Buffett’s Law and Cloud Computing

6 October 2008

In an interesting post on the future of Cloud Computing, Jake Smith says that one of several antecedents of wide-spread cloud computing is the impact of “Buffett’s Law”.  Basically, the law states that Warren Buffett, the billionaire investor is driving change in the business world through the principles of value investing in ways that promote conservative innovation as opposed to radical or flamboyant visionary creation.  “The value of an enterprise is a direct correlation of it’s ability to deliver consistent return on invested capital, regardless of market conditions.”  What does this mean? 

Return on Invested Capital (ROIC) is a measure of the ability of a company to generate EBIT or earnings before interest and taxes compared to the amount of investment in long term debt or equity.  To maximize the ROIC, the company must do two things:  first, maximize its operating profit which translates to maximizing sales, minimizing the cost of good sold, minimizing the overhead involved and working with a low tax rate; second, the company must minimize the debt and investment required which translates into minimizing the working capital requirements and the non-current assets.

The first part is about efficiency of operations.  The second part is about business models.  Efficiency of operations is the realm of lean manufacturing – a philosophy of organizational efficiency that can be applied to just about any process.  Business models relate to how you make money and the decisions about what you do and what you outsource.  Take the decision to outsource PCB assembly rather than purchase the equipment and build the components in house.  If the cost of goods remains the same, out-sourcing is preferred since it lowers the non-current assets which will result in a better ROIC.  To make the purchase of the PCB assembly line attractive, the cost of goods would have to drop significantly compared to what could be produced through outsourcing in order to generate the same ROIC.

How does this apply to cloud computing?  Cloud computing is essentially an outsourced IT model comparable to the outsourcing of PCB assembly.  The cloud offers lower infrastructure for similar performance which means that, even if the cloud is just as expensive as tradition IT, it will be a preferred simply because it lowers the ROIC – hence the impact of Buffett’s Law.

For more on the trends in cloud computing read Jake’s article here or my own take on the changes in IT here.

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