As the title of this article is The Economics of Cloud Computing and we need to talk dollars and cents.

There are three ways to look at this. When I was a student at The Ohio State University, I learned an important lesson about money. There is the way that the business owners view it, the way that the economists view it, and the way that the accountants view it. The way the business owners see it is as cash in hand - finance. The economists view it as effect on the community - economics. The accountants have a big list of rules. They view it that way. You all know how accountants are.

A recent article in Open Source Magazine [1] - heavily quoted - points out some numbers realities, as shown here:

Purchase - on Premise

• $ 15,000 - Quad-Core Servers ( 5 x 3,000 each )
• $ 750 - 1/2 Rack + Gigabit Switch
• $ 15,750 - Total Hardware cost
• $ 5,800 = Annual amortized cost, 5% over 3 years
• $ 0 - Assuming no incremental real estate cost
• $ 2,000 - Annual power & AC cost
• $ 7,800 - Total annual cost on premise

Purchase - at Colo

• $ 8,000 - Colo fees; 1/2 Rack + power + bandwidth
• $ 5,800 - Annual amortized cost
• $ 13,800 - Total annual cost at Colo

Cloud

• $ 35,040 24x7x365 Amazon EC2
• ( $.80 per high CPU Server instance hour )
• $ 8,320 40 hours x 52 weeks
• $ 688 40 hours x 4.3 weeks

The conclusion is that cloud computing isn't always the best economic option, but it fails to take into consideration two very important things.

The first is the difference between operational and capital expenses, which makes a difference to the accountants.

The second is paying for someone to manage it, which is a dramatic oversight, and makes a difference to the business owners. The grid should look a lot more like this:

This is about the money. Hate to say it, I really hate to say it, but what is going to make cloud computing take off is the financial - the economic realities of hardware, staff, and power consumption. Each of our money wizards has a perspective on this, and we will take them one at a time.

How the Business Owners See It
The entrepreneur and the CEO have the same thing in mind most of the time: cash. Theirs is a world of finance not accounts, where cash on hand is the most important figure.

Upfront investment is one of the most important considerations, especially for the small business owner. The early pundits espoused the Internet as a way that David could slay Goliath because "on the Internet you can look as big as you want to be." But this isn't true, nor was it ever.

Even the most modest success story required pretty beefy server power. Once your big idea became even slightly successful, your company had to be prepared to pay the piper in terms of hosting bills or your own servers and bandwidth. The price for success on the Internet is high.

The large enterprise has the same problems with cash. Any application that a Nationwide or Chase Bank puts on the Internet is going to have an instant audience, and will have to have the server power to support it out of the gate. In addition, large organizations are lacking that entrepreneurial spark, so there is also the software development and integration costs to consider.

Scalability and Cloud Computing
While corporate environments have sophisticated server farms, and sometimes even a good virtualization strategy, they still have to be able to scale. Buying enough server hardware and licenses to support the most traffic a company like Nationwide will ever have is very expensive.

Cloud computing provides a solution for both of these company types. Because it's priced like a utility, the organization only has a cash layout for the initial use. This benefits the small company because until critical mass is reached, the costs are very low. The large company only has to pay for the usage for applications today - and tomorrow they can add more with only a marginal increase in cost.

All of this leads to an increase in cash on hand. This provides two very important pieces of the puzzle - the small companies can grow organically and the large companies can buy the small companies. And the cycle continues.

How the Bean Counters See It
Accountants tend not to care about cash - they see everything in terms of accrual accounts. The bucket that something goes in is at least as important as the amount that goes in. They view our little list of costs like this:

The reason for this is that capital investment is an Asset and everything else is an Expense. To tech companies Assets are a bad thing, unless they are intellectual property. In general, computers are a bad investment, and that is what technology companies buy.

A capital asset is something that provides worth to a company, such as a building. When you buy a building, it will help you earn money. Since it has a lifespan, you are expected to amortize the costs against your organization for the life of the asset. If the IRS says a building lasts 20 years, then you get the tax benefits of buying that building slowly, over those 20 years.

Computers are capital assets too, but they have a really short lifespan comparatively. Problem is, if you spend $40,000 on computers in year one and make zero money with them while you are starting up, you still don't even get to write off all of those computers on your taxes in year one.

By comparison, cloud services are considered a utility. Utilities are an Expense, and go in a whole different bucket. Expenses are not assets, and can be fully written off against your bottom line for the IRS. This means there is a significant tax savings associated with "renting" your computer time rather than buying it. That makes the accountants happy.

The Economics of the Situation
Economics can't always be boiled down to guns and butter. However, if the use of cloud computing does in fact reduce the cost of the upfront investment, then it has the effect of reducing the price of a product when demand is low, effectively making more of the product available when demand grows. Cloud computing has the effect of actually slightly changing the shape of the supply curve.

I barely remember my microeconomic theory and I nearly minored in the stuff. Let's refresh. The vertical axis is the price of a good and the horizontal axis is the quantity available. Usually goods are commodities, like guns or butter, but in this case we are talking about whatever computer services you are selling.

Inside the graph is a supply line, which shows that the cost, and thus price, increases when quantity produced increases. There is also a demand line, which displays the quantity that is likely to be purchased at a certain price. This number is lower when the price is higher.

Lowering the Supply Curve
Reducing the fixed cost has the effect of shifting the entire supply curve downward. This means that the company can stay in business longer, even selling a minimal quantity of the good. Reducing the upfront variable cost has the effect of reshaping the line, making the earlier part of the curve flatter. This has the effect of keeping the price lower, longer, driving more demand for the good, earlier.

Take Craigslist, which made early use of the cloud model. The low upfront costs allowed them to spend seed capital on other expenses, show better numbers to the stakeholders, and grow much faster. They made use of the reduced cost of doing business when the demand was low to scale faster as demand grew. Of course, as demand continued to grow, operational expenses drove the cost and thus the price higher, but the initial outlay of cash was lower because of publishing to the cloud.

This works for any entrepreneurial organization as well. If you are starting an application in your garage, you could host it at an ISP that is priced like a subscription, essentially adding a fixed cost to your project. Alternatively, you could get your own server, which is a tremendous upfront capital expense. The cloud gives you the opportunity to start paying for just what you use. If you don't use much, you aren't out much - it's a true variable cost.

Large companies can do much the same. If an application is being hosted in-house, some hours of a server administrator's time must be expended on keeping the environment afloat - applying patches, running tests, and fixing problems. In the cloud, this is taken care of for you. In addition, the project has less fixed cost, and more variable, so if it isn't successful you can mitigate your risk. Lower risk means that more projects can be tried, which is better for everyone.

Where does that leave us? Cloud computing requires less cash at the outset, lowering the barrier to entry for entrepreneurial firms. It has a significant tax benefit, reducing the number of capital assets that the organization must procure before providing the service. Finally, it lowers and flattens the supply curve, driving more demand earlier.

Implementing Cloud Computing
I feel guilty writing a technical article without any technical details. Let's take a few minutes and look at how cloud computing can be implemented in your organization.

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