If you are working in a SaaS you have surely heard the term COS(cost of services), or more commonly COGS(Cost of good services). The COGS (Cost of Goods Sold) is a term that refers to the direct costs associated with the sale of a product or service, and is essential to calculate the profit margin of your company. In this post, we will tell you everything you need to know about what to include in the COGS of a SaaS business and how to calculate it correctly.
What are COGS in a SaaS company?
COGS in a SaaS company are the direct costs associated with providing the service. Although the terms “cost of goods sold” and “service” may seem contradictory, in a SaaS company, COGS is the cost of delivering the software to customers.
COGS includes server hosting and maintenance costs, the cost of software licenses, the cost of third-party services, technical equipment costs, and customer support costs. In short, the COGS of a SaaS are the costs that are incurred directly to provide the service to the customer, which means that they are costs that can be tracked and allocated directly to the service.
For a SaaS startup, controlling COGS is critical to ensure the profitability of the business. If COGS are too high, the profit margin may be insufficient to cover overhead and make a profit. Therefore, SaaS startups should pay attention to operational efficiency and look for ways to reduce COGS costs, for example, by using cloud technology, automating processes or outsourcing certain services to specialized providers.
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Examples of COGS SaaS: What should COGS consider in a SaaS company?
The costs of the services for the SaaS revenue core are mainly composed of the following expenses:
1. Hosting costs: costs related to hosting the software and the infrastructure needed to run it.
2. Employee costs related to maintaining the production environment, also known as infrastructure equipment, DevOps or in-house engineering.
3. Employee costs for application customer support/satisfaction. In COGS, the success allocation should be focused on the people in charge of renewals. Staff responsible for up-selling or cross-selling should be in operational expenses.
4. Cost of any third party software or data included in the delivered product.
5. Any other direct employee costs required to deliver the ongoing service.
It is common for early stage SaaS startups to have discounted server credits from services such as AWS, Google Cloud or Azure, but even if you don’t pay for them you should impute the costs to evaluate business efficiency metrics properly.
Technical and customer support should include the costs of the customer service team and the salaries of the team responsible for keeping the production instance of the software running.
The expenses of the tech team in improving the product should not be in COGS.
What should not be included in the COGS of a SaaS company?
There are expenses that should not be included in the COGS and that we sometimes find included:
1. Sales commissions.
2. Amortized software development costs (we discourage capitalizing these costs in the first place).
3. Product management costs.
4. Customer success costs focused on cross-selling or up-selling.
We also discourage the allocation of other overhead costs to COGS. These are not direct variable costs and the allocation processes are time consuming and generally inaccurate.
Headline gross margin on SaaS license revenue is an important metric for all SaaS companies. Gross margins on SaaS license revenue for our portfolio companies and annual survey data of private SaaS companies, as defined above, are typically 80% to 85%. Companies with lower gross margins may perform very well, but they are fundamentally different in the way they are valued and operated.
How to calculate the COGS of your SaaS company?
The formula for calculating the COGS (cost of goods sold) of a SaaS company could be as follows:
COGS = Hosting Costs + Employee costs related to keeping the production environment running + Employee costs for customer support/success + Cost of any third-party software or data that is included in the delivered product + any other direct employee costs required to deliver the ongoing service
It’s important to keep in mind that these are direct and mainly variable costs necessary to deliver the SaaS application. In general, if these expenses are not paid, the provision of the product and service to the installed customer base will stop or deteriorate rapidly.
In addition, certain expenses should be excluded from COGS, such as sales commission costs, amortized software development costs, product management costs, and customer success costs focused on cross-selling or up-selling.