A common theme in cloud based service is “per user” pricing. A service to provide a VPN authentication service like Pertino looks quite attractive at USD$10 per user.
Most engineers will intuitively know that “per user” pricing is always more expensive than “own it yourself” solution but it can be hard to justify.
For the “own it yourself” solution, the solution pricing is usually know. You will need to create a project that purchases the solution and deploys the product. This cost is usually capitalised by your company since it is an asset to the business and will be depreciated over some time, usually 3 to 5 years. ( The depreciation is a tax loss in most countries).
Once the solution is deployed it will require hardware / software maintenance over the lifetime and some cost for human infrastructure to perform that maintenance. Lets add this to a chart:
The negative part of using a Private Infrastructure is that the full CapEx value must be found to fund the purchase. When you are struggling to get a project funded, using a cloud service that offers a per user pricing. becomes compelling. What also makes sense is that Cloud Solution will get more expensive over time or when it exceeds certain thresholds.
Typically, this cost maps onto a chart like the following.
Note: Cloud services get cheaper in volume so graph value ramps over slightly to reflect the non-linear per user pricing. In my experience, a cloud service is always more expensive than a private solution at some point in the scaling process i.e. per user pricing always works well for small companies and less well for bigger companies.
To compare the monthly cost versus a capitalised solution needs a bit more accounting mathematics which I want to explore.
Depreciation Value or Deriving Yearly Cost
One way to compare a cloud solution is to consider the depreciation value of project cost. For example, assume that project needs $100K as a capital project, then you could make a broad assumption that the straight line depreciation value is an approximation of the monthly cost. Lets also assume (accounting requires a lot of guesswork), that the asset will still have a book value of 15% after three years. Residual value typically means it can be sold for spare parts, second-hand or still have some other value to the business that represents a capital asset.
As we can see, a $250000 asset has a yearly cost of about $70K per annum assuming a 15% residual value and depreciation over 3 years. 3 years is fairly typical for IT Infrastructure but networking equipment is often 5 years because switches & routers are often not replaced or upgraded in less than 5 year periods (which upsets me).
The conclusion is that a cloud service for $70K per annum would be reasonable consideration if you have a project cost of $250K.
When calculating the total cost of the private solution, make sure that you include the following costs:
- capital costs of project assets
- professional services and deployment
- cost of data centre resources such as power, space, cabling
- yearly vendor maintenance fees
- internal operational costs i.e. upgrades, logging, network monitoring, design reviews, etc
Of course, if you want an unfair comparison then don’t include them at all or adjust the residual to zero.
Now, lets use some accounting
guesswork to work out the respective values of project budgets as a service cost and vice versa.
Net Present Value
The reverse calculation is to take the cost of the cloud service and determine a budget value for a project. I use a Net Present Value calculation to get a rough estimate.
Net Present Value (NPV) takes the multi-year cost of a service and calculates the one-off project value based on the lost interest of the capital purchase. For example, lets say you want to buy a new MacBook for $3000 and the payments are $1000 per year. You could make the first payment, then put the other $2000 in the bank and earn interest (opportunity). So a cash up front payment is cheaper instead of the yearly payment but what is the cash value when compared to the value over time.
Now lets consider that a cloud service is charging $ 10 per user on their web page. For 500 users at $10 per month, over a three-year period at 5% average interest rate:
Obviously, this assumes that the price of the of cloud service will remain constant over time. This is unlikely. The cost of goods will always rise over time unless there are market pressures to reduce the price. Cloud services are
- a growing marketplace and are more likely to increase in cost in the next 5 years. Growing markets grow in price.
- Cloud services will increase in value and features over time and expect to charge more to fund those investments.
- Cloud services are often discounted due to early stage venture capital funding that accepts low returns or negative profits in early growth stages
- Most early stage startups have not solved issues of scale or support and prices rise as their business models become more complex when a customer base is retained.
- Or whatever you think. Decrease it if you like but there is very few things in this world that gets cheaper over time. My 0.02c worth.
Lets assume (remember, guessing in accounting is very important), that prices rise at 10% per annum.
So a cloud service priced at $10/user for 500 users would be equivalent to project budget of about $180K.
Note: This assumes that there is NO residual value in the assets. Assuming (that’s guessing in accounting again) you would normally accept a 15% residual value, then add 15% to the right hand column.
See, now you can afford the extra memory modules and software licensing.
The EtherealMind View
It doesn’t take much to learn some accounting basics. I’m fairly sure that I’ve missed quite a bit of nuance in the accounting numbers as there are many different ways to “guess” in accounting. There are also other ways to handle depreciation and present value but I’ve chosen simple and practical options to demonstrate the basic ideas.
Hopefully you have some insight into comparing rental costs vs capital costs. And you can get some approximate results on where the project costs and rental costs of a cloud service cross on the graph.
I’d be interested in content that demonstrates the accounting process in more detail, so please leave comments below.
I have nothing to disclose in this article. My full disclosure statement is here