SaaS Cost of Goods Sold (COGs)
Cost of Goods Sold (COGS) holds a unique level of importance when it comes to businesses that operate in the SaaS world. Despite being the foundation around which we balance key units of SaaS metrics, there is still no general rule about what is part of COGs. Generally Accepted Accounting Principles (GAAP) rules don’t exist. And that fact represents a problem for every SaaS business out there because COGS are truly crucial for overall profitability and valuation.
Perhaps the best way to define SaaS Cost of Goods Sold is that they are the expenses necessary to deliver the service to your customer. By product, we mean a software-enabled service that you promised to deliver during the onboarding process.
- COGS are expenses associated with the production and delivery of your products
What should you include and exclude in SaaS COGS?
Even though we don’t have consensus on costs, the COGs there are some basic costs that you should include in it. So, what are COGS for SaaS:
- Hosting and monitoring costs
- Customer support costs
- Training personnel costs
- Costs of subscription
- Account management costs
It’s easier to understand what’s in and out of the SaaS COGS equation once you put things to the most basic level, meaning you should cross-check every expense related to your COGS. Look at every single one of them and see if they are absolutely necessary in order for you to deliver what was promised. If it turns out that indeed it is necessary you should leave it in there and, vice versa. Unnecessary expenses should be left out of the COGS equation so that you reduce your costs.
Here are some costs that you should exclude from COGS:
- Third-party software
- Overhead costs and charges
- Sales commissions
- Product development costs
- Customer success costs
Now that you know what should and shouldn’t be included in the GOSP equation, it’s time to look at how we calculate GOSP and what are the benefits of it for SaaS companies.
Purchases for initial inventories and purchases during the period of production add to the cumulative cost of GOSP. The formula looks like this:
- COGS = initial inventory + additional production expenses – ending inventory
We already mention that the cost of goods sold for SaaS represents the basis from which we balance some key components of SaaS. Well, this is particularly true when it comes to the calculation of your company’s gross profit margin. Without a clear picture of your gross margin, you will be having a hard time managing your money. Without a COGS it’s not possible to know gross margin and without gross margin, we are not able to know how efficient your business is running.
Once you calculate your COGS, you can do the same for gross profit margin by implementing this formula:
- Gross Margin = (Revenue – COGS) / Revenue
As a general rule of thumb, you should have a COGS around 10-20% of your revenue, while your gross margin should be roughly equivalent to 80-90%. Knowledge of this matter will allow you to be more effective and to understand better the limits of your business.