It looks like a product but is secretly a subscription

The mental minefield of capex and opex

an image of doorstep milk delivery and a close-up of a milk bottle

In my parents' childhood it was more common for milk to be delivered weekly (or twice weekly) by a milkman than to go to a shop to buy it. Milk was a subscription service and that made a lot of sense, especially as the milkman also sold eggs, bread and other staples. Unusually, where I live there is still a milkman.

The bottles are made of glass. When they are empty they are rinsed and then left out for the milkman to collect next time and so are reused. The only (recyclable) waste is the small foil cap. The milkman arrives in an special electric van called a "milk float" so if you are into your environmentalism then milk is the SaaS for you.

At some point though, milk became something your bought at the supermarket, in a disposable plastic bottle that you put in "the recycling" but the plastic is mostly not in fact recycled at all but just moved around. This makes milk an unusual case of a service turning into a product to its detriment.

My teenage weekend and summer job was to be shelf-stacker in a "big box" shop. I specialised in printers and printer cartridges. Customers sometimes wanted to hear my advice but once they received my recommendation of a £100 mono laser they never wanted to hear any more of it. Most of them bought the cheapest printer in the shop, a Lexmark model for less than £30, clearly a screaming deal. A huge fraction of them returned within the week to buy more ink, for the cartridge that was bundled with the printer came only a third full. When they saw that the refill cartridge for their new printer was nearly £40 it often really did become a screaming deal.

The very last thing they wanted to hear about at that point was "that bleeding mono laser again". It would have been more rational to switch printer but sunk cost fallacy exerts a strong pull and the majority did buy the refill cartridge. That little Lexmark cartridge did excellent repeat business.

The secret of printers is that you aren't buying the printer but instead entering into a subscription for printer cartridges, which are often ruinous. But that truth is obscure and printer manufacturers work hard to ensure it remains so.

The dreaded riddle of "capex and opex"

There are two ways to spend money on things. One is to buy something outright and then own it. Accountants call this capital expenditure ("capex") because you're spending your company's share capital. It then ends up on your balance sheet, meaning you count it as something of value that your company owns.

The other way is to rent. Accountants call this operational expenditure ("opex") and instead of owning the thing forever you pay someone to give you access to it for a while. Despite the printer example, it is important to understand that this is not necessarily worse and can often be a better deal.

If, as a company, you owned your own offices you would sink your company's capital into commercial property in the town your company operates in. That would be some capital no longer available to your core business. If your core business has a return on equity of 20% then it's probably a better idea to use your capital there rather than putting it into commercial property which makes only about 7% a year ( a good year).

Software, despite widespread pretence, is usually opex

Not all capex vs opex decisions are so rational, or so clear. One of the great conceits of modern business is to pretend that you are investing capital when you are really just cultivating a new stream of expenses. It's common for people to say that they are "investing in [such and such]" or "building an asset" when really they are just allocating more budget for spending (ie: opex).

What makes an asset, though? More terms from accountancy help. When an accountant values an asset in order to record it on the company balance sheet they mark its value at historical cost or net realisable value - whichever is lower. Demonstrating "net realisable value" proves hard for many software projects. It means you have to find a buyer.

That isn't someone who will buy licences (ie rent access) but someone who would buy the thing outright and take it off you. Generating revenue does not make something an asset - though if you can sell licences (profitably, after costs!) that is a suggestion that there might be someone out there who would buy it or that it could be spun out as a separate business.

In practice is it pretty exceptional for any software project to have a real prospective buyer. That new, "big data" warehouse platform probably won't have any ready buyers - it's too specific to your business, with that analytics data you "need". The new customer service system also won't - no one else in the hospitality industry is crying out for Kafka-based replayability of hotel complaints.

Where does the pressure to capitalise come from? Generally from managers. Most business units have some income and some expenses. If you start capitalising stuff those expenses disappear and, better yet, even start to appear on your balance sheet as an asset - however nebulous. Now your numbers look really good. Accountants have heard this one before and that's why the rules are so strict.

