“Just follow the money.” This was the advice of the secret source Deep Throat to reporter Bob Woodward in the movie All the President’s Men. Following the money can be a way to reveal the complex relations and interactions between different parties, which in the case depicted in the movie lead to the uncovering of the Watergate scandal. In this particular chapter we will also follow the money and bring light to the relations and interactions around cloud. We will demonstrate that cloud computing will have a significant effect on the business model of all economic agents in the IT market. The pressure to change is caused mainly by the shift from assets to services and the change from a license model to a subscription model. The resulting emergence of a more transparent marketplace for IT services is also a factor.
As we will discuss in this chapter the effect of cloud will be felt throughout the industry, by all parties: hardware providers, software providers, service providers as well as internal IT departments. Cloud computing has increased the number of ways these agents can collaborate, interact and charge for IT.
In this chapter, we will start to discuss the major shifts cloud computing is bringing. Then we will cover the effect these shifts have on the flow of money and goods between economic agents in the IT-market. Finally we will describe what is changing for each of these economic agents.
Cloud computing has a significant impact on the way hardware, software and services are produced, distributed and consumed. These changes will be discussed below.
Traditionally hardware and software have been produced, distributed and consumed as assets. Making use of such assets required an (often large) upfront capital investment by the consumer. In the cloud era, services become available that could be consumed on a pay-as-you-go basis. Capital investments in assets are absorbed by the provider and billed to the consumer on the basis of real usage. From the consumer’s perspective, capital expenditure to acquire or develop assets is replaced by operating expenses associated with the use of services. The flip side of the coin is of course that the required capital expenditure shifts from the consumer to the provider.
Traditionally hardware has been bought or leased by organizations. Purchasing equipment is an investment that has a negative impact on the cash flow. Hardware is carried on the balance sheet as a long-term capital asset. Maintenance and depreciation costs are part of the income statement.
In the case of leased hardware, the investment is not taken upfront but as an operating expense. However, because a certain period for leasing has to be contractually agreed upfront, the implications remain the same as in the purchase scenario.
In the cloud era, hardware is no longer bought or leased but instead used as a service to which one can subscribe. The price paid depends on the number of times the service is actually provided. Because no upfront investment is necessary to make use of the service, hardware is no longer carried on the balance sheet and no depreciation is required (Schadler 2008). All costs become part of the income statement. Payments are simply made when the service is provided.
Software is treated exactly the same as hardware in the cloud era. Software is also something one can subscribe to and use as a service. The difference with hardware is the way software is acquired traditionally. Software can either be custom-built or bought based on licenses. A license grants a right to one party to use material owned by the other party, and the material in this case is software. Often the license is limited to a number of users and/or a time period. One needs to pay a fee for the license, which is a capital expenditure. When software is custom-built one normally needs to pay for the total development investment upfront, which would also be a capital expenditure.
While the license model is already quite attractive for providers, the subscription model is even more so. With the subscription model, the costs a user would incur for switching to an alternative service can quickly become prohibitive, creating an effective lock-in. In that way, the service provider not only gets a recurring fee but one that is likely to continue for a long time.
As a consequence of the shift from assets to services, a more transparent and liquid marketplace is emerging. It is transparent in the sense that consumers are able to compare services and prices of different vendors. It is a liquid marketplace because the total trading capacity (of all services) is more scalable and thus provides ways to utilize that capacity better. Sharing capacity drives up efficiency of asset usage among cloud providers in the system and so drives down cost for all. A more transparent and liquid marketplace at the end will mean benefits for the users of this marketplace (the cloud consumers) in terms of finding the right service at a competitive price.
Gartner’s model for IT cost allocation (shown in Figure 4.1) suggests an evolution of IT chargeback from simple cost-allocation schemes to negotiated pricing to market-based pricing. Another level of evolution will see chargeback, which once only operated at the lower layers of IT (like storage, servers and bandwidth), moving into higher layers and using composite metrics that include all layers of the service, including the application (for example the “pay per click” on SAP transactions).
