The Truth about Cloud Economics

The Truth About Cloud Economics

BY DRUE REEVES AND DARYL PLUMMER

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

FROM HBR.ORG

9:48 AM | APRIL 13, 2012

[continued]

ABOUT THE

AUTHORS

Drue Reeves

is vice president

and research director at Gartner,

Inc., and

Daryl Plummer is

managing vice president and

Gartner Fellow, Gartner, Inc.

brought to you by

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.

THE TRUTH ABOUT CLOUD ECONOMICS | BY DRUE REEVES AND DARYL PLUMMER

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The PAYG model’s

flexibility lets

customers scale their

services up or down

based on their needs.

 

Interview with Atul Sood, Vice President for

Advanced Technologies, Wipro

We know that the cloud has been great for start-ups. But how are established enterprises

adopting the cloud?

To answer this question, let’s look back in time and reflect on a critical aspect related to high transaction

costs being one of the reasons for the existence of large organizations as postulated by Nobel Prize

winning economist, Coase. But when the transaction costs decrease or are removed, you would find

large organizations being under attack from smaller, nimbler and more agile start-ups. So, we begin to

see the rise of start-ups that set out to become bigger and better.

The established companies on the other hand made note, but they struggled because of the sunk costs

in IT systems which, once served them well, but proved to be an impediment to growth in a connected

world. On the other hand, business leaders within large organizations saw opportunities through the rise

of new-age technologies, but were held back due to locked-down set-ups, processes, and engagement

models that had been built by their company’s IT. In fact, the frustrated executive could not understand

why the IT team would take three months to help launch a new product , when it could be done easily

through the ‘always available’ IT systems through public cloud environment made available with the

swipe of a credit card. And, this healthy tension between business and IT began to change things within

the company. This pressure from the businesses and an understanding that IT needs to respond much

faster to the market; to the external environment; and service the customer in a much faster way

heralded the adoption of new-age technologies within large enterprises.

So, whether you are a start-up or an established company, the economics of cloud makes sense.

Technology has played a big role as a disintermediary of businesses and we have seen examples where

businesses have been totally redefined by new-age technologies like cloud.

How has the cloud helped companies preserve cash for a stronger balance sheet?

In a post-2008 world, companies have been holding onto cash and committing to new projects or to

asset refresh only after much deliberation. To give you a data point, the time for refresh for an IT asset

would run to three to five years in the late nineties. But after 2008, companies are holding on for five to

eight years to refresh. More importantly, start-ups are now formidable opponents who use Pay As You Go

(PAYG) IT from cloud service providers.

So what does it all mean? Businesses on one hand are under extreme pressure to innovate but they do

not want to go down the old route. They are looking at technologies like cloud where a business division

leader can swipe a credit card and get some of the best IT environments without up-front investment.

So, you have a ‘pay and consume’ based cloud model which is defined not only by technology and its

benefits, but also by the economics around it.

We now see complex workloads migrating to the cloud, as the cloud model is maturing even on the

pricing front. This feeds more innovation, and more specifically around industry solutions. So, today,

solutions for a bank could be different from a utilities company or an insurance provider. This in turn

allows solution providers to come up with unique business models that serve the needs of an industry.

For instance, in India, Telecom service providers, working with cloud providers, developed a model

for timely onboarding of customers as opposed to spending millions of dollars to set-up and run the

infrastructure. In the process, new partnerships were forged between the consumer and provider with

new business models. My sense is that we are heading to an age where the ‘art-of-possible’ will define

the intensity of partnerships.

What should companies do in order to take advantage of the cloud?

First, you have to look what is core and non-core to your company; and, not just in today’s context but

say five years from now. Why? Because, what companies define as core might be completely non-core

as we go along. Remember, we agreed that technology can be a great disintermediary. So, companies

need to re-evaluate their models to identify what they want to hold on to, from a competitive advantage

standpoint, and — leverage the forces of advanced technologies like social, cloud, mobility and analytics

to make their organizations more agile, more dynamic and more responsive. A key aspect here is

to look business process downwards to applications and then infrastructure. If you do not optimize

your business processes, there is a high probability that you would fall into what Robert Solow calls

productivity paradox. This is typical of a scenario where technology does not live up to its stated benefits

because archaic processes still define the usage of technology. Post this; you should cut over to an agile,

dynamic and infinite scalable IT. The icing — you consume on a PAYG model!

 

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