A home truth of mine is that software projects in fact look more like a liability than an asset. Software, whether anyone is getting any benefit from it or not attracts a huge number of very annoying expenses: security vulnerability scrambles, bug fixes and database upgrades, and all of it just lines the pockets of wealthy sysadmins.

Sneaky opex

Like the printers of my teenage years, some things appear to be products but in fact are subscriptions. One sign of a product that is secretly a subscription is networking: if it connects to the internet, and thus to some server, it is likely to be a subscription rather than a product - even if the "product" itself claims otherwise.

My favourite example of this are the "smart" televisions that one day decided, all on their own, to start showing adverts: a new, recurring psychic cost for their subscribers, who had thought they were owners. Another is the tractor manufacturer John Deere, who work hard to ensure that you can no longer keep your tractor in good working order with just a socket set and an owner's manual but also need a paid-up subscription to their online services (else they will remotely disable crucial features).

To paraphrase Leslie Lamport, a secret subscription is one in which the reliance on a server which you did not even know existed can render new expenses onto your continued use of the "product".

Sometimes, though, "opex" is ok. There are times when you truly want a little bite out of something that is very big. You want, for a few hours or minutes, to have access to an enormous data centre: then hourly rental of cloud computers is the thing for you. All of the low-level sysadmin knowledge required to operate such a thing is encompassed in the service offered - and they are quite open about it being a service.

Corporate finance, upside-down

In any given scenario, a company (or person) will want to buy or rent something they need and they should decide carefully which to do. It's fair to say that the answer to that question is the total subject of corporate finance.

Companies rarely succeed based on good corporate finance alone but there is a kind of upside-down corporate finance that can really help: to make your suppliers and customers do bad corporate finance.

An example, very of-the-moment, is to turn what would otherwise be a single purchase of a software package into a long-term rental - a "SaaS". This happened with Adobe Photoshop, which was happily a thing you could buy a copy of for decades until Adobe realised that they could really start cooking with gas if they only made it available for an ongoing fee. For Adobe's subscribers, the lock-in is considerable as access to their existing bank of files and documents is contingent on continued payment.

Another example occurs in business-to-business deals. If one party to the deal is stronger than the other they will often make the weaker party apply their capital rather than invest their own. Supermarkets often only stock items on "consignment" - meaning they pay nothing until the items sell (in fact, usually 90 days after that) and have the right to return them if it doesn't sell. This ties up the supplier's capital in the products instead of Tesco's and so Tesco have them on the grocer's equivalent of "no win, no fee".

A third example is cars. Cars are an extremely annoying product to sell because they are not much use unless they are reliable and if you do make them reliable they tend to last a long time - about 20 years. In order to ensure that most people do not go two decades between new cars, carmakers have enormous consumer finance departments and they strongly encourage people to get their cars via an exceptionally confusing monthly subscription plan called a "PCP". The gist of a PCP is that you pay £250-£500 per month for 4-5 years and at the end you do not own the car - despite pseudo-financial mutterings to the contrary about "deposits", "equity" and "options to purchase" (my golden rule as a consumer is never to buy a financial derivative). At the end of their 4-5 year contract these secret renters are bamboozled at the dealership and convinced to just "roll over" their deal onto a new car with much the same monthly payment and, again, no ownership. It costs considerably more to do this great rigmarole than just to buy outright.

Good business sense is to do only what is reasonable for yourself but great business sense is to make others do what is not.


See also

When I was first getting interested in finance my company's accountant told me that one of the questions he asked accountants at interview was: "What's the difference between a financial versus an operating lease?". I still think this a very pretty sharp interview question. It's a shame my own field does not have such a good "which way is up?" interview question.

The older I get the more widely applicable I think corporate finance knowledge is. For example I enjoyed this article discussing it's relevance to computer game development.

I love Michael Porter's Strategy and the Internet. It would seem reasonable to assumed that any writing on strategy regarding the internet from 2001 would be so dated as to be irrelevant but I think it still hasn't been adopted fully. I also loved Information Rules which covers some of the same material but from a more economic perspective.

I have not gotten onto all the incredible hijinks of the printer cartridge business but will put some quick facts here, all accurate as of mid-2008: