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Highly flexible, but not without its own set of issues
Cloud hosting, as offered by the bigger hosting providers like Amazon (the online retailer and pioneer of cloud hosting), Rackspace and others, is hosting where instead of buying the use of a server on an ongoing basis, you buy an amount of server power and pay for it by the hour or day. If you're thinking that sounds a bit like a Virtual Private Server, you'd be right. The difference is that there is no long-term commitment. You can increase or decrease the server power at any time (though beware; though all cloud hosting providers tout this as a benefit, it can be a complex and time consuming operation - you generally can't just push a button and have more power) and you can switch the whole thing off and incur no further fees until you switch it back on again. Some call it a "pay as you go" service.
Cloud servers work by virtualisation, like a Virtual Private Server, where you're given a slice of computing power, disk storage, etc. Your usage is segregated from other users and you get full access to the server, on which you can run pretty much anything you want. So you get lots of flexibility. On top of this great flexibility the best thing is you only pay for the resources you choose. If you're service is growing you can keep expanding without having to invest a lot in advance (and possibly even in advance of you being certain it will grow!).
That all sounds really good, but in reality, it's not quite that simple. For a given amount of computing power, cloud servers individually are more expensive. A server hosted by Amazon which is kept up and running all day every day (let's face it, most websites aren't switched off at night and weekends!) with a given amount of processing power, a given amount of memory and disk space will probably cost more per month than a renting a traditional dedicated server and is completely unmanaged - you will need technical expertise to set it up and run it. With a cloud server you tend to pay for everything, the server power, the disk storage, the data transfer, etc. This makes comparing prices difficult and also means you cannot know in advance exactly how much you'll spend.
The power of cloud hosting comes when you have multiple servers and you don't need all of them on all the time. Most smaller websites run on a single server, or sometimes two, but they both need to be on all the time to keep the site running. So in this instance cloud hosting will probably cost more. However, if you run a larger site with definite patterns of usage you can use a cloud hosting system to allow you to add and remove extra hardware when you need it and only when you need it. For example, let's say you run a website for school children; it might be very quiet in the week but busier at weekends and through the school holidays. You could use a cloud server system so that you had one server online all the time, but at weekends and holiday times you could add a couple of extra servers to cope with your increased traffic. Doing that would be much cheaper than having three servers constantly running when two of them are hardly doing anything most of the time.
Another advantage of cloud servers is when you only need to run your site for a short period. Maybe you're doing a promotion which only lasts a month - rather than renting a server for a whole year you can rent a cloud server for just that month. Or perhaps you want to experiment with a new system. Cloud serving is perfect for this - we've been known to rent a server for just a couple of hours to get a job done. Even though we have two data centres with lots of servers it's actually easier and quicker for us to just rent something from Amazon for a short period than set up a new server.
Cloud servers can make a great backup mechanism. Rather than paying to have duplicate hardware sitting waiting in case your primary hardware fails, you can get everything set up on a cloud server somewhere then switch it off. You incur no costs (other than perhaps a minimal amount for storage) but if your primary server fails you can power up your cloud server and be back online in far less time than it would take to repair or replace your hardware.
Don't under estimate the complexity of using cloud servers. They are generally only suitable for those with plenty of technical knowledge, particularly if you want to take full advantage of all they can offer. Cloud servers can and do fail, just like any other servers. If you want a robust system you will need to have designed in contingencies which are likely more complex than with simpler, dedicated servers. When Amazon's have had problems with their cloud hosting many of their customers have been caught out by thinking they could just fire up new servers in the same data centre, but instead the whole data centre was not responding. Only those that had designed their service to be transferable between data centres were able to stay online.
In summary, cloud hosting is wonderfully flexible and can be cost effective if you're running a large and complex website, but don't underestimate the complexity of managing a good cloud infrastructure; if you're running a more modest site on one or two servers it's unlikely to be cost effective.