Migrating to the public cloud can have a negative impact on a company’s finances. Public cloud is a pay-as-you-go model, which does not require upfront capital expenditure (CapEx). In FinOps World, monthly invoices are considered as an operational expenditure (OpEx), leading to lower financial performance. If a company uses “Earnings before interest, taxes, depreciation and amortization” (EBITDA) model for financial statements, shifting some of OpEx to CapEx can improve the performance.
One of the Cloud FinOps Optimization strategies is to treat upfront payment for a certain type of Reserved Instances (RI) as CapEx. This article summarizes the impact of OpEx and CapEx, qualifies certain costs as Capex, and improve financial performance.
2 Impact of CapEx and OpEx on financial performance
OpEx are day-to-day costs in running the business such as annual maintenance contract (AMC) for servers, internet, telephone, and power bills.
CapEx are one-time expenses towards assets, such as servers and storage, which benefit the company for many years, thus also depreciating the cost over time.
EBITDA is an indicator of an organization’s financial performance and determines the earning potential of a company, higher the EBITDA, better the performance.
Simplified formula to calculate,
EBITDA = (Gross Income – Operating expenses) + Taxes+ Depreciation + Amortization
- OpEx is part of operating expenses, so the higher the expenses, the lower the earnings
- Capex is amortized (discussed later), shifted out of Operating expenses, and added in the overall earnings. Hence it drives higher earnings.
3 Qualification Criteria for CapEx
International Financial Reporting Standards (IFRS) is a framework to describe a company’s financial performance and prepare statements. They are issued by the International Accounting Standards Board (IASB). IFRS have recently added the criteria under IAS 38 intangible asset to allow certain upfront payments to be treated as Capex.
IAS 38 defines an intangible asset as an identifiable non‑monetary asset without physical substance (Identifiable Asset).
An asset should meet following 3 criteria to be able to capitalize the payments,
- Meets the definition of intangible asset
- The cost of the asset can be reliably measured
- There should be a future economic benefit from the asset (monetary value when its sold)
|Criteria||AWS Standard RI||Convertible RI||Savings Plan (Compute/EC2)||Comments|
|Asset without physical access||√||√||√||No access to physical layer|
|Identifiable Asset||√||√||√||Each resource has Unique resource id|
|Cost of asset can be reliably measure||√||√||√||Cost of Ec2 can be measured by time|
|Future Economic benefits from the Asset.||√||X||X||Capability of being separately sold or transferred in the marketplace.|
Based on the above criteria, only “AWS Standard RI” meets the definition of intangible asset and Capex requirements. Idea of capitalization is move costs from OpEx to Capex, so it is recommended to pay full upfront RI to increase the profit margin for the company.
4 Amortization of CapEx
Amortization is capitalization of intangible asset over its lifetime. In simple terms, upfront cost of an asset is spread across its life time. The upfront payment for RI should be amortized over the term of RI (1 or 3 years) in straight line.
e.g., If RI full upfront payment is $12,000 for a year term. Upfront should be amortized as $1,000/month for 12 months.
Based on how companies report financial performance, CapEx has an impact on the balance sheet and AWS Standard RI can help to improve the profit margin for the company. To adapt this financial treatment, the Cloud FinOps team has to collaborate with the finance team to change the accounting policies of the company.