Figure 4.1: Hierarchy for cost-allocation evolution
To some extent, the evolution towards the top of the pyramid will be driven by the desire of business to benchmark their internal IT relative to external service providers. Already today business executives can easily determine the cost of a transaction, the cost of an application service, or the cost of a gigabyte of storage through public cloud services. This market comparison will force IT to justify any price differences between the services they provide and comparable services that are publicly available. IT departments need to work hard to explain why the overall price for, say, a Windows server is 50% less per hour on Amazon Web Services than what internal IT costs. Internal “private” clouds will be particularly scrutinized by this continuous benchmarking against similar offerings from the public space. This will force private cloud providers to justify and quantify their added value in terms of security, compliance, service levels and support in comparison to the public marketplace.
Traditionally about 80% of the IT budget is consumed by running costs: costs to operate and maintain the current systems. This is the domain of IT, where business has little influence. IT normally charges these costs to the business on a lump sum basis, which is one of the reasons why the business perceives these costs as overhead.
The remaining 20% is spent on projects where new applications are built or package solutions are customized. Normally the business controls the build-costs and handles these as investments.
In the cloud era this will change. Software is used as a service, and once implemented, these services and the associated costs can be directly linked to the business users who asked for them. Depending on the number of business users or the number of transactions, for example, these business users can be charged directly for the use of the software. The costs for migration and implementation can be included in the usage price of a service. In this case all costs can be controlled by the business and the distinction between building and running costs becomes obscured.
The traditional flow of IT services and money is shown in Figure 4.2. The business user requests services that are delivered by a provider (in most cases, the internal IT department) and pays a lump sum cost for these services.
Internal IT contracts different providers and pays them for the software, hardware and services. These providers are paid based on time, material or licenses.
Figure 4.2: Traditional flow of services and money
Figure 4.3 shows all the different ways cloud can impact the flow of services and money. The dark boxes and arrows indicate the changes.
Figure 4.3: Flow of services and money in the cloud era
The main changes depicted in Figure 4.3 are:
| • | A cloud type of provider emerges. This is a new type of service provider that offers cloud-based services (which could be anything provided as a service) and is paid for the actual use of these services. |
| • | A broker role emerges. Cloud computing offers more and different opportunities to acquire services. The number of providers will increase as will the different characteristics of these services (for example, the application programming interfaces). These different kind of services have to be offered to business users in a coherent and integrated way. That is where a broker function is required. This role is sometimes also referred to as the demand function of IT. Chapter 5 will elaborate on this subject. |
| • | Business users will get managed services instead of a whole bunch of loose services. A managed service is a service that is delivered from a service catalogue and integrates different lower-level services into something that adds value for the business user. |
| • | Business users are charged by the broker per service instead of in a lump sum. Business users will see a more direct relationship between what they consume and what they pay. |
| • | The broker is charged per service instead of per time, per material or per license. |
| • | Internal IT as a provider is no longer the single point of contact for its business users. That role is taken over by the broker function. Internal IT, on the supply side, has become a supplier that has to compete with external providers. Internal IT has to deliver services and charge for the consumption of these services. One of the options for internal IT is to transform into a private cloud provider, delivering cloud services that are so critical for the organization that they cannot be outsourced. |
| • | A whole ecosystem of providers will emerge within an organizational context. For example, a SaaS provider is buying software and hardware from different providers to be able to offer a SaaS solution via a broker to business users. Different ways of acquiring goods and services will exist next to one another, resulting in different ways these goods and services will be charged. |
Overall, the cloud will increase the number of options for how to deploy and charge for IT. In order to hide this increasing complexity for business users, the broker function will become more and more important. Chapter 5 will discuss the new IT constitution in more depth.
