Introduction
With the cloud space getting crowded each day, cloud service providers list a host of benefits by moving to the ‘Pay as you Go’ model…. Among other benefits, reduced capital expenses (fixed Capex costs), and increased operating expenses (variable Opex costs) is listed as a key benefit.
The article attempts to analyse this.
In general, from an accounting perspective, by shifting from a capex to opex based model, the benefits can be many.
Some of these could be:
- Use of Opex allows deducting expense in the current year and reduces tax liability applied on net income.
- Opex benefits due to time value of money (100 $$ saved today is better than 100 $$ saved next year)
- No upfront capex expenditure if cost of capital is high and /or capital is not available
- By Diverting capex to opex, the capital saved can be used elsewhere giving a better yield.
All points taken, if you ask a accountant, he would say that it’s just accounting mechanics… He will also list down couple of points that go against this and as one can notice most of the cloud vendors do not mention this.
- Opex decreases the company’s book value as the expense moves to profit & loss statement hitting the bottom line.
- Opex decreases the company’s EBITDA.
- Cost of On-demand services is always high as they carry a utility premium. Think of renting a car vs. a buying a car. By renting a service, you are in a way borrowing money from the service provider, and paying the loan back to them in monthly payments.
- P&L, Balancesheet and cash flow statement looks less attractive.
More often than not, the real tangible benefits of moving from capex to opex are governed by other technical / business factors . Capex to opex movement is just an accounting measure and often tactical. It may well serve some short term financial objectives that the company needs but it is hard to prove that this is indeed true in the long run.
What is Better : Capex or Opex
Should one really care about the opex and capex debate and what should be the choice? Or this is contextual. Often, the reasons of moving from Capex to Opex could be very different and purely financial. For e.g:
1) Shortage / Availability of capital,
2) High Cost of Capital,
3) Overall economic environment which impact investment decisions.
4) Better use of available capital
5) Benefits from alternate capex investment outweighs the higher cost of ‘pay as you go service’ in the long run.
The objectives could be the other way around also (Reduce Opex and increase Capex), for e.g,:
- To boost profits (artificially, some may say) to report to investors and increase shareholder value
- A higher value of assets on its balance sheet
- Cost of capital is cheap and readily available.
- No better use of capital
What this means is that the movement of capex to opex or vise versa is highly contextual. It may all sound good due to current economic environment and capital constraints but may not hold good in all cases and in the long run
The Real Benefits
1) Optimizing capital investment due to shortage / Availability of capital
2) Optimize overall Cost of Capital
3) Workaround the difficult economic environment which impact investment decisions.
4) Investment Options at hand
5) ROI
6) Better profit reporting to investors and increase shareholder value
7) Higher value of assets on balance sheet
8) Better Cash flow management
The financial objective may be tactical in many cases and may change over a course of time.
That said, the real reasons behind a ‘pay as you go’ model or so called ‘opex’ model, may be unrelated to the financial context with very different objectives (Often business driven). These could be:
- Better Utilization Rates
Here is where the real benefits of shared services come into play. If a company is using less than 30% of installed capacity, ‘pay as you go’ model can give significant cost benefits. If it is already using more than 70 %, the benefits may not be that high as utility services come at a premium as compared to owned service for obvious reasons..
- Operational advantages
- Service level improvements
- User satisfaction considerations
- Keeping pace with the technology upgrades
Due to the rapid changes in technology, it doesn’t make sense to sink or locking money into equipment that’s surpassed by the very next model. Opex in the form of pay as you go models help in this regard. Costs are reduced and shifted from capital expenses to operating expenses, which save money. The capital saved can be used elsewhere in more productive investments or reduce the cost of capital.
- Better scalability, metering, automation and virtualization – all for less money than a traditional data center.
The choice architecture should be based upon meeting the business and technical requirements.
A company can choose to use a public shared cloud - on rent and hence opex based model OR go for a private cloud - owned and capex OR an internal cloud (virtualized) that can satisfy all the business / technical requirements for the CIO while also meeting the financial objectives for the CFO.
It all depends on the context. A WIN-WIN situation for all is one that should be looked at.
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Brief on Opex and Capex
Capex
- Capital expenditures are expenses to create assets (or add value to an existing asset) for future benefts with a life that extends beyond the tax year.
- Cannot be fully deducted in the period when they were incurred. Tangible assets (building) intangible assets ( h Money spent on inventory falls under capex ardware etc) are depreciated and intangible assets (patent etc) are amortized over time.
- Cannot be fully deducted in the period when they were incurred. Tangible assets (building) intangible assets ( h Money spent on inventory falls under capex ardware etc) are depreciated and intangible assets (patent etc) are amortized over time.
- Money spent on inventory falls under capex
- Show up in Balance Sheet and Cash Flow from Investing head in the Cash flow statement
Opex
- Refers refers to expenses incurred in the course of ordinary business, such as sales, general and
administrative expenses (and excluding COGS, taxes, depreciation and interest
- Operating expenses are fully deducted in the accounting period during which they were incurred.
- Show up in Profit and loss statement.
- End up in Cash Flow from operating activities head in the Cash flow statement
