My first law of Cloudonomics is that “utilities cost less even though they cost more.” This is a counter-intuitive observation: how can something cost less even though it costs more? What I mean by this is that typically utility services must charge a “utility premium” for resources, over and above the cost of that resource. Consider a enterprise that expends capital to acquire a $3,600 server, and uses it for 36 months, assuming zero residual value. With straight line depreciation, this works out to $100 dollars a month. If a utility service provider acquires that same server and rents it back to the enterprise, it can’t only charge $100. That is only one element of the utility provider’s cost of doing business. In fact, the provider must add sales, general and administrative costs, operating expenses for server management, and margin to provide an acceptable return to shareholders or lenders. Consequently, the service provider must charge something like $140 or more. But in addition to that, unless all the equipment provisioning is done under a stockless distribution model with long term leases, an additional factor comes into play: average utilization. If average utilization of the service provider’s infrastructure is only, say, 50%, the provider might need to charge $280 for each server that is revenue-generating, because at the same time, it is generating $0 for each server that is idle. Consequently, the utility premium, that is, the price differential relative to a non-utility price, has two components: that related to the service provider needing to add costs and margin on top of the base cost, and that related to utilization of the environment. In this case, the utility premium might be 40% to 180%.
Of course, in the real world, additional factors come into play in an apples to apples comparison. A large service provider may get deeper equipment discounts than a small or medium enterprise. Tooling costs can be distributed over a larger base. Staffing costs can be proportional to size of the environment, rather than requiring a minimum: for a small business with one server to have 24/7 monitoring requires five people on payroll — four people working 40 hour weeks doesn’t provide coverage for all 168 hours in the week, nor does it allow for vacations and sick days. Due to factors such as these, utility service providers can generate some economic value to ameliorate the premium.
Why would any enterprise, instead of spending $100 a month, intentionally choose to spend $140 or $180 or $220 or $280 or more?
The answer is that the flip side of utility services is that they cost less or nothing when not in use. While a hotel room may cost more per square foot per night when it is rented, it costs zero when it is not rented. A rental car costs more per car class per day than financing, leasing, or depreciating the car, but costs zero when it is not rented. A utility with a fully variable price, ends up costing less even though it costs more, as long as there is enough usage variability, i.e., demand variability to make the periods where nothing is being paid make up for the periods when the premium is being paid. The specific metric in question is the peak-to-average ratio. If this ratio is greater than the utility premium (expressed as a fraction), then the utility will cost less than the fixed environment.
My paper “The Evolution of Networked Computing Utilities” addresses this in more detail. and you can run a Monte Carlo simulation “The Value of Utility Resources in the Cloud” using your own assumptions about variable demand, utility premiums, and other costs associated with fixed and utility environments. There are some other key assumptions that bear mentioning: the objective of the environment must be to serve demand, and demand must not be deferrable.
If a large spike in demand can just be ignored, then there is no need to ensure resource availability to serve it. In real-world situations, there is an opportunity cost to unserved demand, e.g., revenue loss from customers that are turned away rather than being serviced. The utility premium must be less than this opportunity cost, otherwise it is cheaper to do without the customer than to invest to capture their spend. If demand is deferrable, then a fixed environment that is sized to the average demand is cheaper than a variable environment incurring the utility premium. An example of non-deferrable demand is an emergency room: if you’ve just been hit by a truck, you’d prefer not to wait until next month to see the ER doctor. An example of deferrable demand is having your house painted: if the painter is busy the next few weeks, no problem, you can wait.
The economics of serving non-deferrable demand then, somewhat counter-intuitively, demonstrate that more is less.