In the whole stack of producers and consumers of IT services, the following parties can be identified:
| • | Business users who consume services. |
| • | Internal IT department, which produces and consumes services. |
| • | Incumbent service providers who sell consultancy, technology and/or outsourcing services. |
| • | Software providers who create software which is sold based on licenses. |
| • | Hardware providers who sell computer equipment. |
| • | Cloud providers who sell cloud services. |
How does cloud computing affect the way these different parties produce and consume hardware, software and services?
With the increasing competition between service providers offering different kinds of services under different conditions and prices, the business users have the golden opportunity to reap potential benefits like more agility, more flexibility, cost savings and an improved time-to-market.
David Linthicum, a well-known cloud computing and SOA expert, wrote a blog about the real value of cloud computing, which is right on the money. He identifies three core values: self improvement, agility and time to operations.
“Now that cloud computing is in the mega-hype stage there are continuous attempts to define the true value of cloud computing for enterprises and government. Most of the time we talk about capital expenses versus operating expenses, and sometimes the concept of agility, including the elastic nature of cloud computing. So how should you evaluate the value of cloud computing in the context of your enterprise? The truth of the matter is, there are no hard and fast formulas we can leverage to compute the exact dollar benefit of any new type of technology application, including cloud computing. However, there are many aspects of this new model to consider to help determine the real value of cloud computing:
Self improvement is the value of taking a new look at your existing IT solutions. One of the things that cloud computing forces you to do is to examine your existing IT architecture and determine what works and what does not. Then, create a plan to improve upon it as you relocate aspects of the existing architecture to the cloud. The value here is an improvement on the existing way things are done as you move from platform to platform. This value will be apparent no matter if you move to a cloud platform or not. We’ll see many who brag about how the new cloud computing deployment is such a success and a cost saver, when the core value is really around the improvement in the architecture and not the movement into the cloud. However, I’ll still count this as a true value of moving to the cloud.
Agility is the ability to change your IT solutions to better react to the needs of the business. The value of agility is nothing new; the degree of value will vary greatly from enterprise to enterprise. Cloud computing provides you with the ability to adjust solutions as the business or mission changes, allowing IT to scale up or down, and to do so in almost direct proportion to costs. Moreover, you can more quickly adjust by leveraging the cloud considering that purchasing hardware and software, as well as integration, has been factored out of the equation.
Time to operations is the ability to quickly get something up and running to meet the needs of the business. Related to agility, but not exactly the same, time to operations is the ability for IT to determine on Monday that we need additional storage to support a particular application, and they will have that storage system up and running in the cloud on Tuesday. Or, the ability to leverage Google App Engine to build an application to meet a business need, without having to wait for the hardware and software to be delivered and installed.
Finally, it’s the ability to leverage a SaaS player, such as Salesforce.com or others, rather than go through the pain and expense of implementing an on-premise enterprise software package, most of which are famous for taking more time and money than originally expected. Notice that I’ve yet to mention capital expenses or operational expenses, which are innate to the values described above. I assume that you focus on self improvement, agility, and time to operations as the core value of cloud computing. You’ll find that these factors serve you better in making a business case for cloud computing. They are the true values of the cloud.” (Linthicum 2010)
If done correctly, cloud computing will certainly generate benefits for the business users. This requires a well-balanced approach between the business user who will drive the change and the internal IT department who will act as the guide. The trap for the business users is that they want to order cloud services themselves. Cloud can be so appealing and easy at first glance that they might think they do not need the internal IT department anymore. The result is that the business user will end up in a mess: a bunch of services that are not integrated but cannot easily be discarded will cause the business to be locked into inefficient provisioning. In the end, the expected benefits are nullified. Like any other investment, the cloud can generate benefits but it also has its costs.
