Cost of Goods Sold (COGS) is a crucial element in the business environment and is easy to understand when applied to a traditional operation. But in a software-as-a-service (SaaS) company, it's harder to pin down because you're dealing with software and applications, and direct costs aren't always easy to pin down.
SaaS operations are more commonly known as cloud-based software, where the software is licensed on a subscription basis. A central provider hosts the products, and instead of downloading the app, users access it through a web or mobile browser.
Examples of SaaS companies are:
- Atlassian Corporation
- research monkey
- Sales force
The relationship between COGS and your ability to determine gross profit and gross profit margins is vital to SaaS operations. This article will clarify the differences and show you what expenses you can include and how to calculate CPV for a SaaS business.
What does COGS mean?
Cost of goods sold is the amount of direct cost involved in producing the goods an organization sells. Includes the cost of materials, packaging, delivery, and labor directly related to the manufacturing and delivery process. It does not include general expenses such as sales commissions, rent and salaries.
Accounting standards are specific on certain topics and lack guidance on others. There is no Generally Accepted Accounting Principle (GAAP) when it comes to COGS. This lack of direction is unfortunate, as gross margins are crucial to the profitability, value, and performance of any business.
What does COGS tell you?
CPV is a simple accounting principle that measures the input costs your business incurs in manufacturing products or services and helps determine your gross profit and margins.
Cost of goods sold is subtracted from revenue to calculate gross profit. This metric determines the efficiency of a company in managing its production process. If the COGS increases, there will be less profit; and the lower the COGS, the higher the profits.
The benefits of COGS
CPV is vital to any business because it helps calculate gross profit margin. If you know your gross profit, you know how much excess income you have to cover overhead, rent, loans, and rollovers. It is one of the critical ways to see how well your company can manage the production process and its potential profitability.
Understanding the CPV Equation
Before you can calculate COGS, you must understand the COGS equation:
COGS = Beginning inventory + Period purchases - Ending inventory
For example, if a manufacturing company had an inventory cost of $5,000 at the beginning of the year, spent $15,000 on materials, labor, and delivery during the year, and ended up with $4,000 worth of unsold inventory, the COGS would be $16,000 ($5,000 + $15,000 - $4,000).
Costs incurred during the production of items that are not sold during the year are not included in the calculation. COGS is calculated only on the production costs of goods sold.
Calculation of gross profit and margin
Two numbers determine a company's gross profit: company sales/revenue and COGS. These must be accurately calculated to determine the correct gross profit. Otherwise, any decision based on numbers could lead to a financial crisis in the future.
For ease of reference, you should be familiar with the following definitions:
- Revenue is the amount received for selling the products or services during a specified period. Includes discounts and deductions for merchandise returns.
- Gross profit is revenue/sales minus COGS. This is the amount of profit a company makes after deducting all the costs of the production process.
- Gross margin is a company's gross profit divided by its revenue/sales.
Therefore, we can calculate the gross profit margin using the following equation:
Gross Profit Margin = (Revenue - COGS) / Revenue
This chart illustrates the principle of gross margin. Consider two rival companies that make similar items that sell for the same price but have different CPVs.
|selling a table||$ 120||$ 120|
|CPV||$ 60||$ 75|
|gross profit||$ 60||$ 45|
|Gross margin %||50%||37,5%|
It is pretty clear that Company A is more profitable than Company B.
COGS Deduction Exclusions
Service provider companies, in general, do not have cost of sales, nor do they have inventories. This could include professional singers, accountants, law firms, and real estate agents. Business expenses incurred to operate this type of business are known as cost of services and are not listed as COGS.
Operating Expenses vs. COGS
Both operating expenses and COGS are expenses to run a business, but they are listed separately on the income statement. Operating expenses are not directly related to manufacturing a product or service. Some examples of operating costs include:
- Office supplies
- insurance costs
- public utility services
- legal costs
- Sales and Marketing
CPV for SaaS
When it comes to a SaaS company, CPV is not that simple to calculate. There are several variables in the provision of a software service that are not so easy to identify.
SaaS companies provide software-enabled services that are typically delivered over the Internet, which is very different from a traditional manufacturing company. Therefore, the way you will calculate the COGS will also be different. The elements used to calculate CPV in a SaaS operation even differ from those used by traditional software companies.
What should be included in the CPV
A quick test of what to include in your CPV is to ask yourself if you could still offer the service to your customers if you didn't include this expense. If not, then go into your calculations; if so, then delete it.
