SaaS and the shift from IT CapEx to IT OpEx

network First off, a few disclaimers: no, I didn’t just slam my hand down on the keyboard to write the title of this post.  And no, I don’t have much of a background in accounting or finance, but I have spent a good chunk of my career working in IT operations, managing budgets and expenditures.

One of the things that I have been interested in lately is the business motivation for switching from the traditional model of enterprise software systems (ERP, CRM, HCM, and the like), to SaaS offerings such as and Zoho.

In the closing paragraphs a September 2008 article in the Economist was an interesting comment regarding the business motivations for companies to switch to SaaS offerings:

In a business with high prices and relatively thin rewards it is not obvious how Zoho will win by being cheap, at least with larger customers. Costs are high for a reason. Enterprise applications are complex beasts; they require programmers who know about business; and they are expensive. Customers must be convinced that they can entrust their business to the software. And they need a lot of hand-holding, both in implementing and in running programs. 

I believe one of the single best possible reasons for large companies to switch to the SaaS model is a switch from IT capital expenditures (CapEx) and a move towards IT operational expenses (OpEx).

Behold my feeble attempt to explain the CapEx and OpEx: IT CapEx is money spent on acquiring physical assets for the purpose of running your business.  Examples of IT CapEx: printers, servers, laptops, networking equipment, etc.  OpEx is money spent on the operational aspect of running your business.  Examples of IT OpEx: telephone service, leased network lines, printer cartridges.  Enterprise software licenses are typically treated as CapEx, along with the servers and networking equipment required to host the software.  On the flip side, the monthly fees for internet hosting, data center rack space, and offsite backup are all considered IT OpEx.

The difference between the two is key: IT CapEx is amortized (in the US) over a three year period, so although the cost of licenses show up 30% of their total over the three year period, it’s still a hit to the balance sheet.  IT CapEx also tends to be less fluid and much more expensive than routine IT OpEx.  CapEx spending also tends to be harder to forecast than OpEx.  OpEx typically represents a real cost of doing business: your business needs an internet connection to exist, and you pay for what you use.  CapEx in general is often more fuzzy in relation to its impact on a company’s operations, especially when it comes to IT CapEx.  Sure, you need a server to run your business, but do you really use it 100% for the entire duration of its life?  Even with virtualization tools like VMWare, you’re probably not using it 100%.  Plus, CapEx also has maintenance and “unexpected events” overhead that OpEx doesn’t.  Example: your server room A/C unit just broke (and so did its back-up unit), and now you’ve lost 20 servers due to heat exposure.  The result would be an unexpected increase in CapEx for that quarter.

Here’s an example to illustrate the difference between the two:

Acme Corp. purchases $1,000,000 USD worth of CRM server licenses, alongside $250,000 USD in server and networking equipment to cover CRM costs for 3,000 sales, marketing and finance employees.  Their monthly operating expenses are $60,000 to cover software support/maintenance fees, IT staff, and leased network and internet lines.

Acme Corp. therefore spends $1,250,000 in IT CapEx and $720,000 in IT OpEx for the entire year, but since the cost of the IT CapEx is amortized over 3 years, only $416,000 of the IT CapEx hits the books each year.  Nonetheless, the total is $1,136,000 each year to operate their CRM system.

One drawback, however, is that the CRM system doesn’t begin to provide benefit for Acme Corp. until it’s been installed, configured and deployed to their entire group of 3,000 employees.  The typical ramp-up time for a CRM project (hardware installation, software setup, and customization) is 3-6 months, with many roll-outs spanning a year or more.  This means that the first year of expenses in buying the new CRM software isn’t fully providing Acme Corp. any business benefit, even though they are actively paying for the CapEx during that period.

If they had instead gone with a SaaS provider, and paid monthly subscription fees, those would be counted entirely as IT OpEx, the annual expenses would’ve been easier to and more accurately forecasted, and the ramp up time would be near zero.  The SaaS provider has already undertaken the responsibility of deploying the servers and setting up the base software.

This puts a shift, though, of capital expenditures onto software companies providing SaaS solutions.  It then becomes the SaaS provider’s problem to deal with purchasing server equipment, maintaining data centers and networking equipment, as well as the internet hosting fees.

A final point about SaaS: being able to identify the departments and users who are leveraging a specific SaaS service, and more pay-as-you-go or pay-as-you-grow models will help streamline IT costs, which in the long run will help more companies benefit from modern IT solutions which were typically cost prohibitive for smaller organizations.  Now companies can identify exactly how much its costing them to run certain organizations, and servers and hardware won’t be purchased solely for specific divisions and departments.

Certainly there will be specific types of projects that won’t be good SaaS fits, but with the availability of services like Amazon’s S3 and EC2, and start-up cloud computing companies like Elastra, even dedicated IT projects can benefit from some portions of IT CapEx being converted to IT OpEx.

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