When creating a business case for cloud computing, the benefits and costs shown in Table 4.1 should be taken into consideration.
| Potential benefits of cloud computing | Potential costs of cloud computing |
|---|---|
| Improved agility: IT solutions respond faster to changing business needs | Migration costs: costs to migrate a current solution to a cloud service |
| Improved time-to-operations: : ready ability to quickly get something up and running to meet new business need | Switching costs: costs to switch from the chosen provider to another provider |
| Cost reduction: decrease in all types of costs associated with building and running internal IT | Integration costs: costs to make the cloud services work together with current business processes, applications, and infrastructure |
| Risk reduction: decrease in risks of running internal IT, such as business continuity | Implementation costs: costs to prepare employees for the change, embed the change and educate employees |
| Increased revenue: improved sales resulting from entering new markets or using new business models | Costs of increased risks: what are the costs associated with increased risks, such as data security? |
Table 4.1: Benefits and costs of cloud computing
Booz, Allen, Hamilton has conducted an economic analysis to investigate the potential savings of cloud computing for the US government. They concluded that, over a 13-year life cycle, the total cost of implementing and sustaining a cloud environment may be as much as two-thirds lower than maintaining a traditional, non-virtualized IT data centre. It should be noted that this requires a transition and implementation that will take several years (Alford and Morton 2010).
In any case, the business user is expected to drive the change: find business opportunities, engage the internal IT department and expect them to act as a business in providing services from a service catalogue, just like cloud providers.
As stated before, the internal IT department will increasingly be compared with external service providers like the cloud providers who sell hardware and software as a service priced per use. This is a threat for most internal IT departments, because they are often not yet able to offer services. And even when they are offering comparable services, they are not able to match the pricepoint of external providers. So the internal IT department is under pressure.
On the other hand, the internal IT department has a much deeper understanding of its business users, of the IT market and the organization’s hardware and software landscape than external providers. In addition, somebody in the organization has to look after integration, safeguard the corporate risks and try to achieve purchasing synergies.
The internal IT department is in the best position to deal with these threats and opportunities, and to buy, integrate and orchestrate services. The internal IT department effectively becomes an intermediary between the internal customer and all internal and external service providers.
As well as performing a broker function, most large internal IT departments will use cloud technology to provide their internal customers with private cloud services. The challenge for IT is to develop the right mix of internal and external capabilities in order to become a best-in-class service provider for their internal customers.
These providers traditionally have strong relationships with their clients. They can build on these relationships to help their customers implement cloud services. On the other hand, they can consume cloud services themselves and integrate these in their service offerings (for example, for development and testing). They can even act as a cloud broker between their customers and cloud providers. They know their clients and the IT market very well and, due to their large scale, are able to buy cloud services for the best price and resell or package these services to their clients. They can also offer managed access to different kinds of cloud services. This might be attractive for these clients who have neither the scale nor the capability to explore the IT market.
Because of cloud computing, service providers taking on the role of producer can now provide a larger set of services to their clients and gain a bigger share of the total expenditure by these clients. Of course they will meet with some pressure due to their business model, because these services will be delivered on a subscription basis instead of an hourly fee basis.
Incumbent service providers invest in cloud computing because they face a growing demand from their clients for help in adopting cloud computing and rolling it out across their organizations. Typical services they develop are cloud adoption roadmaps and cloud maturity models.
IBM, for example, developed a whole range of services based on the idea of a hybrid cloud, extending the enterprise perimeter to the cloud (Boulton 2010).
This is the area where a lot is happening. Traditional software providers are under extreme pressure to rethink their business model. The existing license model is rapidly being replaced by a subscription model. Another challenge for the traditional software providers is to change the level of granularity of their services. Their current software has often a very low level of granularity, too low to determine the match between the needed functionality for a given business process and the services. Most ERP-systems are still monolithic and far from being service-oriented.
The main ERP vendors SAP and Oracle, who sell their software through licenses, face strong competition from new players like Salesforce in the CRM area. Salesforce is providing CRM as a service via the subscription model.
Similar competition takes place in the market for generic applications like email and office software. Microsoft, relying on the license model, was and still is the dominant player in this market but is now facing competition from Google, who uses the subscription model. Google is now able to offer an email solution in the cloud for a fixed and relative low cost per user. Microsoft, realizing it has a lot to lose, has concluded that they must be able to offer their software via the subscription model, too. They now invest heavily in cloud. About 70% of their 40,000 developers are working on cloud developments either directly or indirectly. As Steve Balmer said: “for the cloud, we’re all in.” (Dubie 2010).
