by Satish Irrinki (Red Hat)
Increasingly in today’s world, data centers are moving towards software-defined computing, networking, and storage. IT infrastructure that supports the application and data workloads is moving from bare metal servers to cloud. While the most obvious justification for this shift can be summarized as increased efficiency, capacity utilization, and flexibility (to scale up or down), there are less obvious fundamental economic and financial principles in play that contribute to overall business stability of the organizations and lines of business (LOB).
Cloud computing has changed the cost structure of IT infrastructure. Historically, IT infrastructure was considered a capital expenditure (CapEx) that requires large upfront investments leading to higher fixed costs for the business. With the advent of cloud computing, primarily because of its pay-for-use billing model, IT expenditure shifted from fixed operating cost structure to variable operating cost (OpEx) model.
This shift not only decreases the need for larger cash flow requirements or, in lieu, higher liabilities on balance sheet (akin to capitalization of lease expenses) for the CapEx, it also reduces the volatility in the operating income for the business.
The main point is that adopting cloud model decreases the operating risk (the risk arising from the mix of fixed and variable costs) for a business and contributes to increase in business stability. The context is that organizations or LOB has the flexibility to trade fixed costs with variable costs, and as a result, lower their operating risk.
Elasticity of Operating Income
The underlying economic principle that explains the lower operating risk is elasticity, which is a measure of sensitivity of change in one factor with change in other. For example, a measure of sensitivity of change in quantity demanded with change in price is a classic example that is widely known.
A similar elasticity measure that captures the sensitivity of operating income with change in demand (of goods or services offered by the organizations or LOB) is called the degree of operating leverage (DOL). It has to be understood that lower the degree of leverage (DOL), the lower the operating risk for the LOB.
Meaning, a slight change in demand (+/-) will have minimal effect on the corresponding change in operating income when the elasticity is lower. The inverse is true when the DOL (elasticity of operating income) is higher. I.e., a small change in demand will have significantly higher effect on the change in operating income when the elasticity is higher.
The tabular analysis below illustrates that lower the CapEx, or equivalently higher the OpEx for the organizations or LOB, the lower the operating risk, DOL.
DOL is measured as a function of Quantity Demanded (Q), Unit Price (P), Variable Unit Cost (V), and Fixed Operating Cost (F) and is measured as:
DOL = (% Change in operating income)/(% Change in units sold) = [Q*(P-V)]/[Q*(P-V)-F]
The table below illustrates the effect of trading CapEx with OpEx on DOL.
Let’s analyze rows 1 and 2 as a set. The DOL, sensitivity of operating income with change in demand, at Q= 200,000 units demand, is lower at 1.37 when the Fixed Cost is lower. The trade off is that the variable cost (unit cost) is higher at $6 when the fixed cost is lower. We can make a similar observation in rows 3 and 4. Thus, quantitatively we can assert that the DOL is relatively lower when the CapEx is lower and OpEx is higher.
As we can see, the operating risk for an organization or lines of business is relatively lower when the CapEx is traded for OpEx. Thus organizations or LOB increase their business stability due to reduced volatility in operating income when they adopt pay-for-use cost structure offered by cloud computing pricing models.
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