Here are some suggested costs that can be included in COGS calculations for a SaaS business, as long as they are not part of your operating expenses:
- Software license fees for third-party embedded applications
- Application monitoring and hosting costs
- Website development and support costs
- Customer service and account administration costs
- Data communication charges
- subscription costs
- Costs for employees directly involved in production and delivery
- Costs of professional services and training personnel
Customer Success (CS)
The essence of CS is a strategy to ensure that customers receive what they expect when dealing with your brand. It may be important when they purchase your product or enter into a non-business relationship, such as when they contact you to resolve a problem. It could also be a follow-up after the purchase or collect information to give feedback to the different departments.
Customer service's knowledge of buyer preferences and the overall relationship is essential when deciding on marketing and advertising campaigns. In addition, the interaction that the CS has with the customer can help develop the products.
CS has a lot of ground to cover, and you'll need to assess where it will fit into your company's overall ethos and cost structure.
CS under cost of goods sold
One way to view customer service is as part of your product. If experiences, brand connection, and support service are key drivers for your customers, CS is an important part of your product. If that's the focus of your business, customer service should be one aspect of the CPV.
Putting it here will help you assess your costs more efficiently and change your company's focus when developing new products to sell. Function, form, and price aren't the only things vying for a customer's attention, and support service can be your trump card.
There is a downside to putting customer success in CPV: You'll end up with a more expensive product, which will affect prices and profit margins. You can overcome this by making sure the customer realizes and understands the additional value they will receive.
CS in Sales and Marketing
You may prefer to put the CS in sales and marketing if your primary focus is getting leads during the customer tenure. By putting it here, customer service can attract new customers, build trust, and help close sales.
The benefit of putting CS here is that the price of the product will be cheaper. The money is spent anyway, but the concept of costs and returns can create different structures and greater flexibility.
Again, you must ask yourself this vital question: Can I continue to offer the service to my clients if I do not include this expense?
What should be excluded from the CPV
The following costs should not be included in COGS calculations (note that some companies will include them and others will not):
- Sales commissions
- Customer success costs associated with additional sales
- Product development costs
- Costs associated with internal operations
- Third party software for internal applications
It's wise to keep it simple and avoid complicated assignments or chargebacks, as these can change over time. By following the tips above, a potential investor or buyer will understand the financial numbers, as they are generally in line with most SaaS businesses.
How to Calculate CMV?
In general, it is suggested that the gross margin of a SaaS company is around 80-90%, which means that its COGS would be around 10-20% of revenue. This margin level is a general benchmark accepted by the SaaS industry. These margins are essential when requesting financing or looking for investors to indicate the profitability of the business.
When it comes to a SaaS company, getting an accurate gross margin figure can be tricky. It's not easy to define cost of goods sold and you can instead think of it as cost of revenue.
Here's an example CPV for two fictitious companies creating similar services:
|Support and maintenance cost||$ 15.000||$ 5.000|
|license cost||$ 6.000||N / D|
|lodging cost||$ 2.000||$ 5.000|
|development cost||$ 25.000||$ 20.000|
|cost of subscriptions||$ 1.000||N / D|
|The total cost of income||$ 49.000||$ 30.000|
Software services usually do not have any kind of inventory transfer as they are usually subscription based. Therefore, the COGS equation would simplify as total costs accrued during the period ($49,000 for Company S and $30,000 for Company T).
Calculation of gross profit and margin for a SaaS company
Calculating gross profit and margins for a SaaS business is as essential as it is for any traditional manufacturing business. Sales and marketing costs, director salaries, and rents are paid out of gross profit. The higher the margin, the more there is to reinvest and the faster the business can grow.
Gross profit is the amount of income that remains after the costs of maintaining that income have been deducted.
Let's use our earlier example of Company S and Company T, assuming they both generate the same amount of sales:
|Sales||$ 260.000||$ 260.000|
|CPV||$ 49.000||$ 30.000|
|gross profit||$ 211.000||$ 230.000|
|Gross margin %||81%||88,5%|
In this example, Company T has better margins and may have more funds than Company S. The factors driving this difference are customer support, development, licensing, and subscriptions. The two significant costs are related to staff, which is always a major cost for SaaS companies.
Gross margin is a crucial, but often overlooked, measure of a company's financial health. Changes over time can reveal underlying issues with the management of the company or a change in the market. SaaS companies are recurring revenue businesses, and the more they can increase their gross margin over time, the more revenue they can generate per customer.
Margins in a SaaS environment are essential for investors looking to grow their business. High margins with reasonable customer retention rates lead to better reviews.
When it comes to mitigating risk and competing in a tough market, high gross margins keep the company ahead of the pack, even as growth slows. The SaaS market is expected to continue to grow and competition to become fiercer. That's why it's imperative to understand COGS and how it affects gross profit and margins.
A profitable business is a healthy business. A SaaS company is more likely to succeed the more profitable it is. Reviewing the finances will help you set new goals and run an efficient operation.