Traditionally, hardware is bought or leased by the internal IT department. In the cloud era hardware is either sold as a service or incorporated into other services, just like software.
Hardware providers like HP, IBM and Dell face competition from Amazon who offers infrastructure as a service through the cloud. In response the traditional market leaders will have to find ways to do exactly the same.
The fact that software is provided as a service implies that hardware providers will see an increased demand from cloud service providers. Microsoft, Google, Amazon, IBM and the like are buying a lot of hardware to build huge data centers to provide cloud services around the world. The internal IT department, on the contrary, will buy less hardware.
It is still unclear whether cloud computing will reduce the total capacity of computer hardware required worldwide. It is expected that cloud computing will increase the average utilization level dramatically. On the other hand, the availability of clouds will drive new ways of using computer capacity, such as for analytics, which could offset the gains from efficiency.
Companies like Amazon Web Services, Google and Salesforce are already providing cloud services on a pay-per-use fee—sometimes even for free.
Amazon Web Services (AWS) offers a highly standardized commodity platform via a subscription model. AWS was one of the first real cloud providers. The story goes that Amazon introduced their Elastic Compute Cloud (EC2) because they developed a highly available and scalable infrastructure for their retail business that was only in demand during the Christmas season, not for the rest of the year. By re-using this spare capacity for other purposes, Amazon was building on the same core capabilities they had to develop for their retail business. On the other hand, it was largely by coincidence that Amazon jumped into the cloud business. One of their lead developers, Chris Pinkham, got homesick and wanted to go back to his home in South Africa. Because Amazon didn’t want him to leave the company, they gave him the freedom to innovate. As a result, EC2 was born in 2006 (Higginbotham 2010). Cloud computing is just another business model for Amazon, but it is a fast-growing one. It is estimated that cloud services could generate about $650 million in sales for AWS in 2010.
Google is offering cloud services like Gmail, Google Apps and Picasa. These are geared to consumers and small- and medium-sized enterprises. Most of their services are free, at least for consumers. Because Google is able to attract a lot of people to their services they can attract a lot of advertisements. These advertisements are their main revenue stream. Google is also active in the market for large enterprises with cloud services like Google Apps (Bradshaw 2010).
Companies like Amazon, Google and Salesforce definitely set the pace. They are closely watched by all other service providers.
And new providers are entering the market by offering cloud services specific to certain communities, like government. In Chapter 8, we will discuss the role of government in the context of cloud computing and data.
The bottom line of this chapter is that cloud computing has a significant impact on IT economics. The way IT services are produced, distributed, consumed and charged will change dramatically. The subscription model where hardware and software is sold as a service is quite different from traditional models where licenses, hours and hardware components were sold. This again has an impact on the way the business users are charged by IT. Billing becomes much more transparent. The business gets insight into what it is paying for. This influences their buying behavior, and certainly has a positive influence on the business-IT relationship. At the end of the day, the overall benefits to business might be considerable!
For the IT parties involved, the question remains who will be ready to benefit and who will have a hard time to adjust. The internal IT department will face strong competition from cloud providers and has to rethink its role, most likely changing from a supplier of services to a broker of services. The incumbent service providers have a different opportunity: to help their customers with cloud computing. On the other hand the self service aspect of cloud computing will put some pressure on the demand for these providers. The software providers are under the largest pressure. They face strong competition from the cloud providers and are rethinking not just their pricing, but their entire business model. Some of these software providers will start to offer their solutions as a service, others may being too reluctant or slow to adapt and could lose marketshare dramatically. Finally hardware providers will see a change in their client base. Instead of the internal IT departments, providers of cloud services will become their prime customers, probably asking for different products that better fit the cloud datacenters.
In the next chapter we will discuss in more depth the changing role for the internal IT department.