructure, thereby merely accessing or renting, they can forego capital expenditure; and consume resources as a service, paying for what they use. i.e. addressing the scalability for large scale applications.

Another example as a layman, when you create a document using word processing software, that document stays on the device you used to make it, unless you physically move it to somewhere. Office 365 is similar to how cloud computing works. Except instead of accessing just your email, you can choose what other relevant application or information you have access to within the cloud.  The cloud makes it possible for you to access your information from anywhere at any time. While a traditional computer setup requires you to be in the same location as your data storage device, the cloud takes away that step. The cloud removes the need for you to be in the same physical location as the hardware that stores your data. Your cloud provider can both own and house the necessary hardware and software to run your home or business applications with lesser cost and higher availability.

Financial Overview of Cloud Computing:

The important part of cloud's appeal is obviously financial; for CIO, cost management is not a piece of cake. The maintenance of legacy enterprise datacenter fascinate the majority of IT budgets and IT managers are looking for ways to create increased capacity and flexibility within their current computing facility and condensed hardware footprint; thereby lowering costs and increasing their return on assets (ROA). Infrastructure as a service that allows organizations to shed at least some of their expensive IT infrastructure and shift computing costs to more manageable operational expenses.

Lowering Total Cost of Ownership (TCO): 

It is often the financial metric used to estimate and compare direct and indirect costs of a product or a service. The basic cost model for cloud is you pay as you go, pay for what you use, pay less as you use more and grow bigger and pay even less when you reserve capacity. These are the important points to consider when calculating TCO of running cloud computing environment.

Companies dealing with reduced budgets everywhere, cloud computing is definitely the way to go when it comes to consolidating IT operations. It can help the company to reach both IT and financial goals. Thus, cloud computing enables to reduce server sprawl and lower total costs of ownership. The backed virtualization is making it fast, inexpensive and there are no upfront capital costs.Elasticity is here a game-changer because renting 1 machine for 1,000 hours will be nearly equivalent to renting 1,000 machines for 1 hour in the cloud. Today, the user would likely wait 1,000 hours or abandon the project. In the cloud, there is virtually no additional cost of choosing 1,000 machines and accelerating such processes. This will enable users and organizations to rapidly accomplish complex tasks that were previously prohibited by cost or time constraints. Being able to both scale up and scale down resource intensity nearly instantly enables a new class of experimentation and entrepreneurship.

Lowering Business Opportunity Cost:

Another cost consideration related to cloud computing, which is opportunity cost, that is, the fallout from loss of alternatives as a result of choosing one path or another. The economics of Cloud Computing is compelling organizations to move from traditional IT infrastructure to pay-as-you-go model. The opportunity costs that organizations pay to manage their own computing needs  is an important concept when discussing the economics of Cloud Computing because it allows one to assess the true cost of any potential action. The cloud allows costs to be delayed until the very moment resources are needed, may allow money to be invested in the short term with initiatives that have a greater return over the long term.

On the other hand, one might object the difficulty of quantifying the savings. When it comes to potential cost savings, there is a take on this matter that it is impossible to estimate exactly the financial impact that the adoption of cloud computing has on one’s organization. Because time is something hard to quantify in money, it might be a bit confusing to calculate, for example, the reduced costs of the fact that a process runs twice as fast.

Shift From CapEx to OpEx:

The cost differences often stem from capital and operating expenses like hardware and software, maintenance and support, and facilities -- all things that both users and operators understand. The source of these cost differences typically comes from the variations in base cost and economies of scale. Base cost differences in hardware and software are most often associated with volume buying. Meaning that a cloud provider that purchases a thousand servers is likely to get a better price than a retail buyer that purchases only a few. While a move away from CapEx is undoubtedly attractive to organizations, it is via TCO that the economic benefits of Cloud Computing become most clear.

Let’s take a very high level example - if there is a small organization running a 3-tier application deployed in premise and each tier is having a 2-node cluster for high availability and of course the web tier is under a load-balancer supported by basic network equipment. So the total cost of ownership (TCO) of owned assets is much higher for the complete in-house traditional IT environment. Whereas the same environment can have approximate 15% cost reduction in case of managed IT services and approximate 30% in case of pay-as-you-go cloud model adoption. Actually there are a lot of factors that go into defining what will be the percentage of cost reduction for managed IT services and cloud adoption but this calculation is just a specimen which we have seen in many small environments. These numbers are the figures based on our understanding so you may differ on these numbers because you will know your environment and business model better to derive the percentage of cost reduction. Of course the type of cloud adoption also matter, like private, pubic or hybrid.

Financial Considerations for Cloud:

OpEx gives flexibility to the organization to terminate its operating expenses at any point of time. These expenses during the year considers against the P & L account and do not impact the balance sheet. However in capital purchase, the server or software or any fixed asset being acquired with full capacity regardless of whether it is being fully utilized at the time of making investment. These cost reflects on balance sheet of the company. It requires upfront payment and its ongoing costs (by way of depreciation or financing costs) still need to be borne in income statement of the company. In other side with OpEx where, this is evident that long term investments are no longer required, payments can be deferred in steady mode. Although it is correct that organizations accepts a premium per unit for the flexibility to be able to suspend service.  

Elimination of capital expenditure will significantly lower the risk premium of projects, allowing for more experimentation. This both lowers the costs of starting an operation and lowers the cost of failure or exit – if an application no longer needs certain resources, they can be decommissioned with no further expense or write-off.

Converting CapEx into OpEx has an important influence on fixed and variable costs of the firm. Expanding an infrastructure is traditionally done through capital expenditures (CapEx) which comes with a three to five years depreciation cycle and a balance sheet impact. Expanding infrastructure through cloud model allows transforming the cost in an operational expenditure (OpEx), with no depreciation mechanism and hence no cost inertia if a service is decommissioned for example. By reducing its operating leverage, the proportion of fixed costs relative to variable costs, the firm is able to reduce its risk too.

This affects the firm’s weighted average cost of capital (WACC) but also the way to calculate the return on investment and the appropriateness of the project by calculating its Net Present Value (NPV). However, cash flows are affected by the methods of pricing that is used in cloud computing. The pay-as-you-go model used by the industry makes cash flows more volatile. Cash flows, particularly after tax cash flows, are important determinants of a firm’s future value and a measure of a firm’s financial ability to stay afloat and pay its credit holders. The firms by moving from a CapEx to an OpEx model has to switch its strategy and focus most on the management of operational expenses rather than its balance sheet. This is a great shift in management and firm’s strategies.

Cloud computing holds the promise of not only providing attractive cost savings and financial gains at the enterprise level but also may contribute to the larger societal objectives of energy efficiency and environmental protection and sustainable development. Still many CIOs remain skeptical around attainable ROI, tracing to a number of factors.  Looking the past they still recall the longer than expected payouts from earlier major CRM and ERP investments.

Contributed By: 
Dr. Amarendra Kumar

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  1. Lloydaddib
    13/01/2018 06:04 AM

    I like everything you post. You've done really good job.

  2. Williamasync
    13/01/2018 03:27 AM

    I like this post on cloud finance aspects. thanks...

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