When does colocation become more cost effective than renting dedicated servers?

Actually, they are bundling the cost of a maintenance contract with the hardware vendor into your monthly fee. The real advantage is that you don't need to buy or build a datacenter.

There's three ways to get servers: owning, renting space, or renting servers.

Owning

1. Dedicate a room you can put raised floor into
2. Get two power domains coming into it
3. Get a UPS on each domain, or at least one
4. Set up power distribution so you can plug each half of each piece of equipment into a different PDU with a different power domain
5. Get a pair of AC units
6. Install enough racks for your gear
7. Buy servers, switches, etc. with maintenance contracts, ideally on leases that expire when the maintenance does

Pros:

• After your datacenter is built, you only ever need to pay for new gear.
• All your users will have a cheap high speed connection to their servers.

Cons:

• You run into problems if you grow past the first one. Datacenters don't come in very many sizes, and if you can't knock down a wall to make your existing one bigger, moving to a larger room is only really an option when you're decommissioning your existing gear anyways (like at the end of a lease). Adding a second datacenter in the same building will be as expensive per square foot of raised floor as the first one, usually.
• Telecom to the outside world is usually more expensive for you than it is for a colocation facility.

Renting space

Instead of paying once to build a datacenter, you rent a scalable number of racks (or rack units) in a colo's datacenter.

Advantages:

• You will never run out of room, and will always be able to buy more rack units from them
• They are already on a large pipeline to the internet, making your bandwidth costs from your servers' side fairly affordable
• You don't need to worry about power, cooling, or cabling. In theory, they should be able to do all that as well or better as any private shop.

Disadvantages

• If they can't cable, cool, or power IT gear as well as they claimed in the brochure, it's out of your control. You can't easily move most IT equipment once it's installed.
• They charge an ongoing rate, no matter how many years you're with them. Eventually, the money spent on this will exceed the money you'd have spent building your own, admittedly smaller and less scale-efficient, datacenter.
• Unless you're really specific, you never know who is being given physical access to your servers. Are other clients allowed to monkey around in the hot aisle you use to store your fiber cable?
• Server applications are usually designed assuming there's a LAN between them and the users. They're not very efficient with bandwidth sometimes, and this can mean that even though the telecom costs on the server side are low (as most colos are on a cheap to rent backbone), you might need to purchase a heavier-duty line than you would otherwise have been able to get away with.

Renting servers

It's like renting rack-space, except you also don't own the servers. You can rent whole servers or shared servers.

Advantages

• It can be very cheap
• You don't need to manage an operating system, instead being given a standard, managed VM or application share

Disadvantages

• On a shared server, if your neighbour knocks down a wall, it'll fall into your bath. Or, more specifically, you're subject to certain shared resources like memory, CPU, and disk. If they have an out of control process, you can see your response time take a hit, or worse, your entire server become unavailable.
• Even if you have a dedicated server, not being able to manage the OS will sometimes leave you unable to do certain things you need to, like if an app you run requires a specific build of Linux.
• As soon as you have a few shares, it probably would have been cheaper to rent a server. As soon as you have a few servers, it'd have been cheaper to rent the rack space and buy the server. As soon as you have a few rack units, it'd have been cheaper to build a datacenter.

People Whether they're on your payroll or your hosting provider's payroll, someone needs to maintain IT gear. If building your own datacenter would force you to hire someone to manage the physics behind the technology (cable management, environmentals, etc.), then factor that into the cost. If you can just make your network admin do it for no more than he or she currently makes, then don't.

I don't think there's a magic number. It's a business decision. If you need certain specifications that aren't available from the host, you should co-locate. If you can support your own hardware, and trust smart hands enough to handle minor issues, co-locate.

Evaluate your footprint and see what the fee structure looks like at the colo.