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.
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
A COGS calculator is an online tool that allows business owners to easily calculate their COGS. All one needs to do is enter the required information, such as material and labor costs, and the calculator will do the rest. These calculators are especially useful for small business owners who do not have a dedicated accounting team.
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Impact of COGS on Accounting
COGS is an important figure in a company’s accounting, as it represents the direct costs associated with producing goods and services. Therefore, COGS has a significant impact on the profit and loss statement, cash flow, taxes and other financial aspects of the company.
In accounting terms, COGS is used to calculate the company’s gross margin, which is the difference between sales and cost of goods sold. A high gross margin indicates that the company is generating enough revenue to cover its costs and make a profit.
In addition, COGS also affects the company’s profitability, as higher costs reduce net profits. Therefore, it is important for companies to keep their production costs as low as possible to maximize their profits.
In terms of taxes, COGS is also important because it is used to calculate the company’s income tax. Production costs can be deducted from income to reduce the amount of taxes the company must pay.
COGS can also affect payroll taxes because production costs can include employee wages and benefits. Therefore, companies should ensure that their production costs are accurate and documented to avoid problems with the Internal Revenue Service.
In summary, COGS is a vital figure in a company’s accounting, as it affects the profit and loss statement, cash flow, taxes and profitability. Companies must keep their production costs as low as possible to maximize profits and meet their tax obligations.
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.
It is important to note that COGS can vary depending on the industry and the type of product or service being produced. For example, a company that produces physical goods may have a higher COGS than a company that offers digital services.
In summary, COGS is an important financial indicator for investors, as it allows them to assess a company’s operating efficiency and its ability to generate profits. It is important for investors to understand how COGS is calculated and how it varies by industry and the type of product or service being produced.
Frequently Asked Questions about Cogs
What is cost of goods sold and how is it calculated?
Cost of goods sold (COGS) is the total cost of goods that a company has sold during a given period. This cost includes the direct costs associated with producing the goods, such as raw materials and direct labor. To calculate COGS, all direct production costs must be added together and subtracted from total sales.
What is the difference between gross margin and EBITDA?
Gross margin is the difference between sales and cost of goods sold. It is a profitability indicator that shows how much money is left over after direct production costs have been paid. EBITDA, on the other hand, is a more comprehensive measure of profitability that includes indirect costs, such as general and administrative expenses and depreciation and amortization costs.
How is gross margin calculated and what does it indicate?
Gross margin is calculated by subtracting cost of goods sold from total sales and dividing the result by total sales. It indicates how much money is left over after direct production costs have been paid. A high gross margin indicates that the company is producing goods at a relatively low cost and selling them at a relatively high price.
What is CAPEX and how does it affect COGS?
CAPEX, or capital expenditure, refers to investment in fixed assets, such as machinery and equipment. CAPEX can affect COGS if the investment in fixed assets reduces production costs. For example, if a company invests in new machinery that reduces production time, the cost of production may decrease, which in turn may reduce COGS.
How does cost of goods sold relate to cost accounting?
Cost of goods sold is an important part of cost accounting. Cost accounting refers to the process of identifying, measuring and allocating costs to the products or services a company produces. COGS is a key component of cost accounting as it represents the direct cost of producing goods sold.
How can gross margin be improved and cost of goods sold reduced?
There are several ways to improve gross margin and reduce cost of goods sold. One way is to reduce direct production costs, such as raw materials and direct labor. Another way is to increase the selling price of goods without increasing production costs. In addition, a company can improve gross margin by reducing indirect costs, such as general and administrative expenses.