Myths of the Cloud: CAPEX vs OPEX – What is the big deal?

In almost every article for Software as a Service and the Cloud a HUGE deal is made of the benefit of how new cloud applications convert capital expenditures to operating expenditures.  So what is the big deal?

A capital expenditure (CAPEX) is an investment in assets such as servers, software licensing and the implementation of the software.  If you buy the software, the implementation costs are includable in your asset as a necessary cost of preparing the asset for use.  Later enhancements, training, etc. are often expensed in the period as an operating expense (OPEX the cost of normal business operations).

For certain companies, mostly large companies, it is about budgets and balance sheets.

• If there is a freeze or a limit on capital expenditures (CAPEX) then a SaaS application is allowed where an investment is not.
• A company may have loan covenants and acquisition of a new system is often financed.  Although the new system adds an asset it also increases liabilities and can change the debt to equity ratio or affect loan covenants from lines of credit and other finance sources.

For most businesses these arguments are moot and miss the true economic questions:

1. Will the cloud/SaaS application provide a lower total operating cost?
2. Is there a long term commitment inherent in my cloud contract that may require balance sheet treatment?
3. Is there transfer of ownership which will require capitalization?

1. One clear benefit of the cloud is that you pay for the capacity you need instead of acquiring a fixed capacity in  a traditional model.  In addition, because of economies of scale, enhanced technology and other factors, a cloud provider should be able to provide the infrastructure at a lower cost of ownership (for comparable capability) than a small business can on its own.

Often the cloud provides new capabilities for remote access, integration and functionality that just isn’t available in entry level systems used by most small businesses.   In this manner the cloud can increase the top line further increasing the ROI or in effect offsetting the total cost of operation for the new systems.

Another factor that can lower the total cost of operations is the time to value.  Many cloud providers have developed rapid implementation programs and “pre-configured” elements to reduce implementation time and costs when compared to a traditional on-premise deployment.  I-BN’s “Start & Grow” program for Sage 100 (formerly known as MAS 90/200) and SAP Business One have cut the deployment cost by as much as 75%  and has resulted in rapid deployments measured in days rather than weeks or months.  This again improves the ROI by reducing the upfront implementation costs and is much more salient than the CAPEX vs. OPEX argument.

2. Many SaaS applications require multi-year commitments and payment up front.  These multi-year commitments can also be financed.  In either case, you have created a balance sheet prepaid asset that needs to be amortized over the life of the commitment.  If financed, the associated liability must also be added to the balance sheet of the company.  This may not be a capital expenditure for company and may affect loan covenants differently than a traditional capital expenditure, but for most small businesses, who cares?

3. Companies like I-BN offer cloud services combined with software in a hybrid model.  Combining terms with cloud services our customers gain the benefits of an elastic cloud supported by leading technology and a team of experts with ownership of the business management software after the initial term.  In this type of arrangement ownership of the asset transfers to the company at the end of the term, and accordingly the asset should be recorded on the books of the company at the beginning of the contract term.

The concept of transfer of ownership is akin to purchasing versus leasing a car.  If you plan on a short lifespan for an asset, or  flipping a car so you are always driving new cars with the latest features, a subscription model makes sense.  If you plan to keep an ERP system for 10 years or longer, you must look at the total payments over the anticipated life and discount that cost using some expected cost of capital.  Often a subscription versus purchase analysis results in a 2-3 year break even on the licenses for purchase versus subscription.  For example, if a license costs $150 per month per user compared to $3,000 to purchase, without cost of capital in about 20-24 months the license would have been paid for.  Even if you factor in a 20-22% license maintenance fee, $600 per year compared to $1,800 per year adds up quickly in your ROI calculation.

So the bottom line is that CAPEX vs. OPEX should rarely be the deciding factor if a factor at all in systems selection.  A companies choice of business management platform should be based upon meeting your  business requirements, ease of use, and total cost of operations over the anticipated life of the software.

Tags: capex, capital expenditures, implementation costs