Cloud costs within corporate finance

2 November 2012

Although the cloud is here to stay, a more streamlined approach to cloud computing will rely on efficient IT spend. So how should organisations approach the cloud at the highest levels within IT and corporate finance? Gartner research vice-president Kurt Potter outlines the economic and financial challenges of cloud computing from a ‘finance-out’ perspective.

Cloud computing is radically changing how IT organisations manage IT spend and staff. Economically, cloud computing is a direct response to an IT marketplace addicted to 'speed and quality' that needs a shift to 'cost and business' value. Because expectations of IT services have not been managed, there's a gap between internal client expectations for service levels and the ability of enterprises to pay for them.

For 2011, the global market forecast for public cloud is estimated at $89bn, with a five-year CAGR of 19%. Compared with a forecast of $2.6trn for all IT marketplaces in 2011, cloud represents only 3.5% of the IT marketplace and is expected to reach 9% in 2015.

"For 2011, the global market forecast for public cloud is estimated at $89bn, with a five-year CAGR of 19%."

Before the recent economic downturn, cloud computing was a solution looking for a problem. Now it is a set of IT services that can help IT leaders reach new IT spending targets. At face value, few IT leaders would be concerned (from an opportunity or threat perspective) about a percentage as low as 3.5%, but public cloud computing has a deeper significance. As a suitable substitute for some internal IT services, public cloud computing puts pressure on the entire IT cost structure to perform better from an efficiency perspective, even if there are differences in service levels.

As the value of everything changes over time, many business leaders are willing to trade higher service levels for the lower cost that cloud computing promises. Many enterprises can no longer afford the luxury service levels delivered by traditional IT organisations. Given a price comparison, some will tend toward cloud computing. Without the appropriate controls provided by better IT financial management and IT cost transparency, cloud computing will be in direct competition with traditional IT organisations for funding.

Cost-cutting vs increasing IT spend

The long-term economics and historical financial results of innovation and value-chain collapse dictate market conditions whereby the cost benefits from cloud computing may be offset by higher consumption, which will include mostly waste.

"When moving like-for-like to the cloud, enterprises and IT organisations often spend more."

With all the hype surrounding the benefits of cloud computing, it's difficult to forecast that anything other than a reduction in global IT spending or IT outsourcing (ITO) will occur; however, many enterprises have seen instances where the IT organisation ends up spending more on a technology or product once it becomes commodity-like and its per-unit cost falls significantly.

When it is less expensive, IT and business users consume more. So many IT organisations will end up spending more in certain service and product categories when they become available in the cloud. Even though some of this consumption will map to higher revenue growth or benefits, it is often wasteful and contributes only marginally to better outcomes. When moving like-for-like to the cloud, enterprises and IT organisations often spend more. Real cost savings come when system designs and deployments are rethought.

Although the economic concept of higher consumption being a result of lower pricing is one reason many enterprises will spend more with cloud computing, there are many other reasons, such as poor project planning, failure to consider business process re-engineering, poor integration, poor estimating and failure to adequately manage systems after projects are completed. CIOs should, therefore, improve the maturity of IT service management, benchmarking and chargeback to manage demand for cloud services, and to better understand when the price is right for migrating IT services outside the IT organisation.

To prevent disenfranchisement and wasteful decentralisation of IT spending related to the cloud, the same IT management practices are necessary. CIOs need to expand their strategic vendor management and IT procurement practices to prepare for the cloud computing revolution. Better business-case templates and management will help focus the cloud decisions on business value.

The convergence

Although the shift in IT's role in the long term will be from an organisation that builds IT systems to one that brokers the integration of IT services, there are other reasons that CIOs need to round out the management functions when they are in a low maturity state. Three trends will drive functional maturity within the CIO's office during the next five to ten years:

  • sustaining shared IT services
  • preparing for cloud computing
  • preparing for the next recession.

Given the context of what each CIO office should be preparing for or sustaining, the natural market forces are also forcing the convergence of three unconnected IT management streams and phenomena:

  • IT service portfolios and catalogues
  • chargebacks and cost allocations
  • cloud computing.

