Traditionally, COGS, or cost of goods sold, has been used as an indicator of how well a business is performing, particularly in relation to its operational efficiency. If the cost of creating what you sell is more than what you charge for it, you’re in trouble. But if you don’t produce a physical product, is COGS still a useful metric?
COGS stands for cost of goods sold, sometimes also known just as cost of sales. Fundamentally, it’s calculated to identify exactly how much a business has to spend to create the product or service that they sell. Therefore, direct costs of production are included, but business operational costs aren’t.
Unfortunately, there is no generally accepted accounting practice (GAAP) when it comes to calculating COGS. For product-based businesses, that doesn’t really matter, as it’s usually pretty clear which items the company has spent money on that directly relate to creating the product, like materials, labor, and delivery costs.
For SaaS businesses, things become a lot more murky. There are no obvious direct costs in relation to SaaS, especially if it’s a subscription for a license of software that is cloud-based. There are a number of theories on what should be included in COGS for software, but not everyone agrees. That can lead to companies being tempted to keep their COGS as low as possible, in an effort to bolster their gross profit. But if you’re looking for any kind of financing as a SaaS business, then a lender is going to look into the details of what you’ve included in your COGS and make their own decision on your profitability.
But how does COGS work for SaaS companies who don’t create a physical product? And what metric should a SaaS consider when calculating the cost of sold software? We delve into the details of COGS for SaaS.
The formula for calculating COGS is as follows:
COGS = Inventory (at beginning of period) + Direct Costs during period - Inventory (at end of period).
So, how does a SaaS business use this formula, when they don’t have inventory or many direct costs? Some people prefer to think of COGS as just the total direct costs spent during the relevant time period.
And what are direct costs for Saas? It’s generally accepted that the following items are directly associated with the cost of providing a software license:
If a cost is not directly related to the service or license that you sell, then it should be placed under operational expenses, which are indirect costs of doing business. Any sales operations that relate to cross-selling or upselling, for example, would count as operational expenses, and not as a cost of goods.
There are different views on whether your customer success team is a part of your COGS or not. While including it in COGS will undoubtedly increase this metric, having customer success be an integral part of how you view the direct costs of creating your service may have knock-on effects, such as improving your retention rates and reducing churn.
So if COGS is so difficult to identify for SaaS companies, why is it still needed?
Once you know your COGS, you can then calculate your gross profit and your gross margin. These are often used by financial companies who you might look to in relation to funding; either venture capital, angel investors, banks, or other alternative financing options.
It’s also useful to understand the direct cost of providing your services so that you can set an appropriate price, consider timing and amounts of increases, and generally anticipate your growth as a business. If you have already obtained equity funding, then you will want to know what runway you have available before more financing will be required, and understanding your gross margin will help you do that.
Your gross margin is calculated as follows:
Gross margin = (sales revenue - COGS)/sales revenue x 100
So, for example, if your revenue for the year was $1,000,000 and your cost of sold software was $600,000, then your gross margin would be as follows:
($1,000,000 - $600,000)/(1,000,000 x 100
Gross margin = 40%
As you can see, if you under-calculate your COGS by not including all the truly direct costs, you will come out with a better gross margin:
($1,000,000 - $400,000)/1,000,000 x 100
Gross margin = 60%
If a lender asks for data on your gross margin to understand the financial health of your company and your likely growth trajectory, it seems obvious that the second calculation would work more in your favor. But would it truly represent your costs and your growth potential?
The average gross margins for SaaS businesses in 2021 ranged from 67% to 80%. This puts COGS at around 10 - 20%.
When financial companies are considering investing in or lending to a SaaS business, they will consider a number of metrics and compare them to benchmarks. Generally, higher gross margins will drive higher valuations, and so investors and lenders will likely look carefully at this figure. But unlike product-based businesses, alternative financing tailors their analysis of risk on the type of data that is relevant to the company, and for businesses who exclusively depend on recurring revenue streams, annual recurring revenue (ARR), among other metrics, will also be important factors.
Understanding benchmarks means you can be in control when you approach a potential lender or investor. If your metrics are not within the standard benchmarks, then it’s worth considering why. Have you missed something (or included something) in your COGS calculation that is impacting that number? Do other metrics like ARR tell a better story of your company’s financial health? Be prepared to either adjust your definitions or justify your decision on what you included in your COGS.
In all industries, understanding the metrics involved in a company’s financial health is essential if a founder wants to focus on growth. That’s easier in more established industries where COGS is easy to calculate. As the SaaS industry matures, the nature of understanding the true financial story, both as a snapshot in time and as the company grows, is deepening to be more relevant. This allows funders of all types to accurately assess the risks involved in offering financing and underwriting appropriately.
If you’re not sure which metrics are important to track as a growing SaaS business, then contact Capchase. Our Growth Advisors work directly with our clients to provide insights on their business health and develop the most flexible terms for their funding that allow businesses to scale and grow. Find out more about Capchase Grow by calculating how much Capchase can help extend your runway through our runway calculator.