Managing your Saas COGS (Cost of goods sold) is a critical element of running any business.
Often, when someone mentions COGS there’s this natural tendency to think of physical products and manufacturing companies. Admittedly, production or retail can be the most understandable application of COGS.
But running a SaaS business doesn’t mean COGS are an irrelevant metric that is impossible to calculate. It also doesn’t mean that a SaaS company is strictly considered a service business, or that all costs should go into overhead.
Although SaaS businesses are typically subscription-based software companies with business models vastly different from those of a manufacturing company, managing your COGS is a critical aspect of keeping your business profitable.
Tracking COGS is just as important in SaaS as it is in the physical goods space.
What is COGS?
COGS, or cost of goods sold, refers to the direct costs required to produce the finished goods sold by a business or organization. The metric can include all aspects of material, production, delivery, and labor associated with the manufacturing costs.
Generally, COGS excludes indirect or overhead costs. It’s the measure of the input necessary to generate the output required by customer demand.
The Saas COGS Equation
The theory behind calculating COGS for the period in question is relatively simple.
COGS = Starting Inventory + Purchases During the Period – Ending Inventory
It’s important to note that COGS only applies to goods or services that are sold. For example, in a typical physical products company the COGS calculation could look like:
- $20k = Starting inventory
- $65k = Purchases and direct salaries for the period
- $15k = Ending inventory
- $70k = $20k + $65k – $15k = COGS for the period
Generally speaking, software companies have little to no inventory.
How is COGS Useful?
COGS is a key component in determining the company’s gross profit, gross profit margin, and ultimately the profitability of the entity. As such, understanding and controlling your COGS is elemental in successfully steering the company.
For example, over the last quarter, your SaaS company earned $200k in net revenue. If your COGS for that Revenue was $80k, your gross profit would be $120k, and your gross profit margin 60%.
Gross Profit ($120k) = Revenue ($200k) – COGS ($80k)
Gross Profit Margin (60%) = Gross Profit ($120k) / Revenue ($200k)
Your gross profit margin shows what percentage of your sales stays in the company. Your gross profit determines what you can afford to spend on overheads, G&A (general and administrative) expenses, and how much you have leftover to reinvest in the business.
COGS for SaaS
SaaS businesses tend to blur the lines between being service providers and traditional manufacturing businesses. Selling services and software through the internet makes calculating COGS challenging.
One handy rule of thumb: when defining which of your costs belong in the COGS basket and which in the Operating Expenses basket it’s helpful to ask:
If this expense were excluded, would it be possible to deliver this product or service to a new customer?
If yes, this expense category belongs in Operating Expenses.
If no, put it in the COGS basket.
Let’s take a look at a few examples of expenses that should generally be considered in COGS:
Cost of Dev Ops
SaaS businesses are software companies. You won’t have a product without developing or coding it. While the costs incurred to build the initial product wouldn’t be COGS, the teams maintaining, and improving your product that is live and being used by your customers belong in your COGS.
Cost of Software Tools
Anything your staff uses that is necessary for the delivery of the product should go in your COGS. This can include security tools, chat bots, debugging tools, etc.
Cost of Hosting and Server Space
What you pay to have your product available for delivery or download, or a website enabling customers to sign up and purchase your software belongs as well to COGS. However, any separate staging or development environments and their associated hosting costs would not be COGS.
Especially if your SaaS includes a service, for example, a “done for you” setup, these staff costs should be included.
For example, a website analytics SaaS sets up the tool on a client’s website and even sends out staff to the client’s location.
Recurring Affiliate Sales Commissions and Royalties
These costs are generated by having other people sell your product and are paid out over the duration of the customer’s subscription as a referral commission. However, if you pay one time sales commissions to your sales team, these can also be considered sales and marketing costs.
Depending on your business model, a few of these cost categories could go either way.
Customer Service staff, for example, should go under COGS if they are focused on helping your clients and customers better use your product.
Or, they could go under Sales & Marketing expenses if the staff’s main focus is on generating leads and attracting new clients. To further complicate it, sometimes you can make the case to allocate an employee’s time between COGS and another account.
However you decide to consider your customer service (and any other) staff, your COGS should consider the fully burdened cost. This means that the departments are responsible for every expense originating from their operational activities.
Everything involved in the delivery of the product should be included: all wages, taxes, travel expenses, software, etc. Everything.
Department heads need to be responsible for the full scope of the costs they have control over. Overheads and SG&A can’t become a collector for costs that the departments don’t want.
The Importance of Tracking COGS
There is a business reason that physical products companies track COGS so closely. Managing these costs is a critical aspect of managing your business and controlling your profitability.
Understanding your COGS lets you:
- Calculate margins
- Improve cash flow
- Better manage your cash runway (especially if you’ve taken on external investment from a fund or VCs)
- Better price your products (even if you’ve got a loss-leader, be intentional about your pricing).
Knowing your COGS can help you make better, more strategic decisions about your operations.
Get Expert Accounting Help
It’s tempting to think that COGS applies only to manufacturing and physical products businesses. But that’s not the case at all.
COGS is a critical metric for SaaS companies to monitor and control. It helps you better manage many core elements from pricing strategy to cash flows
If you’d like expert help getting clarity on your SaaS business’s COGS and other startup accounting topics, give us a call at Founder’s CPA. We understand SaaS businesses and the startup industry.