Understanding COGS & Gross Margin for SaaS Startups
As a finance-oriented person, I've spent a fair amount of time over my many years in venture reviewing startups' financials and advising founders on how to best account for their company's activities. One accounting concept I've seen cause an undue amount of confusion in SaaS (Software as a Service) startups is the Cost of Goods Sold (COGS). I believe it's crucial for founders to fully wrap their heads around COGS due to how it impacts Gross Profit (GP) and Gross Margin (GM) and, thereby, largely describes the scalability of a company's business model.
Disclaimer: While I spent a fair amount of time studying finance and accounting during both my undergrad and graduate school days and have been particularly focused on the topics of startup finance, accounting, and metrics during my decade in venture, I am not an accountant and do not have a CPA (yet...). So, please take what you read below as a primer ahead of conversations with your company's actual accountants and let them advise you on how to best record your expenses.
What are COGS, and why do they matter?
COGS represents the direct costs associated with delivering your product or service to customers and, as such, should be directly linked with the revenues generated. COGS should be comprised entirely of variable (as opposed to fixed) costs, meaning that if your revenues were $0, your COGS should also be $0.
Illustration: Manufacturing Business
To make this concept more intuitive, imagine a generic manufacturing company with a factory that buys 2-3 types of input materials and produces a single type of widget, which it then sells to customers.
Some examples of the variable costs (VCs) of each widget would include:
the costs of the 2-3 types of input materials needed per widget,
the labour cost for factory workers involved in the production process (but not supervisors, administrative staff, etc.),
the utility costs (water, power, etc.) associated with the production process (but not the power needed to heat/cool or light the administrative offices or break room, etc.),
the freight costs of shipping the finished widgets to customers (assuming the customers aren't sending their own trucks to collect the widgets at the factory)
Note how the cost of the factory itself, the land it sits on, or any other expenses do not change directly in response to increases/decreases in production (at least not in the short run). If the factory sat idle (i.e., zero units were produced) for a given period of time, VCs should be close to $0.
Why COGS Matters
On your company's Profit & Loss statement (P&L), COGS are deducted from Revenues to compute the Gross Profit (GP) and Gross Margin (GM). GM is a key metric because it's used, among other things, for gauging the scalability of a company's business model and, in theory, should only change in response to changes in the business model.
Accurately calculating COGS is essential for understanding how the profitability of your SaaS business responds to changes in revenues. By focusing on variable costs, you can ensure that your COGS accurately reflects the cost of delivering your service. This, in turn, allows you to make more informed decisions about pricing, scaling, and overall financial management.
SaaS COGS
There are two reasons I've seen as to why COGS might not be as intuitive in a SaaS business
they have far fewer VCs: this is the key behind the scalability that makes software companies a favored category by venture investors.
complicated cloud pricing structures that accountants (generally speaking) don't understand well enough to separate into variable and fixed costs.
This is a key distinction that sets COGS apart from other expenses, such as Customer Acquisition Costs (CAC).
What to Include in COGS for a SaaS Business
For SaaS startups, COGS typically includes the following expenses:
Variable Components of Hosting and Infrastructure Costs
These are the costs associated with running your software - including cloud services like AWS, Google Cloud, or Azure - that will scale proportionately with increased usage.
One problem is that not all cloud computing costs are broken down into variable and fixed as neatly as widget materials and the lease on a factory. This is where your engineers and accountant need to work together and exercise some judgment as to which costs belong in which bucket.
Third-party software and APIs
If your service relies on third-party software or APIs, the costs associated with these services should likely also be included in COGS, as they likely scale with usage.
Payment Processing Fees
Any fees paid to payment processors (e.g., Stripe, PayPal) for handling customer transactions should be included in COGS. These fees are directly tied to the revenue generated from customers.
Data Storage
COGS should include costs associated with storing customer data, such as database services and backup solutions, to the extent that they scale with the number of users.
Customer Support (sometimes...)
COGS should include the portion of customer support (CS) costs that will vary in the short term.
This is very simple if you've outsourced CS to an outside firm that charges you based on usage (e.g., the volume of customer inquiries).
This is less clear when, as is most often the case, your CS team is internal. I'd argue to only include any portions of this spending that will vary month-to-month, based on the volume of customers, but to keep the rest as part of OpEx.
CAC vs COGS: a Common Pitfall
Customer Acquisition Costs (CAC) represent the costs associated with acquiring new customers, such as marketing and sales expenses. Their relation to revenues will likely be a frequent topic of discussion, and there may even be mentions of your company's "CAC Margin"; this most often means your Average Contract Value (ACV) less CAC (resulting in a "Net ACV") divided by ACV.
While this is, indeed, an important topic of discussion as it pertains to the soundness and scalability of the company's go-to-market (GTM) strategy, I have seen it sometimes get conflated for a discussion of COGS and GM, which it is not as CAC are not directly tied to the delivery of your service and should be categorized separately.
In short...
In summary, for SaaS startups, COGS should include variable costs such as flexible portions of hosting and customer support, third-party software, payment processing fees, and data storage. By keeping COGS separate from CAC and other fixed expenses, you can gain a clearer picture of your business's financial health and make strategic decisions to drive growth.