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How a Little-Known Financial Model Can Finance Migration to the Cloud

Posted by Stacy Nethercoat on Aug 23, 2017 12:00:00 PM
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One of the biggest challenges to getting the most out of the cloud model is figuring out the best way to profit from it. Good new­s – there’s a concept from 80 years ago that applies well to the cloud financial model.

If you haven't heard of the Rule of 78, you’re not alone.

Created in 1935, the Rule of 78 was originally used in the banking industry to model the expected cash flows from interest across payment periods. Although it sounds complex, the Rule of 78 is a surprisingly easy concept to grasp.

The chart below applies the Rule of 78 to a subscription-based model where one new subscription is generated each month of the year. In the traditional sales model, this would net 12 billing events for the entire year. But with a cloud subscription model, billing events grow exponentially, resulting in 78 total billing events through the year.

In this example, if each billing was $1,000, you would have recognized $78,000 in revenue as opposed to $12,000 in the traditional on-premise model.

Financing a Cloud Go-To-Market Strategy

So what does a banking model have to do with cloud subscription investment planning?

The application of investment models used to communicate expected returns on traditional IT market opportunities fall short on illustrating the lifetime value of subscription-based services to an audience that isn’t familiar with the nuances.

That’s where the Rule of 78 is valuable. 

The Rule of 78 is a disruptive way to illustrate investment and expected returns of a subscription model, helping IT organizations of all types better understand the financial complexities inherent when tackling the cloud opportunity.

It’s important to note that the way I’ve seen the Rule of 78 used typically results in the organization breaking even after sales commissions are paid at the end of 12-16 months. But starting the following year, the organization carries over those subscriptions’ net of attrition and continues to earn profit dollars with greatly reduced sales and administrative costs.

Barriers to Adopting the Rule of 78

You may be looking at the diagrams above wondering why more companies haven’t already switched over to a subscription-based plan.

Many IT organizations are hesitant to migrate from traditional models because they’ve grown accustomed to the investment frameworks supporting short-term cash flow from large one-time lump sum customer billings of service or product. Switching to a subscription-based plan results in disruptions not only in the cash flows expected, but challenges the very investment models these organizations have used to finance operations and growth strategies.

Seizing the Rule of 78 Opportunity 

Switching to a subscription-based cloud model doesn’t need to be an either/or proposition. With industry research pointing to the likelihood of hybrid cloud being the technology model of choice over the near term, consider an investment strategy to support subscription profit flows alongside financial plans supporting more traditional model IT opportunities.

There are instances of companies switching to subscription-based services at once, like Adobe—which, almost overnight, transitioned from selling annual software licenses to selling programs as a monthly subscription-based service. But in my experience, this isn’t the norm. That’s what is great about the Rule of 78 – it can be used as a “one-off” to support the investment planning for a specialized business unit focused on cloud, while the traditional business utilizes existing processes.

What are your thoughts on the Rule of 78 investment model? Is your company considering a major investment in cloud services delivery, or do you have any stories of your company’s transition into the subscription-based industry? Share your thoughts and experiences below.

For more information around cloud migration, contact our cloud team today at tdcloud@techdata.com.

Tags: Cloud, rule of 78, cloud migration

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