Cost of Goods Sold (COGS) is a crucial element in the business environment, and it’s easy to understand when applied to a traditional operation. But in a Software as a Service (SaaS) company, it’s more difficult to pin down because you are dealing with software and applications, and the direct costs are not always easy to define.
SaaS operations are more commonly known as cloud-based software, where the software is licensed on a subscription basis. A central provider hosts the products, and instead of downloading the application, users access it via a web or mobile browser.
Examples of SaaS companies are:
- Atlassian Corporation
- Survey Monkey
- Sale Force
The relationship between COGS and its ability to determine gross profit and gross profit margins is vital to SaaS operations. This article will clarify the differences and show you what expenses you can include and how to calculate COGS for a SaaS company.
What does COGS Mean?
The Cost of Goods Sold is the amount of direct cost involved in producing goods that an organization ultimately sells. It includes the cost of materials, packaging, delivery, and labor directly related to the manufacturing and delivery process. It does not include indirect costs, such as sales commissions, rent, and salaries.
Accounting rules are specific on certain issues and lacking direction on others. There is no Generally Accepted Accounting Principle (GAAP) when it comes to COGS. This lack of direction is unfortunate, as gross margins are crucial to the profitability, value, and performance of any business.
What Does COGS Tell You?
COGS is a simple accounting principle that measures the input costs your business incurs when manufacturing products or services and helps determine your gross profit and margins.
The cost of goods sold is subtracted from the revenue to calculate the gross profit. This metric determines how efficient a business is in managing its production process. If COGS increases, there will be less profit; and the lower the COGS, the higher the profits.
The Benefits of COGS
COGS is vital for any business because it helps calculate the gross profit margin. If you know your gross profit, you know how much excess revenue you have to service your overhead, rents, loans, and reinvestment. It’s one of the critical ways to see how well your business can manage the production process and its potential profitability.
Understanding the COGS Equation
Before you can calculate COGS, you need to understand the COGS equation:
COGS = Starting inventory + Purchases during the period – Ending inventory
As an example, if a manufacturing company had a $5,000 cost of inventory at the beginning of the year, spent $15,000 on materials, labor, and delivery during the year, and ended with an inventory of $4,000 of products not sold, the COGS would be $16,000 ($5,000 + $15,000 – $4,000).
Costs incurred during production for items that are not sold during the year are not included in the calculation. COGS is only calculated on the production costs of the goods that were sold.
Calculating Gross Profit and Margin
Two figures determine a company’s gross profit: the company’s sales/revenues and COGS. These must be calculated accurately to determine the correct gross profit. Otherwise, any decisions based on the figures may cause a financial crisis down the line.
For ease of reference, you should know the following definitions:
- Revenue is the amount received from selling the products or services over a specific period. It includes discounts and deductions for returned merchandise.
- Gross Profit is the revenues/sales minus COGS. This is the amount of profit a company makes after deducting all the costs of the production process.
- Gross Margin is a company’s gross profit divided by its revenues/sales.
So we can calculate the gross profit margin using the following equation:
Gross Profit Margin = (Revenue – COGS) / Revenue
This chart illustrates the principle of gross margin. Let us consider two rival companies manufacturing similar items that sell for the same price but have different COGS.
|Company A||Company B|
|Sale of one table||$120||$120|
|Gross Margin %||50%||37.5%|
It is quite clear that Company A is more profitable than company B.
Exclusions from COGS Deduction
Service companies, in general, do not have any cost of goods sold, nor do they have any inventories. These may include professional singers, accountants, law firms, and Realtors. The business expenses incurred to run these kinds of businesses are known as the cost of services and are not listed as COGS.
Operating Expenses vs. COGS
Both operating expenses and COGS are expenditures to run a business, but they are listed separately on the income statement. Operating expenses are not directly coupled to the manufacture of a product or a service. Some examples of operating costs include:
- Office supplies
- Insurance costs
- Legal costs
- Sales and marketing
COGS for SaaS
When it comes to a SaaS company, COGS is not as simple to calculate. There are several variables in providing a software service that are not as easy to identify.
SaaS businesses provide software-enabled services usually delivered via the internet, which is vastly different from a traditional manufacturing business. So the way you will work out COGS also will be different. The items used to calculate COGS in a SaaS operation differ, even from those used for traditional software companies.
What Should be Included in COGS
A quick test to find out what you should include in COGS is to ask yourself if you could still give your customers the service if you did not include that expense. If no, then it goes into your calculations; if yes, then you exclude it.
