Gross profit margin (GPM) can tell you a lot about a SaaS startup's profitability and the efficiency of their operations. It's also a key financial metric that potential investors use to evaluate startups for funding and to determine their valuation.
Perhaps even more top of mind for startup leaders and investors alike are cash burn rate and runway, which require careful management to maintain business operations and momentum.
These are important financial calculations to get right! SaaS startups, however, often miscalculate their margins and their runways.
It's an honest mistake, really. Accounting software isn’t typically designed to do proper cost accounting for SaaS companies — many programs are still tailored to traditional manufacturing companies (think raw materials, shipping charges, etc.).
The root of the problem is something we see often when reviewing financials for young SaaS businesses: they're incorrectly booking their cost of goods sold, or COGS, or not accounting for COGS at all.
Let's explore both scenarios:
Scenario 1 – Company A (Incorrect COGS)
Company A’s gross margin is only 25%, which is far below our investment criteria of 50%. After further analysis, we found that Company A books all salaries and wage expenses, commissions, and bonuses as COGS, resulting in the low gross margin.
Company A is a pure SaaS company offering a B2B turnkey solution through monthly/annual subscriptions. For these types of companies, we typically consider hosting and server expenses (AWS Reserves, Microsoft Azure, etc.) as the main component of COGS.
GPM for a true SaaS business typically ranges from 70% to 95%, depending on the type of product, and it includes technology ecosystems. For example, you should think about the revenue share component of ecosystem partnerships as COGS if you are listed Salesforce’s AppExchange or similar platforms.
Scenario 2 – Company B (No COGS)
Company B’s gross margin, according to their accounting software, is 100%, which is, of course, impossible. For some reason, Company B doesn’t book any COGS and allocates everything into operating expenses.
Company B offers professional services to help customers build tailored applications using their tech-enabled platform. This requires Company B to hire contractors or full-time developers to perform services.
After looking further into their financials, we found that Company B should have allocated 70% of their total payroll expenses to cost of goods sold because 70% of their developers’ time is spent helping customers build their apps. This reallocation drives down their gross margin from 100% to 55%, which is a pretty stark difference.
COGS and the SaaS P&L
A strong accounting foundation creates a trustworthy SaaS P&L that gives leaders the right information to drive better business decisions. Without accurate COGS, you can't get a good assessment of your margins or your cash runway, in particular, and that can lead your business in the wrong direction — or worse, your startup could fold up completely.
Don't leave yourself flying blind. Follow the best practices for calculating your SaaS startup's cost of goods sold below.
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What's included in COGS for SaaS?
For a SaaS business, cost of goods sold (COGS) are the direct costs you incur producing (building and running) subscription-based software services. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good or service. COGS may also be referred to as cost of sales or cost of revenue.
SaaS COGS do not include operating expenses, which are costs that support the entire business, not just delivering your software or product, such as:
General administration (G&A) expenses
Research and development (R&D)
Sales and marketing
Rent and insurance
Legal fees
Including operating expenses in your COGS and over-reporting your cost of goods sold can decrease your margins, impede your growth, and make it difficult to both manage your runway and raise capital.
Expenses to include in SaaS COGS:
A pure SaaS business should include the following expenses in their COGS:
Cost of hosting applications, security, and monitoring services
Payments for third-party software and subscriptions that directly support the delivery of your SaaS solution
Transactional expenses like travel and invoicing
Data warehouse fees
Employee salaries and expenses for any of the following:
Technical support, which manages inbound customer questions, requests, issues, and bug reports
Professional services who handle customer onboarding, though this may fall under tech support at your startup
Customer success who retain happy customers
Dev ops to keep your software application running smoothly
SaaS COGS Examples
To properly account for the cost of goods sold in your SaaS startup, it's easiest to not think of them as COGS, but as the cost of revenue. Ask yourself this:
What are the expenses I'll incur to create revenue — expenses that will make or break my ability to serve my customers?
Let’s use the following two software companies as examples. Both companies are currently generating $100,000 MRR. We'll calculate gross margin for each with proper accounting for COGS, as shown in the P&L below.
ABC Company has five customer support representatives, which cost $4,000 each per month. Each employee has licenses to numerous software products they need to offer effective support to their customers. This costs ABC Company $1,000 per month per employee. Last, ABC Company has hosting expenses of approximately $1,000 per month.
XYZ Company does not need any customer support representatives for their product. As they do not need any support representatives, they also do not need any licensing for the employees they don't have. XYZ company typically pays around $5,000 a month for hosting.
Sample SaaS P&Ls
| ABC Company | XYZ Company |
|---|---|---|
Sale (One Unit) | $100,000 | $100,000 |
Cost of Goods Sold | | |
Support and Maintenance | $20,000 | $- |
Hosting | $1,000 | $5,000 |
Licensing | $5,000 | $- |
Gross Profit | $74,000 | $95,000 |
Gross Margin | 74% | 95% |
In this scenario, we can see that XYZ Company had better margins. In other words, XYZ Company is able to retain more of each sale compared to ABC Company. The largest factor driving this variance is the cost of customer support representatives. This aligns with what we frequently see in SaaS businesses — staffing is often the biggest expense.
How do established SaaS companies report expenses?
If you aren’t sure how to account for a certain expense or recognize revenue, it can be helpful to look at public tech companies (especially cloud companies) to see how they report their financials and gain insight into their accounting practices.
Learn from the big guys:
It’s particularly worthwhile to explore financial statements, earnings releases, and Management Discussion and Analysis (MD&A) statements to see how well-known tech companies account for various aspects of their business and how they clarify information for investors.
These companies spend a lot of money to have their financials prepared by some of the best accounting firms in the world, so we can all learn something from them!
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