As more and more private clouds are deployed, organizations will face the requirement to implement chargeback or at least show back. Key to implementing chargeback is setting the chargeback rate. Much as pricing significantly impacts a public cloud provider, for the private cloud provider, the chargeback rate has significant implications. This white paper examines three strategies for setting prices for private cloud operators.
Public cloud operators, or for that matter any business selling a product, set pricing based on the pricing triangle. The triangle contains three key balance points for pricing a product:
- Product or Service Cost – unless you are selling something as a loss leader, price is generally set above cost. The greater the delta between cost and price, the higher the margins. Determining the cost of IT services can be challenging. But in general, is a summation of computer, network port, storage port, storage space, power, datacenter space, software, maintenance, and support costs.
- Value – this is the perceived value of the product from the customer’s point of view. Segmenting the potential customers helps to determine what portion of the potential customer base finds the value of your product the greatest. Hopefully, this segment values the product greater than the costs and, this segment is large enough to drive significant top line revenue. For IT, the customer values tangible items such as up time, patch management services. The challenge for IT are the value items they are required to provide the corporation, such as compliance with back up policies, that the individual IT customer may not value.
- Competition – no matter the cost or perceived value to customers, competitors dramatically drive market pricing. It is possible to price above competitors costs provided the perceived value to a customer is there. Conversely, competitive pricing can reduce even the strongest value point. For IT, the competition is surfacing as public cloud providers.
A balanced approach with the triangle sets a price that provides sufficient margin, is defensible against the competition and has the customer seeing sufficient value in the price.
While the balanced approach is preferred for corporations selling goods and services, it may not be preferred for private cloud operators. Other pricing strategies could be:
- Cost plus pricing that ignores the value and competitive legs of the triangle. Cost plus pricing simply takes the cost of a product and adds a set mark up. For IT, this is the traditional chargeback approach.
- Value based pricing only looks at the value delivered to a customer yet ignores competitive pressures.
- Commodity pricing ignores all the value added services a vendor provides, and simply sets prices based on the offerings of competitors.
Ideally, an enterprise uses the cost triangle to balance the three inputs to pricing and come up with the right price. But IT is not actually a true vendor and there is actually a hazard to pricing this way for IT services. Value, cost plus, or competitive pricing may actually be preferred based on the goals of the private cloud initiative for an enterprise.
So which strategy does one use? There are three pricing strategies for charging back or show back:
- Price to reduce sprawl and waste
- Price to push IT to operate as a business
- Price to enable open market competition between IT and outside vendors
We will examine each of these pricing strategies and how the pricing triangle may be different.
Price to Reduce Sprawl and Waste
By exposing the cost of resources consumed by a business unit, business units are motivated to reduce their spending to maximize their internal P&L. Inefficient consumption happens with VM sprawl and over allocation of resources to a virtual machine. Sprawl occurs simply because of the impression that “VMs are free” while over allocation of resources occurs when application owners insist on deploying the same resources to a virtual application as a physical application regardless of utilization.
What is the optimal pricing strategy to reduce sprawl and waste?
Since the goal is simply to reduce waste, coming up with a reasonable cost to deliver services and exposing that cost to end users is the optimal strategy. Since it is the act of exposing the cost that drives efficiency, there is no reason to charge the actual prices. Some logical formula that takes into account actual cost, then modifies the pricing to be below public cloud providers is all that is needed.
Why price below public cloud providers? Pricing significantly above public cloud providers could actually introduce an incentive for internal customers to seek out external providers. Since external providers many times don’t meet the compliance requirements of a private cloud, this would not be a preferred result. Since the goal is simply to reduce waste and not compete on the public market, pricing more than public providers is not a good strategy. By adjusting the actual internal costs, pricing less than the competition, and simply highlighting the value added services, IT organizations can achieve the goal of reducing waste without driving their customers to external providers.
There is a hazard, however, with charging back in all these scenarios. Once an IT group charges back, they lose some amount of control over the resource. For an individual business unit, wasting 30% of an IT asset could be a minor line item on their balance sheet not worth the trouble to correct. For the IT group, however, if every business unit wasted 30% of their IT resources, that adds up to significant waste for the company. So although chargeback is in place, retaining the ability to force corporate wide efficiency must be maintained. One VKernel customer actually charged a higher rate for wasted resources than efficiently used resources.
Price to Push IT to Operate as a Business
For this second strategy, the pricing triangle actually provides good guidance on how to price. Assuming internal customers are not permitted to use competitive offerings from sites like AWS, setting prices to cover costs makes the most sense. Since IT generally provides many additional services that external providers do not provide, internal costs tend to be higher than competitive offerings. So it is important to actively market the added value IT provides. Exposing actual costs will push IT to reduce these costs over time which is good, but also provides IT with a platform to market the added value services they provide. The same hazard exists with internal customers wasting resources as it did with goal #1. And, despite IT directives not to use outside vendors, public cloud operators will start to make progress in rogue business units.
Price to Enable Free Market Competition with External Vendors
This goal is perhaps the most challenging for IT but also a requirement for organizations looking to implement advanced hybrid clouds. External competitors like Amazon are generally cheaper than internal IT. But they also don’t offer all the value added services. However, some of these services may not be valued by individuals inside the corporation. Rogue development organizations may not care about esoteric compliance requirements. If IT operates in the free market without significant marketing to explain the need for higher internal IT costs and the value add it provides, end users will go for less expensive services, but also place corporate assets at risk.
Pricing in this model would be to price at cost or best case at a competitors pricing. IT would then market the value added services to end users. In this model, applications move between internal private clouds and public clouds based on the lowest cost. Hence the hybrid cloud label. Despite the theoretical efficiency, there are many pitfalls with hybrid cloud/market based pricing. Is IT still responsible for an application owner who moves his app to the public cloud for lower prices yet fails to recognize the public cloud provider does not meet compliance requirements? The list of hybrid cloud pitfalls is long, but the pricing strategy in this case is the most pure of the three.
Common Benefits and Pitfalls
Whichever goal and pricing strategy is selected, there are common benefits and pitfalls:
- All models require determination of actual IT costs per virtual machine. This is an invaluable exercise.
- All models require an inventory of the value added IT services such as compliance, back up, patch management
- All models require marketing value added services
- Loss of control that pits the greater good of the company vs. individual end users. Once end users are “paying” for a service, they can waste it. Allowing internal IT to push for across the board efficiencies is important to contain IT spending.
- Easy comparison to public providers – exposing cost information provides an easy comparison for end users to compare internal prices with public cloud providers. This ease of comparison invariably will drive internal customers to select external providers for cost reasons or at least question why the internal resources supposedly cost so much.
- Charging back provides context for people to depart the corporate standard to “save money”.
Selecting a pricing strategy for IT is challenging. Understanding the goal of chargeback and show back is the starting point to select the proper pricing strategy. Care should be taken to avoid pitfalls and while harvesting the benefits of a more rigorous financial approach to delivering IT services.