An organization's IT costs are many-fold, which include expenses for hardware and software as well as expenses for support and management. Typically, these costs fall into two categories:

Capital expenses (CapEx): The initial investment for a particular IT service or solution. For example, when an organization decides to implement a software solution to address a particular need -- for example, enterprise resource planning (ERP) -- CapEx would include all physical hardware and software purchases. CapEx investments are for the lifetime of the solution. CapEx are an up-front expense, which are either paid as a lump sum or financed with extra charges.
Operational expenses (OpEx): The recurring costs incurred while operating a particular system. For the ERP case, that would include utility fees (such as power and cooling) to keep the infrastructure running, space leases if the facility is rented, personnel costs to support the system, and software support and license fees. OpEx are typically a monthly recurring charge.

The business model for IT software has evolved over the years into the following forms:

Traditional model: An organization purchases licensed software, which it then owns and maintains.
Open-source model: Software is essentially free, but the organization pays vendor support costs.
Outsourcing model: An organization hires another company, possibly overseas, to manage and maintain the software.
Hybrid model: A software vendor sells highly standardized software to many clients, along with software management and support, thereby amortizing costs of expertise, software management, and support across several clients.
Cloud computing model: Software is developed and delivered over the Internet to many clients at lower costs.

Reducing Capital Expenditure

Organizations choose to reduce their capital expenditures so they can limit the commitment of large investments for long-lived IT resources. Shifting expenses away from capital expenditures and into operational expenditures enables organizations to stretch their IT budgets and limit up-front costs. Specifically, organizations opt to make investments that have a bigger return on investment in the short term rather than investing in long-lived IT resources whose value depreciates over time. Operating expenses are pay-as-you-go, meaning organizations pay by the month and get value every month. With cloud computing, they can simply rent the resources and incur little to no capital expenditures.

The cloud-computing paradigm offers a transition of the IT business model from CapEx to OpEx. CapEx in IT systems is a long-term investment that freezes a large sum of money into a single investment. OpEx, on the other hand, is a recurring expense which could enable the company the agility to utilize the funds in other profit-yielding investments.

Cloud Service Provider Economics

For a cloud service provider, long-term CapEx as well as recurring OpEx costs are unavoidable. An important challenge for cloud service providers is to satisfy the demands of their clients while achieving high-average utilization in order to make a profit, which depends on their ability to build data centers with high efficiency and reliability at manageable costs. Cloud service providers amortize their costs over a large number of users.

Cloud service providers build large and reliable data centers in order to attract large volumes of users and maximize their profitability. Just like other utility providers, cloud service providers can then procure and maintain hardware and software at significant savings per unit.

Economies of Scale

Cloud service providers organize their infrastructure into large data centers, which typically leverage three main areas:

Supply-side savings: Large-scale data centers lower the cost per server.
Demand-side aggregation: Aggregating demand for computing allows server utilization rates to increase.
Multitenancy efficiency: When changing to a multitenant application model, increasing the number of tenants (that is, customers or users) lowers the application management and server cost per tenant.

Cloud service providers undertake the difficult task of building and maintaining data centers for users. For this model to be feasible, cloud service providers must leverage economies of scale and bring in many users. Providers benefit from economies of scale in the following areas:

Cost of power: Electricity is rapidly becoming the largest element of total cost of ownership (TCO) in a data center, accounting for approximately 15% to 20% of total costs. Large cloud service providers can place their data centers in locations with lower power costs and sign bulk purchase agreements with electric providers to reduce electricity costs. In some cases, they are building their own power supplies that leverage advancements in solar energy and other green energy sources.
Infrastructure labor costs: Cloud computing enables repetitive management tasks to be automated. In addition, in larger facilities, a single system administrator can service thousands of servers with the use of advanced management software.
Buying power: Cloud service providers can purchase equipment in bulk from manufacturers, which can lead to major discounts over smaller buyers. In addition, cloud providers standardize their servers and equipment, which helps in lowering purchase and support costs compared to smaller IT departments.

Cloud providers such as Amazon, Microsoft, and Google build dozens of data centers all over the world in order to achieve economy of scale and to minimize latency by minimizing the distance between data centers and users.

Cloud use cases

Reducing Capital Expenditure

Cloud Service Provider Economics

Economies of Scale

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