Total Cost of Ownership (TCO)

Computer hardware and software have associated direct and indirect costs. For example, when you purchase a network-attached disk drive, you have the direct costs of the hardware device, plus, possibly, a warranty. Before you purchased the device, you likely spent time researching the device, shopping, and finally placing your order, which then required a tax and shipping expense. After the device arrived, you spent time installing, configuring, and testing the device. Finally, the device was ready for use and began to consume power and generate heat. Admittedly, for the one disk drive in this case, the indirect cost may be small. The point is that you can establish a series of costs before the acquisition, at the time of the acquisition, and following the acquisition.

When you examine the economics of the cloud, you need to consider the total cost of ownership (TCO) of an on-premise solution compared to that of the cloud.

You should consider the following items when you calculate the total cost of ownership for various computers, hardware, network, and software solutions:

• Software (server, desktop, notebook, tablet, and mobile)

  • Prepurchase research

  • Actual software purchase or licensing

  • Installation

  • Training

  • Version and patch management

  • License management

  • Security considerations

  • Administration

• Hardware (server, desktop, notebook, tablet, and mobile)

  • Preacquisition research

  • Actual hardware purchase

  • Installation

  • Testing

  • Footprint and space

  • System downtime

  • Electricity and air conditioning

  • Insurance

  • Replacing failed components

  • Decommissioning, removal, and disposal of previous equipment

  • Cost related to scaling solutions to new demands

  • Equipment footprint and space

  • System maintenance

• Data storage

  • Preacquisition research

  • The actual device purchase

  • Installation

  • Testing

  • Security considerations

  • Backup operations

  • Data-storage footprint and space

  • Electricity and air conditioning

  • Maintenance

  • Failed component replacement

• Network equipment

  • Internet access (Internet service provider)

  • Preacquisition research

  • Actual component acquisition

  • Installation

  • Training

  • Security considerations

  • System down time

  • Maintenance

  • Administration

Economies of Scale

Economies of scale is a term used to describe the cost savings that a company may experience (up to a point) by expanding. Assume, for example, that a data center has two system administrators who oversee 100 servers. Each administrator is paid $50,000. The cost, on a per-server basis, for system administration becomes the following:

Assuming the servers are running similar operating systems, the two administrators may be able to oversee as many as 1000 servers. In that case, the cost on a per-server basis for administration becomes the following:

So, in this case, by scaling the number of servers, the company can bring down the per-server administrative costs. Further, the company may reduce its per-server software-licensing costs and other expenses due to the larger volume of servers.

Cloud-based data centers, because of their size, experience significant economies of scale. As cloud-based data centers come to supply computing resources, the savings cloud providers can offer due to their economies of scale are termed supply-side savings. Further, because many cloud-based providers use a multitenant approach, perhaps a SaaS solution that uses virtual servers or an IaaS data center that houses multiple clients, the providers gain efficiencies and cost reductions, part of which can be passed back to the customer.

As discussed, one of the largest costs within the data center is power. Because the larger data centers can combine power across multiple customers, the centers can purchase power at better rates than could a smaller data center.

Capital Expenditures

Capital expenditures (CAPEX) are large expenditures, normally for a plant, property, or large equipment. Companies make large capital expenditures to meet current or future growth demands. Because capital expenditures have value over a number of years, companies cannot expense the expenditures in full during the current year. Instead, using a process called expense capitalization, the company can deduct a portion of the expense over a specific number of years. Different asset types (buildings, vehicles, or computers) are capitalized over a different number of years, based on rules of the U.S. government’s Internal Revenue Service.

Traditionally, a company would have to make a large capital investment for a data-center facility, its computers, power supplies, air conditioning, and so on.

The cloud eliminates many company’s needs for a large data center and the corresponding capital expenditures. Instead, companies that utilize the cloud experience operational expenses.

Operational Expenses

Operational expenses (OPEX) are expenses that correspond to a company’s cost of operations. Within the data center, for example, the operating expenses include the following:

• Power and air conditioning

• Rent and facilities costs

• Equipment maintenance and repair

• Internet accessibility

• Software maintenance and administration

• Insurance

When a company migrates its IT solutions to the cloud, the company will have a fee for the cloud-based services they consume. However, because of the cloud-service provider’s economies of scale, the operational cost of using the cloud will likely be lower than those the company would have experienced within an on-premise data center.

Return on Investment

Return on investment (ROI) is a measure of the financial gain (or return) on an investment, such as a new piece of equipment. For example, assume that a company can repeatedly save $10,000 based on a $50,000 investment. The company’s first year ROI for the investment would become:

Assume that company can repeatedly save $7000 making a $25,000 investment. The company’s first year ROI on that investment would become:

The higher the return on investment, the better. Using an ROI in this way, a company can compare two or more investment opportunities.

Traditionally, before investing in a large data center, a company would determine the ROI on the investment. Because one typically does not have a large investment within cloud-based solutions (cloud solutions normally have monthly operational expenses), calculating the ROI for cloud-computing solutions can be difficult.

Some IT personnel will instead evaluate the benefits of the monthly cloud investment based on factors such as the following:

• Rapid scalability: Customers can make and implement scaling decisions quickly.

• Reduced total cost of ownership: By leveraging the cloud-service provider’s economies of scale, the customer’s total cost of ownership will normally be less.

• Improved business continuity and disaster recovery: The cloud becomes an operational insurance policy for fail-safe operations.

• Increased cost controls: Customers normally pay only for the resources they consume and may be able to align that increased resource consumption with increased revenues.

• Enhanced ability to right size: Companies can monitor system utilization and scale resource use up or down to best align resources with demand.

Profit Margins

A company’s profit margin, often simply called the margin, is a ratio of the company’s income to revenue:

Assume, for example, a company has $500,000 of revenue and the following expenses:Non-IT related expenses: $300,000IT data-center expenses:

To calculate the company’s income or profit, you simply subtract the expenses from the revenues:

Then you can calculate the company’s profit margin as follows:

Assume that by migrating its IT data center to the cloud, the company can reduce its IT expenses to $75,000. The company’s margin, in turn, would improve as follows:

One way to determine the benefit of moving to the cloud is to evaluate a company’s on-premise profit margins compared to the cloud-based profit margins.

Understanding Chargebacks

As you have learned, the cloud is based on a “pay as you go model,” meaning, companies pay for the resources they use. Depending on a company’s size, the company may receive a large bill monthly for the company’s cloud use. To better understand the cloud costs, many companies divide the costs across different business groups. For example, the company may allocate 30 percent of the costs to marketing, 20 percent to information technology, 30 percent to sales, and 20 percent to operations. Accountants often refer to such cost allocation as charge backs.