By David Gross
Just about every IT, networking, power, and cooling vendor serving this industry promises to both "reduce capex and opex". But these goals are often meaningless, especially in the case of capital budgets, which often require board approval, and are set for the year. Moreover, the number one objective of a capital investment is to get the highest possible return, as measured by IRR, not to spend less than you did during the last upgrade cycle. And in the case of opex, it's very easy, and very common, for salespeople to make spreadsheets showing big opex reductions that are not always achievable in practice, especially when most data centers are already very capital-intensive and highly automated.
Far more attention getting than droning on about opex, capex, ROI, and TCO like the herd, is to focus on more specific financial metrics that your product can improve upon. IRR and NPV are good places to start. Because most sales presentations confuse payback period with ROI, have no time value of money, and do a poor job showing tradeoffs, they have limited credibility. IRR, which in my experience is known by some, but not all sales and marketing people, is the most important metric for any capital investment. While it might take some education to explain what it represents to some buyers, if all the community college students taking introductory finance courses can learn it, I'm sure the CIO you're selling to can as well.
Showing posts with label TCO Models. Show all posts
Showing posts with label TCO Models. Show all posts
Tuesday, January 4, 2011
Tuesday, November 30, 2010
Data Center TCO is a Meaningless Number
By David Gross
Few metrics are as overused yet as useless as TCO. Largely developed by sales and marketing to close deals, it has very little connection to financial reality, because it ignores the time value of money, offers little support of any kind for a buy vs. build decision, and typically pulls in a lot of costs that you are going to incur anyway.
With data centers, TCO numbers can get comical, because this is an automated industry, where personnel costs are often a very small share of total outlays. And while vendors love to talk about how they save power, which can also reduce operating costs, many of the products that save power require higher up front capital outlays, providing weak financial returns. So then how are you supposed to measure data center costs? How are you supposed to decide between more power consumption or more capital outlays?
As I wrote last week, data center expenditures should be set to minimize the NPV of cash outlays within operational constraints. This is very different than randomly tagging your PDUs, CRACs, or servers with allocated overhead costs as TCO models typically do. Moreover, many of the financial decisions that take place involving a data center don't involve money, but time. If you're building your own facility, it's not really a decision to spend more or less, it's a decision to spend now. If you're renting additional space, you're not just deciding on how much to spend, but when. Moreover, TCO really doesn't apply, because you don't own anything, and if you force some sort of TCO calcuation, you need to place a discount rate on future rent payments, each of which occurs at a different point of time.
Specifically, here are some things the industry can do to bring TCO models closer to the financial reality:
1. Stop Summing Costs from Different Time Periods and then Comparing Them to One Another.
This is a common tactic, to claim half of the "expenses" are capital costs. Problem of course is that there is no such thing as a capital expense, there's depreciation of up front capital outlays.
Moreover, don't say 50% of your "expenses" are capital outlays, say 60% of the present value of your cash outlays are capital expenditures at a 7% discount rate, but this rises to 70% at 12%, which is your corporate cost of capital. If it costs more to borrow in the future, you'll need to look at renting more. This is just one way in which financial data can be used to support important decisions, instead of just validating some vendor marketing department's claim about savings.
2. Stop Making Pie Charts with Cost Categories
Just about every aspect of a data center operation can be rented or bought. A key decision factor then isn't whether power is 15% of costs or 20%, but the fixed cost of turning a rented item into an owned one. In the case of the facility, this is obviously going to be very high, in the case of a blade server, it will be low. This ability-to-buy is far more important than assigning a percentage to facility rent or blade servers because you need both a building and servers regardless of what you decide financially. What matters is if your cash outlays are higher than peers or competitors because you're leasing when you should be buying, or building when you should be renting.
3. Constantly Monitor the Tradeoffs You've Made
TCO often does a poor job of determining trade-offs that underlie decision making. For example, if you buy a power hungry, 9 watts per Gbps Ethernet switch because it has a low port price, you need to monitor prices for power, prices for higher line rate ports, alternate protocols, alternate topologies, in addition to your corporate cost of capital.. The cost justification for such a tradeoff could change, and it won't show up in any static TCO spreadsheet.
Ultimately, as time passes, corporations will be spending more on renting, building out, and operating data centers. Those that move beyond TCO models stand to gain significant financial benefits over those who try to force numbers into convenient categories that have little to do with financial reality.
