COGS for SaaS, under GAAP
Is that enough acronyms for you?
Once upon a time, accountants developed a standardized way of representing the economic model of a company. If you had a widget factory, the cost of manufacturing each widget would be Cost of Goods Sold (COGS), and everything else was overhead (Sales, General, and Administrative, or SG&A).
COGS are your variable costs (because those costs vary with the number of widgets made each month) and SG&A are your fixed costs, because the overhead is the same each month, no matter how many widgets you sell.
Revenue minus COGS gives you gross profit, gross profit minus SG&A gives you net profit.
It’s a nice tidy way of thinking about your widget factory, and it gives insight into the economic leverage of the operation. Once you’ve sold enough widgets to offset the factory overhead for the month, the gross profit on each additional widget sold becomes pure profit, because the overhead for the month is already covered. It’s all about the economic leverage, baby.
Today, of course, many tech companies don’t fit this model. In particular, Software as a Service (SaaS) companies are extremely common in the 2021 startup world, but there are no manufacturing costs of the widget. So what to you put down as COGS? Unfortunately, GAAP (Generally Accepted Accounting Principles) doesn’t give us any direct guidance on the topic.
I think the easy way to think of this is as follows: If you charge a $20/month subscription for your SaaS business, what is your cost of delivering that $20 worth of service? Probably some bandwidth, some servers, and maybe some support.
Many SaaS entrepreneurs pretend this cost is zero. They think to themselves, “Hey, the beauty of SaaS is that the cost of having 1 customer is the same as the cost of 100 customers, so it’s all gravy!”
It is true that the economic leverage of a SaaS business is compelling (that’s why investors love them so much) but it’s not true that COGS is zero. The cost difference between 1 customer and 100 customers is probably negligible, but what happens when you scale to a million customers? You’d have to buy a lot more servers and bandwidth, so the variable costs of your business are not zero.
Here are the things that might go into COGS for a SaaS business:
- Software license fees for embedded third-party software.
- Application hosting and monitoring costs.
- Customer support and account management costs
- Bandwidth
- Costs for employees directly involved in production and delivery
- Professional services and training personnel costs
I’m a big fan of understanding what the unit economics are for your venture. For most SaaS businesses, one unit equals one customer for one month. So if the revenue is $20 for that one unit, what are the costs of providing that unit? It’s some mix of the costs outlined above.
The problem for startups, of course, that at the beginning your monthly AWS bill is the same whether you have 2 customers or 200. So it’s tempting to think that your COGS is zero, but it’s not.
And because as the founder you’re handling all the customer support issues yourself, and so you think there’s no cost there. But that’s only true if you think your time is worthless.
Here’s a way to approach the issue: Two years from now, when you are very successful and have 100,000 SaaS customers, what will your all your costs of delivering services to those customers be? AWS hosting, Support team, customer success team, help desk software, etc. Add all that up, divide by 100,000, and you’ll have an idea of what your steady-state COGS will look like.
In the meantime, enjoy the fact that you’re building a company with tremendous economic leverage. But make sure on your spreadsheets you are keeping the SaaS delivery costs (COGS) separate from the SG&A costs (overhead). It’s the way accountants and investors expect to see it, and it will create analytical insight for you as you scale your business in the years to come.
