Gross Margin is one of the most important factors in determining the performance and valuation of a software as a service (SaaS) company. In order to get accurate gross margins, a company needs to understand their cost of goods sold, commonly referred to as COGS. Unfortunately for most founders, there are no standardized definitions of what should be included in a SaaS company's COGS. In this article, I 'll lay out the most common definition and the five elements that should be included in your COGS. Using this definition will give you the most useful information to run your business and eliminate any confusion when talking to investors. Let's take a look about what to include in your COGS and what to keep out.
What Should be Included in COGS?
Your COGS should be all the costs related to your product. There are generally five elements that should be captured:
Hosting Costs - Any cost needed to host and maintain your software. Most startups use Amazon Web Services (AWS) or something similar.
Employee Costs for Keeping the Production Environment Running - This is your DevOps or Infrastructure team. If your DevOps team (or person) has multiple responsibilities, then you can allocate their costs based on what percentage of time they spend on maintenance vs other activities.
Employee Costs for Customer Support - This should be the cost of people specifically focused on renewals. If your company is still small and has the same people making the initial sales and renewals, then you can use an allocation for how much time that person spends on renewals vs new sales.
Third-Party Software - The cost of any third-party software or data that is included in your delivered product. For example if you need to pay Microsoft for an add-in so that your product can be exported to Excel, that cost should be included.
Any Other Direct Employee Costs - This includes any employees required to deliver the ongoing service.
These five costs above are directly tied to the product. To put it another way these are the costs that if not paid would cause the service being offered to end or deteriorate. Keep in mind that not all businesses, especially early stage ones, will have all of these costs, but this is a great starting point for most founders. The graphic below illustrates the costs commonly associated with COGS
What Should NOT be Included in COGS?
So now that we have seen what to include in COGS, let's take a look at what should stay out. The simple answer is anything not listed above (duh) but I have a list below of some of the more common costs founders include that should be excluded:
Any allocated overhead costs
Amortization for software development
Sales commissions
Product management costs
Upselling or Cross-selling costs
Included any of the costs above will hurt your gross margin percentage by artificially lowering it. Raising money is hard enough, you don't need to shoot yourself in the foot by making things look worse than they are.
Summary
Calculating COGS correctly is important for any SaaS company. Make sure to include only the costs directly tied to the product and leave out the costs that are tied to operating your business (OpEx). If you are having trouble calculating your COGS, reach out to us at InfleXion Point. We are happy to help!
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