What Should be Included in COGS for My SaaS Business?
October 21, 2021
Surprisingly, GAAP does not have a clear definition of what should be included in a SaaS company’s Cost of Services (COS), commonly called Cost of Goods Sold (COGS) and perhaps most appropriately sometimes called Cost of Revenue (COR), so each company is pretty much left to its own judgment on what should be included.
The Impact of Gross Margin on SaaS Valuations
Gross margin is one of the most important factors in determining a SaaS company’s performance and valuation, so the lack of a standardized COS definition can result in confusion and debate when an investor is trying to figure out just what a SaaS company is worth. We have reviewed thousands of SaaS company financials, before and after the adoption of ASC 606 (revenue recognition) and ASC 340 (cost recognition relating to contracts), and we have seen the full range of COGS definitions. Through that exposure, we have come up with the recommendation outlined below. This recommendation is derived from three factors:
- It is generally the most common definition we see.
- Using a common definition allows your company’s financials to be easily compared to others.
- We believe it to be the most useful from a management perspective.
What is Considered COGS in a SaaS Company?
In terms of cost of services for the core SaaS revenue we recommend the following:
- Hosting Costs
- Employee costs related to keeping the production environment running – sometimes called the infrastructure team, DevOps, or internal engineering
- Employee costs for customer support/success of the application. For COGS the success allocation should be for people focused on renewals, personnel (or allocation for personnel) responsible for upsells or cross-sells should be in operating expenses
- Cost of any third-party software or data that is included in your delivered product
- Any other direct employee costs required to deliver the ongoing service
These are all direct and primarily variable costs required to deliver the SaaS application. Generally speaking, if these expenses were not paid, the provisioning of the product and service to the installed base of customers would stop or deteriorate quickly.
Hosting costs should also include all core communication costs, and in the rare instance in which a company owns and maintains the servers used to deliver its product, depreciation on those owned assets. Since the vast majority of software companies now utilize off-site hosting, the need to include a depreciation expense in COGS is a practice we rarely encounter.
Customer/technical support and customer success should include the salary and other direct costs of the CS team that is primarily focused on retention and renewals. The portion of the CS team’s effort that is spent on upselling and cross-selling should be in its own operating expense line of included in sales. The salaries of the team responsible for keeping the production instance of the software up and running should also be included in COGS. All other R&D expenses should not be in COGS.
About those professional services…First off, if your company has more than a negligible amount of professional services revenue from implementations or ongoing services, it is a good idea to report those costs and revenues separately. Implementation is a different business than the ongoing provisioning of a SaaS product, and a company should not mix the revenue and cost of each because it obscures the core economics of both businesses. Without knowing a gross margin on just SaaS license revenue, things like CAC Ratios cannot be accurately computed. Also, a SaaS business should absolutely know if it is making or losing money on professional services, and it should be doing so intentionally.
Second, professional services are a topic of guidance under ASC 606 and ASC 340. The determination of when to recognize professional services revenue and its related costs hinges on whether such services are distinct from the delivered product itself. If the services cannot be sold separately from the SaaS product, then the revenue and expenses from such services must be allocated across the expected term of the customer contract. In other words, a SaaS company may need to capitalize its professional services expenses versus recognize it when payment is received. *This is also true for certain below-the-line expenses like sales commissions.
The above definition is most consistent with what we see day-to-day and provides management with a solid view of the company’s contribution margin. Management can then decide how to invest that contribution margin back into sales, marketing, and product development on a discretionary basis.
What Should Not be Included in a SaaS Company’s COGS
Things not to be included in COGS that we sometimes see included are:
- Sales commissions
- Amortized software development costs (we discourage capitalizing these costs in the first place)
- Product management costs
- Customer success costs focused on cross-selling or upselling
We also discourage the allocation of other overhead costs into COGS. These are not direct variable costs, and allocation processes are time consuming and generally inaccurate.
The core gross margin on SaaS license revenue is an important metric for all SaaS businesses. Gross margins on SaaS license revenue for companies in our portfolio and our annual survey data of private SaaS companies, as defined above, are generally 80% to 85%. Lower gross margin businesses might do very well, but they are fundamentally different in the way they are valued and operated.
Note: A version of this post was first published in 2017, and this was updated in 2021 to reflect current best practices. For more on SaaS accounting best practices, please see: What Should a SaaS Income Statement Look Like?
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