Few metrics are as overused yet as useless as TCO. Largely developed by sales and marketing to close deals, it has very little connection to financial reality, because it ignores the time value of money, offers little support of any kind for a buy vs. build decision, and typically pulls in a lot of costs that you are going to incur anyway.
With data centers, TCO numbers can get comical, because this is an automated industry, where personnel costs are often a very small share of total outlays. And while vendors love to talk about how they save power, which can also reduce operating costs, many of the products that save power require higher up front capital outlays, providing weak financial returns. So then how are you supposed to measure data center costs? How are you supposed to decide between more power consumption or more capital outlays?
As I wrote last week, data center expenditures should be set to minimize the NPV of cash outlays within operational constraints. This is very different than randomly tagging your PDUs, CRACs, or servers with allocated overhead costs as TCO models typically do. Moreover, many of the financial decisions that take place involving a data center don't involve money, but time. If you're building your own facility, it's not really a decision to spend more or less, it's a decision to spend now. If you're renting additional space, you're not just deciding on how much to spend, but when. Moreover, TCO really doesn't apply, because you don't own anything, and if you force some sort of TCO calcuation, you need to place a discount rate on future rent payments, each of which occurs at a different point of time.
Specifically, here are some things the industry can do to bring TCO models closer to the financial reality:
1. Stop Summing Costs from Different Time Periods and then Comparing Them to One Another.
This is a common tactic, to claim half of the "expenses" are capital costs. Problem of course is that there is no such thing as a capital expense, there's depreciation of up front capital outlays.
Moreover, don't say 50% of your "expenses" are capital outlays, say 60% of the present value of your cash outlays are capital expenditures at a 7% discount rate, but this rises to 70% at 12%, which is your corporate cost of capital. If it costs more to borrow in the future, you'll need to look at renting more. This is just one way in which financial data can be used to support important decisions, instead of just validating some vendor marketing department's claim about savings.
2. Stop Making Pie Charts with Cost Categories
Just about every aspect of a data center operation can be rented or bought. A key decision factor then isn't whether power is 15% of costs or 20%, but the fixed cost of turning a rented item into an owned one. In the case of the facility, this is obviously going to be very high, in the case of a blade server, it will be low. This ability-to-buy is far more important than assigning a percentage to facility rent or blade servers because you need both a building and servers regardless of what you decide financially. What matters is if your cash outlays are higher than peers or competitors because you're leasing when you should be buying, or building when you should be renting.
3. Constantly Monitor the Tradeoffs You've Made
TCO often does a poor job of determining trade-offs that underlie decision making. For example, if you buy a power hungry, 9 watts per Gbps Ethernet switch because it has a low port price, you need to monitor prices for power, prices for higher line rate ports, alternate protocols, alternate topologies, in addition to your corporate cost of capital.. The cost justification for such a tradeoff could change, and it won't show up in any static TCO spreadsheet.
Ultimately, as time passes, corporations will be spending more on renting, building out, and operating data centers. Those that move beyond TCO models stand to gain significant financial benefits over those who try to force numbers into convenient categories that have little to do with financial reality.
Sunday, August 1, 2010
Data Center TCO - why no IRR?
by David Gross
In our first post on TCO Models a few weeks ago, I mentioned how these things rarely account for the time value of money, and how this can create dramatic distortions in the actual costs of the products the models are supposed to support.
I've looked through a few more models lately, and have yet to see an IRR, or Internal Rate of Return. In one otherwise informative model on data center TCO, the author decided to sum capex and opex together into one big TCO number. When I worked in capital budgeting, we would have tossed any project authorization request out the window if it did this, and most marketing people knew this.
The most important financial metric to anyone planning capital for equipment is not TCO or ROI, but IRR. Yet it's always missing! It's no wonder so many TCO models do little to improve market share for products that supposedly have the competition beat on cost. The first step to changing this is for vendors to stop beating their chests about incredible savings, and to incorporate IRR and the time value of money into their analysis.
In our first post on TCO Models a few weeks ago, I mentioned how these things rarely account for the time value of money, and how this can create dramatic distortions in the actual costs of the products the models are supposed to support.