Here are some suggested costs that could be included in the COGS calculations for a SaaS business as long as they are not part of your operating expenses:
- Software license fees for embedded third-party apps
- Application hosting and monitoring costs
- Website development and support costs
- Customer support and account management costs
- Data communication expenses
- Costs of subscriptions
- Costs for employees directly involved in production and delivery
- Professional services and training personnel costs
Customer Success (CS)
The essence of CS is a strategy to ensure that customers get what they expect when dealing with your brand. It could be important when they buy your product or enter into a non-commercial relationship, such as contacting you to solve an issue. It may also be following up after the purchase or gathering information to give feedback to the various departments.
Customer service’s knowledge of the buyer’s preferences and the overall relationship is essential when deciding on marketing and advertising campaigns. Also, the interaction that CS has with the customer can help develop the products.
CS has a lot of ground to cover, and you’ll need to assess where it will fit into your company’s overall ethos and cost structure.
CS under Cost of Goods Sold
One way to look at customer service is as part of your product. If experiences, brand connection, and backup service are essential factors for your clients, CS is a significant part of your product. If this is the focus of your company, then customer service should be an aspect of COGS.
Placing it here will help assess your costs more effectively and change the company’s focus when developing new products to sell. Function, form, and price aren’t the only things that compete for the customer’s attention, and the backup service might be your ace in the hole.
There’s one negative to placing customer success under COGS, and that is that you’ll end up with a more-expensive product, which will affect both pricing and profit margins. You can overcome this by ensuring that the customer perceives and understands the extra value they’ll receive.
CS under Sales and Marketing
You may prefer to place CS under sales and marketing if the primary focus is on gathering leads during the customer’s tenure. By placing it here, customer service can attract new clients, build confidence, and help complete sales.
The benefit of placing CS here is that the pricing of the product will be cheaper. The money is being spent anyway, but the concept of costs and return can create different structures and better flexibility.
Once again, you need to ask yourself that vital question: Can I still give my customers the service if I did not include that expense?
What Should be Excluded from COGS
The following costs should not be included in the COGS calculations (note that some companies will include them while others don’t):
- Sales commissions
- Customer success costs associated with upselling
- Product development costs
- Costs associated with internal operations
- Third-party software for in-house applications
It is advisable to keep it simple and avoid complicated allocations or chargebacks, as these can change over time. If you stick with the above suggestions, a potential investor or purchaser will understand the financial figures, as they are generally in line with most SaaS businesses.
How to Calculate COGS?
It is generally suggested that a SaaS company’s gross margin should be around 80-90%, which means that their COGS would be about 10-20% of the revenue. This margin level is a general benchmark accepted by the SaaS industry. These margins are essential when applying for any funding or looking for investors to indicate how profitable the business is.
When it comes to a SaaS company, getting an accurate gross margin figure can be tricky. It is not easy to define the cost of goods sold, and you may want to think of it instead as the cost of revenue.
Here is an example of COGS for two fictitious companies creating similar services:
|Company S||Company T|
|Cost of support and maintenance||$15,000||$5,000|
|Cost of licensing||$6,000||N/A|
|Cost of hosting||$2,000||$5,000|
|Cost of development||$25,000||$20,000|
|Cost of subscriptions||$1,000||N/A|
|The total cost of revenue||$49,000||$30,000|
Software services tend not to have any form of inventory carried over, as they are usually subscription-based. So the COGS equation would just be simplified as the total costs accrued during the period ($49,000 for Company S and $30,000 for Company T).
Calculating Gross Profit and Margin for a SaaS Company
Calculating gross profits and margins for a SaaS company is as essential as for any traditional manufacturing business. The sales and marketing costs, directors’ salaries, and leases are all paid out of the gross profit. The higher the margin, the more there is to reinvest and the faster the business can grow.
Gross profit is the amount of revenue left over after the costs of servicing that revenue has been deducted.
Let us use our above example of Company S and Company T, assuming they both bring in the same amount of sales:
|Company S||Company T|
|Gross Margin %||81%||88.5%|
In this example, Company T has better margins and can keep more funds than Company S. The factors driving this difference are customer support, development, licensing, and subscriptions. The two significant costs are staff-related, which is always a major cost for SaaS companies.
Gross margin is a crucial but often overlooked measure of a company’s financial health. Changes over time may reveal underlying issues about the company’s management or a change in the market. SaaS companies are recurring-revenue businesses, and the more they can increase their gross margin over time, the more revenue they can generate per customer.
Margins in a SaaS environment are essential to investors who want to grow the business. High margins with reasonable retention rates of customers lead to better valuations.
When it comes to risk mitigation and competing in a tough market, high gross margins keep the company ahead of the others even when growth slows. The SaaS market is expected to continue to grow, and competition will become fiercer. That is why it is imperative to understand both COGS and how it affects gross profit and margins.
A profitable business is a healthy business. A SaaS company has a greater chance of achieving success the more profitable it is. Reviewing the financials will help you set new goals and be able to operate an efficient operation.