For a Software as a Service (SaaS) business, the Cost of Goods Sold (COGS) is somewhat different from traditional manufacturing businesses. SaaS companies typically have minimal physical production costs. Instead, their COGS primarily consists of the direct costs related to delivering the software service to their customers.
Here are the SaaS financial model templates I've built.
Definition of Cost of Goods Sold (COGS):
COGS represents the direct costs associated with producing goods or delivering services that a company sells. These costs are directly attributable to the business's revenue-generating activities and vary proportionally with the volume of items produced or services delivered. COGS excludes indirect expenses such as selling, general, and administrative expenses.
For a SaaS company, the COGS provides insights into the direct costs associated with delivering the software service. Understanding COGS for SaaS businesses is crucial because it allows for the assessment of gross margins, which can influence pricing, investment, and growth strategies. See below for how it effects KPIs like customer lifetime value (cLTV).
Potential COGS for a SaaS Business:
- Hosting and Server Costs: The expenses associated with hosting the software or application, which might include cloud service fees, data storage costs, and other related infrastructure expenses.
- Third-party Service Fees: Many SaaS businesses rely on third-party tools or platforms, for which they pay regular fees. This can include things like payment processing fees, external software tools, or plugins that are essential for the main service's functionality.
- Support and Customer Service: Wages and benefits for customer support teams who assist subscribers or users directly.
- Software Licensing: Costs incurred for using licensed software or platforms that are integral to the SaaS product.
- Maintenance and Updates (for more details see below): The expenses associated with maintaining, patching, and updating the software to ensure its smooth running. The most accurate method is to allocate time between new development vs ongoing maintenance and this can be subjective to a degree. The key is having a good justification.
- Security: Costs related to ensuring that the software is secure, which might include things like SSL certificates, security audits, firewall services, and more.
- Data Costs: If your SaaS deals with large volumes of data, there could be costs associated with data transfer or additional storage.
- Depreciation: If your company invests in physical hardware servers or other equipment, you might account for depreciation as part of COGS.
- Content Delivery Network (CDN) Costs: For businesses that need to ensure fast delivery of content or software globally.
- Backup and Recovery Systems: Any costs associated with ensuring data continuity and recovery.
Implications of classifying items as cost of goods sold or general operating expenses:
One of the most important financial performance metrics that is analyzed for any SaaS business is gross profit and gross profit margin. It is essential for properly estimating the lifetime value of a customer. If the average cost to deliver services to a customer is high relative to revenue from the average customer, and you extrapolate that over many years, it can result in a low cLTV as well as a poor LTV to CaC ratio. Investors and anyone evaluating a SaaS business will want to understand these metrics. This SaaS margin modeling template is a good place to start when looking at configuring what you think is your 'ideal customer'.
Guidance on Software Developers / Engineers (new development vs ongoing maintenance allocations)
Whether software developers fall into the Cost of Goods Sold (COGS) bucket in a SaaS business can be a subject of debate and interpretation. However, there are general guidelines and industry standards to consider:
Initial Development vs. Ongoing Maintenance:
- Initial Development: Typically, the costs associated with the initial development of the SaaS product (i.e., building the software from scratch) are capitalized and then amortized over the expected useful life of the asset (software). These are not treated as COGS but rather as a capital expenditure that becomes an intangible asset on the balance sheet.
- Ongoing Maintenance and Updates: The costs of developers related to updates, bug fixes, and smaller feature additions (which are essential to retain and support existing customers) can be considered COGS. These are costs directly tied to maintaining the product's serviceability for current users.
- Developers who are directly responsible for maintaining the uptime, functionality, and service quality of the software for current customers could be included in COGS.
- On the other hand, developers working on new features, modules, or entirely new products (which are not yet generating revenue) would typically not be included in COGS.
Financial Analysis Perspective: From an analytical standpoint, including software developers in COGS for a SaaS company can provide a clearer picture of the company's gross margin. This can be crucial for investors and stakeholders to understand the cost structure better.
Practicality: In a rapidly evolving SaaS business, it might be challenging to bifurcate developer time strictly between "maintenance" and "new development." Some companies might choose a practical allocation method, while others might opt for more detailed time tracking.
In summary, while there's a basis for including certain software developer expenses in COGS for a SaaS business, the decision often depends on the specific activities of the developers, the company's interpretation of accounting standards, and the company's goals in financial reporting.