I've looked through a few more models lately, and have yet to see an IRR, or Internal Rate of Return. In one otherwise informative model on data center TCO, the author decided to sum capex and opex together into one big TCO number. When I worked in capital budgeting, we would have tossed any project authorization request out the window if it did this, and most marketing people knew this.
The most important financial metric to anyone planning capital for equipment is not TCO or ROI, but IRR. Yet it's always missing! It's no wonder so many TCO models do little to improve market share for products that supposedly have the competition beat on cost. The first step to changing this is for vendors to stop beating their chests about incredible savings, and to incorporate IRR and the time value of money into their analysis.
Tuesday, July 13, 2010
Why TCO Models Fail
by David Gross
For years, data center and telecom suppliers have presented TCO models to customers promising a full range of financial benefits, from lower operating costs to more revenue to reduced capex. But they're not taken very seriously. Understanding that these payback scenarios are often created by engineers with limited financial knowledge, some companies will venture out to a large consulting firm that itself has limited product knowledge in order to validate some of their claims. But the result is the same, a McKinsey or Bain mark on a spreadsheet does little to add credibility to numbers that no financial analyst with budget responsibility can take seriously.
The reason these business cases fail include:
In addition to ignoring these financial realities, many business cases get tossed in the trash because they show no understanding of operational realities. This often occurs with the clever models put together by MBA consulting firms with little industry experience. I once saw a business case that showed new revenue amazingly appearing with the purchase of a new switch. What was not shown was any recognition of time needed to sell the 150 gigabit+ capacity within the switch, to negotiate large bandwidth purchases, network planning, circuit ordering, credit checks, or any of the typical issues that come up with major network capacity issues. Adding in reasonable operating expectations for filling capacity threw the IRR under many companies' cost of capital, and made buying the switch a bad deal – per the supplier's own business case.
Having survived two bruising recessions in the last decade, purchasing managers will not go to bat for a vendor that cannot show the financial depth that the finance department needs, or operational understanding that puts credibility behind any financial projections. With so many cost-of-ownership and payback models ending up as a big waste of time and effort, smart hardware suppliers need to reconsider how they present the financial justification for buying their equipment.
For years, data center and telecom suppliers have presented TCO models to customers promising a full range of financial benefits, from lower operating costs to more revenue to reduced capex. But they're not taken very seriously. Understanding that these payback scenarios are often created by engineers with limited financial knowledge, some companies will venture out to a large consulting firm that itself has limited product knowledge in order to validate some of their claims. But the result is the same, a McKinsey or Bain mark on a spreadsheet does little to add credibility to numbers that no financial analyst with budget responsibility can take seriously.
The reason these business cases fail include:
- Scattered Financial Benefits – most financially worthwhile products cut capex, increase productivity, or add to revenue, but not all three
- Automatic Layoffs at Installation – operations staff are often modeled to disappear after a new router or switch is installed, this of course never happens in practice, a more sensible way to present this is to demonstrate that your product can improve productivity, not that it cuts opex
- No Time Value of Money - many engineers and product managers will say “ROI” 100 times without ever showing an IRR, or Internal Rate of Return, on the capital outlay of buying their product. A 15% “ROI” is pretty good if it occurs over 8 months and will beat just about any buyer's cost of capital, but it is dreadful if it occurs over 3 years - the IRR at 8 months is about 23%, while at 3 years it's about 4%.
In addition to ignoring these financial realities, many business cases get tossed in the trash because they show no understanding of operational realities. This often occurs with the clever models put together by MBA consulting firms with little industry experience. I once saw a business case that showed new revenue amazingly appearing with the purchase of a new switch. What was not shown was any recognition of time needed to sell the 150 gigabit+ capacity within the switch, to negotiate large bandwidth purchases, network planning, circuit ordering, credit checks, or any of the typical issues that come up with major network capacity issues. Adding in reasonable operating expectations for filling capacity threw the IRR under many companies' cost of capital, and made buying the switch a bad deal – per the supplier's own business case.
Having survived two bruising recessions in the last decade, purchasing managers will not go to bat for a vendor that cannot show the financial depth that the finance department needs, or operational understanding that puts credibility behind any financial projections. With so many cost-of-ownership and payback models ending up as a big waste of time and effort, smart hardware suppliers need to reconsider how they present the financial justification for buying their equipment.
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