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The cost of capital around Reserved Instances

By Leah Weitz on March 12, 2015
The cost of capital around Reserved Instances

All Upfront, Partial Upfront, or No Upfront? It’s a relatively new question for Reserved Instance buyers—and it introduces new factors into calculating RI needs. Because now, selecting the right Reserved Instances for your business will come down to more than just utilization rates; understanding your business’s cost of capital, and factoring in your accounting desires, is key to choosing between your payment options. Leveraging the new Reserved Instances effectively, and generating savings without jeopardizing cash flow, will depend on these metrics.

The new considerations

The new Reserved Instance types offer three different payment options: All Upfront, Partial Upfront, or No Upfront. You’ll end up paying for all hours of the reservation term no matter which of the three you choose; the variable comes down to how much you can pay at once, and what your subsequent savings rate will be. The more money you’re able to pay upfront, the less money you’ll have to pay overall. All Upfront offers the highest savings rate, and No Upfront the lowest. All three offer significant savings over on-demand.

Obviously, the highest savings rate is the most desirable. However, fronting the money necessary to secure that rate will have some degree of impact on your business by driving a considerable hit to your company’s wallet all at once. Quantifying that impact, and comparing the potential disadvantages of such a commitment to the savings that you’ll earn in the process, can help to shape your decision.

What’s your cost of capital?

When we say “cost of capital,” what do we mean? In this context, “cost of capital” refers to the combination of hard cost and opportunity cost associated with raising and spending money on a particular investment (a Reserved Instance). The hard costs might include selling equity to raise capital or making debt payments if you’ve taken out a line of credit or loan; the opportunity costs refer to the loss of potential gain from investing your dollars elsewhere. Determining which Reserved Instance type you should get is a trade off between the heightened cost of capital associated with All Upfront or Partial Upfront RI types, and the increased savings rate that they deliver.

If you have lots of cash in the bank and are accumulating capital all the time, such as at a large, publicly-traded enterprise business, fronting the money for an All Upfront Reserved Instance won’t be such a stressor on your finances; it’s not like making the purchase upfront will cause you to run out of money. You’ll therefore have a low cost of capital, and the All Upfront deal, with its higher savings rate, will be a no-brainer.

But what if your cost of capital isn’t quite so low? At a startup or smaller business, spending all of that money at once could represent a serious strain on your budget—or even be impossible. If paying for the whole reservation term in one upfront lump would require cutting back in other areas, you’ve got a sky-high cost of capital that will likely outweigh the increased savings rate associated with an All Upfront. A No Upfront payment plan would likely be a better fit.

Partial vs. All: The accounting factor

There’s a fairly notable difference between All Upfront and No Upfront savings rates. When you choose the No Upfront option, you end up paying considerably more overall than you would had you chosen All Upfront—you simply pay it over the course of the reservation, rather than all at once when you first make the purchase, in order to accommodate the limitations of a startup or small business’s budget. However, the Partial Upfront is very similar to All Upfront in terms of savings rate (the difference is about 1%). The only substantial difference is in how it’s paid; a sizable chunk of the cash is paid upfront, but a remaining portion is paid over the course of the reservation duration. That means your choice between these two options will come down to accounting preferences and payment method rather than savings.

Many large businesses are electing All Upfront in order to avoid the accounting hassle associated with splitting up the bill over time. By paying for the reservation all at once as an All Upfront, they can treat it as a fixed asset that can be depreciated over the duration of the term. However, the fact that Partial Upfront doesn’t require such a significant upfront payment means that businesses with a higher cost of capital can compromise on their payment plan without settling for the lower savings rate of No Upfront. Which of the two you choose will depend on whether the advantage of the accounting simplicity outweighs your cost of capital.

Making the choice

When you’ve decided on which Reserved Instance type and corresponding payment method will work best for you, it’s time to calculate how many and what class of Reserved Instances you need to achieve the greatest savings for your infrastructure.

One easy way to do so is with the Cloudability Reserved Instance Planner. Filter the Planner by the RI type you want, and it’ll generate a list of recommended purchases to keep your infrastructure covered with the highest available savings rates for your selected payment plan.

exclude Reserved Instance types

You can try the planner yourself by logging in or signing up for a free 14-day trial of Cloudability Pro.

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