Usually, improvement in the maturity of one IT management practice or capability is accompanied by improvements in the maturity of two or more additional IT management practices. To challenge IT and business leaders further, there are many combinations and iterations of shared IT services, public cloud and private cloud.

With most new IT innovations (such as client/server computing, desktops and handheld devices), the entry point based on business need occurred primarily in the business units, only to later come under the control of central standards. There is little evidence that this will not be the case with external cloud computing, and a partial disenfranchisement of the traditional IT organisation will begin. To manage the public cloud, most IT firms must become the broker of these services.

The legitimacy to do this is accomplished by successfully managing the now independent IT management practices of IT service portfolios, cloud computing and chargeback. As an added benefit, this convergence also fulfils the preparation needed for sustaining shared IT services, cloud computing in general and the next economic recession.

Capitalisation of IT investments

Financially, cloud computing adoption and exploitation are at odds with many of the capital and expense policies implemented recently because of austerity actions. First, many enterprises want to shift to an 'asset-lite' model, driven by a goal to increase the return on assets during the next five years, which favours an externalisation policy within IT, particularly traditional ITO, where IT assets are transferred to service providers. Cloud computing would also align with these long-term goals.

Second, many enterprises are blessed with liberal amounts of available capital, not just for IT. But there are policies to freeze expense levels and even decrease expense ratios over the next few years. Many IT finance professionals estimate annual maintenance levels for cloud computing at 20% of the purchase or capital cost of a service or system, divided by its useful life, and this is not much different than that for ERP or point-solution investments.

"There are many combinations and iterations of shared IT services, public cloud and private cloud."

Third, other enterprises are tempted by the promise of reducing capital expenses or investments altogether because of cloud computing. Many of the estimates by Gartner clients have shown that there are still significant transition costs (including write-offs of existing assets if replaced by the cloud) because of any new investment - whether it's infrastructure utility computing, SaaS or other cloud alternatives. The capital requirements don't go away.

After partnership with a cloud vendor, some of what is considered traditional 'maintenance' costs will continue to be expensed annually, because they are predictable every year, and no additional business benefits are delivered from the existing functionality. Often, similar systems created by the IT organisation are not retired, and costs can increase because of cloud vendor ambitions for upgrade and the IT firm's failure to retire legacy systems. Then, the risks of vendor lock-in begin.

With the promise of switching vendors quickly because of commodity market conditions, IT companies may enjoy a buyers' market to force prices down due to competition; however, for some cloud computing services, there may not be competition. Changing may be architecturally difficult and require transition capital, and larger firms may need multiyear contracts and minor changes that alter the service from cloud computing back to traditional ITO.

"Enterprises are tempted by the promise of reducing capital expenses because of cloud computing."

Switching cloud vendors is difficult because of a lack of standards. Although these will emerge in the long term, the marketplace has responded by increasing the number of cloud brokers that can be engaged by the IT organisation to migrate systems from one provider to another.

In the end, the percentage of IT spending devoted to IT capital may decline because of cloud computing and follow a pattern similar to that of software in general. But before this can happen, enterprise policies will have to change related to caps on the operational budget, an increase in capitalisation thresholds and long-term asset ownership decisions. In practice, it can be much more difficult to go asset-free.

Many major vendors' software licences continue to drive corporate accountability for the business beneficiaries of user-owned or provider-owned software. Many clients believe that the financial benefits from cloud computing exploitation will not come organically, but from well-defined and well-managed financial goals.

Compared with a forecast of $2.6trn for all IT marketplaces in 2011, cloud represents only 3.5% of the IT marketplace and is expected to reach 9% in 2015.
Figure 1. IT management costs will focus on the convergence of IT services and chargeback rates.
Kurt Potter is a research vice-president within the Gartner CIO Research Group, covering IT financial management, including drivers and trends related to IT spending and staffing, cost transparency, performance management, and benchmarking and measurement.