The Truth About Cloud Economics

The financial reasons for the huge growth of cloud services seem crystal clear: cloud computing simply allows us to pay for what we need only when we need it, right?

But the truth is, companies adopting cloud computing often miss the risk and depth of change needed to embrace a cloud economics model as they embrace cloud services. It turns out that the financial model for cloud computing has far more nuances for both a company and its cloud services provider than many people understand up front.

So what is the financial model for cloud computing? Let’s start by saying it’s a combination of how people make money in the cloud and the risks associated with adopting new payment styles. Many people assume it’s all about moving to a “pay-as-you-go” (PAYG) model and while this is certainly a big piece of it, it also involves operating versus capital expenses, subscriptions to services, and customers paying for outcomes (not technology). The good news is that these models are already familiar to most businesses.

Companies routinely spend money on items vital to the business. They also trade operating expenses for subscriptions and services necessary for business operations, but not directly related to the business. This includes those that would otherwise be too expensive to own and operate (think electricity). They expense nonessential items to someone else who specializes in offering these items as a service.

Cloud computing is no different. Why should a toy or cosmetics company own and operate multiple data centers? It’s much easier and economically sound to pay for a service for a short time period and then stop paying for it when you’re finished with it, rather than wasting money on something another company can do better, faster and cheaper. But this can present issues for both the consumer of the cloud service as well as the provider.

For companies, cloud computing’s new economic model stands in stark contrast to the traditional economic model of IT where we buy technology from a vendor as a capital investment and continue to invest in maintaining and servicing it over time. Traditionally, much of the money allocated to technology has been locked away in capital expense allocations used for buying physical goods. However, cloud services are just that, a service, and require reallocating money to operating expense budgets. This can be a big change when your company must still pay to maintain existing infrastructure. It may even mean that new lines of expenditure must be created if cloud services don’t replace existing services. (And you don’t need us to tell you how hard it is to create new lines of expenditure.)

The reward for this potentially painful transition to operating expense is that the business gains flexibility and the ability to buy the services they need when they need them. But if you’re a CFO, you’ll have to decide whether you like consistent or variable expenditures. Operating expenses can be difficult to predict and control because service subscriptions can come from anywhere at any time. Ask yourself if you have a predictable cloud requisition/governance strategy that makes future service acquisitions easy.

For cloud services providers, the PAYG model’s flexibility lets customers scale their services up or down based on their needs. If the consumer can easily add or subtract resources and pay for cloud services in small increments, the provider has no guarantee of future business. Therefore, to reduce this risk, the provider must dictate service terms and conditions in its favor. But here’s the problem: if the consumer assumes most of the risk, then he will never host a critical application with a cloud service provider. That would limit cloud computing’s market growth to the set of noncritical applications or to small-to-midsize businesses that would rather use cloud services than build a $500 million data center in the U.S.

On the other hand, if cloud providers assume all the risk, then in most cloud environments (with multiple consumers), the amount of liability within a provider’s service could be greater than the value of the company (which we all know is no way to run a business). And if the service provider cannot afford the insurance premiums necessary to cover the liability without raising prices to the level that the service becomes too expensive to consume…well, you get the picture.

So, to combat this kind of risk, cloud providers will enter into what are called “enterprise agreements,” where the two parties can define the parameters of the relationship based on mutual risk sharing. Essentially, this ensures that each party has a vested interest in the financial success of the other party. There’s risk, but there’s also reward for better service.

In the end, providers that deliver better service and better guarantees will ask for — and get — more money. Consumers, on the other hand, will get the flexibility of “pay-as-you-go.” As long as they can figure out a way to pay for it.

Source: HBR Blog