If cloud computing services offer the tremendous benefits and flexibility that executives promise, why doesn't Amazon Web Services (AWS) charge more for them? It's not just that they may be kind hearted people: AWS is looking to build economies of scale and set low prices that act as a barrier to entry for new competitors.
Service providers and IT vendors are quick to tout the benefits of cloud computing, citing the ease with which companies can test and deploy applications or scale up the number of servers they are running during periods of peak demand. They also cite the financial benefits that come from using cloud computing services, such as the ability to exchange up-front capital investments in favor of variable expenses that can be spread out over many months or years.
The value that companies get from these services should mean customers are willing to pay a premium for them, but AWS wants to keep its prices low, giving up the opportunity to earn higher margins in exchange for greater economies of scale that give it an edge over rivals, a strategy that Andy Jassy, senior vice president of AWS, said is rooted in the company's heritage as an online bookseller.
"We always have tried to look at what our cost structure is and then, as much as we possibly can, give those savings back to customers. I think some of it really comes from the way that we think about our businesses, every business," said Jassy, who's worked in all of Amazon's business units during 13 years at the company.
"There is no doubt in my mind that it will be a high volume, low margin business," he said.
The AWS business model is simple. The company offers a range of cloud computing services and charges customers based on how much they use them. There is no minimum monthly fee.
For example, AWS bills customers of its CloudFront content distribution service every month based on how much data is transferred, the number of download requests received, and where the data is distributed from. For content distributed from Amazon's servers in the US, the company charges $0.15 per gigabyte for the first 10TB transferred each month, with the price per gigabyte declining as the total monthly volume of data increases. Prices are slightly higher for content distributed outside the US, particularly in Asia.
AWS uses a similar pricing model for its other services, including Simple Storage Service (S3) and Elastic Compute Cloud (EC2). This low cost approach to cloud computing resonates with customers used to paying higher prices for their in-house systems, Jassy said.
"Cost was a big driver for them, and it wasn't the only driver for them, but they felt like for a long time that technology providers had been making very rich margins on them, even when their cost structure would have afforded to giving some of that back to customers," he said.
By keeping prices for its services low, AWS should attract customers who find they face higher costs running similar infrastructure services on their own. As demand for AWS services increases, its growing scale will give it greater bargaining power with suppliers, who are increasingly likely to sell their products at lower prices to win business from AWS. That should allow the company to continue lowering the prices that it charges to its own customers over time, without cutting into its profit margin.
"The beauty of a common outsource centre for a lot of companies, especially if they don't think this is a strategic competency for them, is that they will never be able to match an independent third party who can pool the costs across a bunch of other players," said Paddy Padmanabham, a professor of marketing and international management at INSEAD.
Economies of scale also form a barrier to entry for new competitors as any company that wants to compete with AWS will have to match its low prices. The impact of AWS's strategy is already being felt, even though adoption of cloud computing services is just getting started.
"AWS has a public rate card that's driving prices down for infrastructure as a service to be very much commoditised, and it's hard for service providers to compete in that space," said Carl Eschenbach, senior vice president at VMware. That will be difficult for smaller companies without the same economies of scale, unless they find ways to differentiate their services and create value in ways that AWS doesn't offer. "These guys have to figure out how they go beyond that (low-cost) game," Padmanabham said.
To do that, cloud computing providers must offer services that create value beyond what AWS offers, either by offering platform services for custom applications or software applications that command higher prices and better margins than infrastructure services. That's already starting to happen.
"We see our VCloud partners saying, 'We're going to stand up infrastructure as a service based on VMware but, oh by the way, we're going to start layering other services on top of it," Eschenbach said, citing VMforce, a platform as a service offering recently launched in partnership with Salesforce.com, as just one example.