Accounting for Cloud Computing
We’ve all been reading about Cloud Computing for some time now, and some of you have either been using Cloud Computing services or implementing Cloud Computing within your organizations. In many cases, the interaction of technical people with “Cloud Computing” was either a pay-as-you-go model with a Public Cloud service (EC2, Terremark, Savvis, etc.) or rapid virtualization and automation of their Private Cloud computing environment. At first glance, everything associated with the Cloud experience was great because it satisfied a top requirement from the business …. saving money!!
But as we all know, there are always two sides to every story. In this case, we ask the question, “Is saving money going to make the company leadership happy?”
Huh?? How can saving money not be a good thing for the company leadership?
Let me explain by highlighting an interesting snippet (below) from a recent Forbes.com interview, Rich vs. Poor IT Organizations. In the interview, there is a discussion about the challenges of deploying cloud computing, from a technology, business and internal-politics standpoint. One section jumped out at me and it’s worth explaining to anyone that doesn’t deal with accounting on a regular basis.
But will the business units actually pay for IT when they haven’t had to itemize those costs in the past?
“Good question, and that’s where cloud computing is running into a problem. All prior IT money was essentially free to the business units. CapEx came from corporate and they didn’t see it. CapEx is based on depreciation, but for business unit leaders their performance bonus is based on EBITDA (earnings before interest, taxes, depreciation and amortization). Essentially IT is free. Your bonus isn’t affected by depreciation. In cloud you don’t have the upfront CapEx, but you do have an operating expense that is above the EBITDA line. Companies going into their second year of cloud are asking, when is this charge going to stop? The answer is never.”
If you’ve never dealt with accounting, this might seem like a strange concept. Isn’t all money counted the same way by the business? Not exactly. The first concept to understand is CapEx (Capital Expenses), which means that money is spent to buy a tangible thing, like a server or network switch or storage array. While the company pays the vendor for the equipment with real money, it doesn’t immediately account for that purchase on its books. It uses something called depreciation, which is an accounting term that means you try and match the cost of the asset to when it’s actually used and only consider the portion used as an expense. So if a server cost $10,000 and the expected life of it was 4 years, then the company would account for it as a $2,500 expense each year (note: that’s a simple accounting explanation, there are modifications to this that are more advanced). Depreciation is essentially an Operating Expense (OpEx), but it’s treated slightly differently from an accounting standpoint. Hence the discussion in the article. If the usage of that same server had come from a Cloud Computing “service” (public cloud or outsourced), then its annual cost would be treated as an actual Operating Expense (OpEx).
Let’s examine some basic accounting principles and where they apply to the usage of those computing services and how they are paid for:
- Revenue – Operating Expenses = Gross Revenues
- Gross Revenue – (Interest, Taxes, Depreciation, Amortization) = Net Revenues
Confused? Tired of reading about accounting minutia? No problem, there won’t be any more talk about accounting going forward.
I only highlight this up because it can effect the mindset of the people utilizing IT services. As the article highlights, if you’re a VP/GM of a Business Unit and your compensation/bonus is tied to Gross Revenues (pre-EBITDA), then you’re perfectly fine with IT buying equipment as CapEx (actually depreciation of the CapEx equipment) doesn’t effect your number. But if the IT comes via a Cloud Computing “service” and is treated as an Operating Expense, then it lowers the overall revenue number for your compensation/bonus. In both cases, the Net Revenues (after EBITDA) for the company might be exactly the same, but that VP/GM might be happy or sad based on how IT delivered the service.
Is there a right or wrong answer in this model? Am I arguing that Cloud Computing is right or wrong? No and No. It just helps to be aware that the way the service is accounted for can have an impact on making different groups in the company happy. Cloud Computing, or variable vs. fixed cost computing, can change the way the stakeholders of IT look at how IT services are delivered.Cloud Computing is a powerful new way of applying technology to solve business needs, but it does involve some changes in mindset (both technical groups and business groups) that should be understood.