Economics for cloud service providers
Evolution of the IT business model
An organization’s IT costs are manyfold, which include expenses for hardware and software, as well as expenses for support and management. Typically, these costs fall into two categories:
- Capital expenditure (CapEx): The initial investment for a particular IT service or solution. For example, when an organization decides to implement a software solution to address a particular need, say, enterprise resource planning (ERP), CapEx would include all physical hardware and software purchases. CapEx investments are for the lifetime of the long-lived solution. CapEx is an upfront expense, which is either paid as a lump sum or financed with extra charges.
- Operational expenditure (OpEx): The recurring costs incurred while operating a particular system. For the ERP case, that would include utility fees (such as power and cooling) to keep the infrastructure running, space leases if the facility is rented, personnel costs to support the system, and software support and license fees. OpEx is typically a monthly recurring charge.
The business model for IT software has evolved over the years into the following forms:
- Traditional model: An organization purchases licensed software, which it then owns and maintains.
- Open-source model: Software is essentially free, but the organization pays vendor support costs.
- Outsourcing model: An organization hires another company, possibly overseas, to manage and maintain the software.
- Hybrid model: A software vendor sells highly standardized software to many clients, along with software management and support, thereby amortizing costs of expertise, software management, and support over several clients.
- Cloud computing model: Software is developed and delivered over the internet to many clients at lower costs.
The following video discusses the evolution of these models with examples:
Reduce capital expenditure
Organizations choose to reduce their capital expenditure so that they limit the commitment of large investments for long-lived IT resources. Shifting expenses away from capital expenditure into operational expenditure enables organizations to stretch their IT budgets and limit upfront costs. Specifically, organizations opt to make investments that have a bigger return on investment in the short term rather than investing in long-lived, depreciating IT resources. Operating expenses are pay-as-you-go, meaning organizations pay by the month and get value every month. With cloud computing, they can simply rent the resources and incur little to no capital expenditure.
The cloud computing paradigm offers a transition of the IT business model from CapEx to OpEx. CapEx in IT systems is a long-term investment that freezes a large sum of money into a single investment. OpEx, on the other hand, is a recurring expense that could enable the company to utilize the funds in other profit-yielding investments.