How to determine cost of goods sold (COGS) for your SaaS business

The cost of goods sold (COGS) is a simple accounting principle that measures the direct costs your business incurs as a result of producing and delivering products and services.  including the cost and transportation of raw materials and the cost of labor and storage fees. COGS excludes indirect costs like sales, marketing and distribution costs.

Knowing what goes into COGS is critical for any business. However, while COGS is pretty straightforward for a traditional business, for SaaS businesses, direct costs are not always easy to identify and define. 

While a better understanding of SaaS COGS can enable you to create an accurate profit and loss (P&L) statement, differentiating it from other types of expenses is essential for financial reporting and strategic planning. 

COGS forms the basis for calculating gross profit and gross margin, both of which are key metrics that provide insights into a company’s financial health. By accurately identifying and managing COGS, SaaS companies can better align their pricing strategies, manage resources, and ultimately drive profitability. 

This article is intended to provide you with an in-depth understanding of SaaS COGS, including the challenges around figuring out what expenses you should include in your COGS, and how to calculate it for your SaaS business.

Understanding COGs in SaaS

SaaS operations are commonly referred to as cloud-based software, which is licensed on a subscription basis. Instead of customers downloading an application that must be maintained on their own servers, the SaaS business hosts the product on a cloud server where customers can access it via a web or mobile browser.

As mentioned earlier, COGS represents the direct costs involved in producing the goods or services a company sells. From an accounting perspective, COGS is neither an asset nor a liability. It is recorded as an expense on the income statement.

For SaaS companies, In both traditional businesses and SaaS businesses, COGS increases linearly with revenue. This becomes pretty intuitive once you understand what COGS is. 

In traditional manufacturing businesses for example, COGS includes the direct costs attributable to the production of physical goods, such as raw materials and labor as well as factory overhead costs. So, the more products a company sells, the more expenses it must incur to produce them.  

COGS increases linearly with revenue in SaaS, too. However, it’s a little more complicated for a SaaS business because once developed, the same SaaS product can be sold to any number of customers. In the SaaS context, the more customers you get, the higher your costs are for delivering your product. 

Due to the linear relationship between the costs of delivering your product and the number of customers you serve, COGS can be quite variable. In SaaS, these costs typically consist of expenses in the following four categories:

1. DevOps expenses – the server and infrastructure 
2. Customer success teams
3. Professional services
4. Merchant and transaction fees

What to include in SaaS COGS

Let’s take a closer look at each of the categories above to better understand what should (and shouldn’t) be included in COGS on your income statement. 

1. DevOps expenses

DevOps expenses are the server and infrastructure costs associated with hosting and delivering your product via the cloud, including:

• License fees for any software or platforms necessary to maintain the production environment and deliver the product as a service to customers.  
• People costs associated with the product engineers and developers needed to maintain the production environment.
• Cloud hosting and server expenses, including compute (the amount of bandwidth you’re using to process your customers’ workloads) and the costs associated with storing their data. 

It’s worth noting here that cloud hosting with providers such as Amazon Web Services (AWS), Microsoft Azure, Google Cloud are typically one of the largest components of COGS for a SaaS company. This is because cloud providers charge based on usage. Hence, these costs are directly proportional to the scale of operations. 

2. Customer success

Account management and customer success teams ensure customers successfully use the product, resulting in higher customer satisfaction and reduced churn. Costs related to these teams are part of COGS since they are directly related to service delivery, including

• Salaries and bonuses, benefits, and training
• Software tools and any related infrastructure used to directly support customers (e.g. a helpdesk ticketing system)

3. Professional services

Professional services are considered part of COGS as they are directly associated with delivering the product to customers, such as: 

• Initial implementation services (onboarding the customer)
• Custom implementation services 
• Consulting services

4. Merchant and transaction fees

Merchant and transaction fees – the cost of collecting payments from customers – are also part of the COGS in SaaS. They are a direct component of delivering the product to customers because customers must first pay for their subscriptions before that can happen. 

These costs typically include:

• Credit card transaction fees
• Expenses for any software required to implement a payment processing system. 

What shouldn’t be included in COGS

Identifying and accurately categorizing direct costs is important to understanding SaaS COGS. However, figuring out if a specific expense falls into COGS can become a bit murky when looking at software costs and people-related expenses, such as salaries, benefits, bonuses, etc.  

SaaS companies must be careful to distinguish between direct costs and other business expenses, such as research and development (R&D) costs, sales and marketing (S&M) expenses, and overhead. These costs should not be included in COGS calculations as they do not directly contribute to the delivery of service.

Here are some examples of expenses that are not considered part of COGS:

• Sales commissions
• Product management costs
• Amortized software development costs
• Third-party software used for in-house applications
• Customer success costs focused on up-selling/cross-selling

Rule of Thumb: When deciding whether to include an expense in your COGS, ask yourself, “If I eliminate this cost, can I still sell my product?” If yes, then it’s not COGS.

With a more comprehensive understanding of the components of direct costs, SaaS CXOs can gain a more accurate picture of their cost structure, to further inform their pricing strategies along with business forecasting and planning. 

Additionally, by controlling direct costs, SaaS companies can increase their gross margins, thereby impacting business profitability and financial health. 

SaaS COGS vs. operating expenses

Operating expenses (OpEx) appear on the income statement as a line item separate from COGS because these are expenses that are not directly related to the delivery of your products and services. 

OpEx includes two main categories of expenses: 

• Sales and Marketing (S&M) expenses, which encompass all the costs associated with selling your products and services, including making them attractive to your target market.
• General and administrative (G&A) expenses, which include overhead and indirect costs associated with  running your business operations.

Calculating COGs for your SaaS business 

Since SaaS products are subscription-based services delivered online, it can be challenging to calculate COGS because of the nature of “direct” costs. A good general rule to follow for SaaS businesses when trying to decide how to categorize an expense is, if you cannot deliver your service without incurring the cost, you should include it in your COGS.

While both direct and indirect expenses are necessary for the smooth running of your SaaS business, it is important to distinguish between the two. COGS is intended to reflect the direct cost of producing the goods or services sold by a company. 

Including indirect costs in COGS can result in an inaccurate calculation of gross margin. This, in turn, could lead to incorrect financial reporting and poor strategic decision-making.

It’s important to note that there is no Generally Accepted Accounting Principle (GAAP) for calculating COGS in SaaS or subscription-based businesses. Therefore, it’s quite common for SaaS businesses to simply calculate COGS as just the total direct costs spent during the relevant time period.

Relationship between SaaS COGs and gross profit margin 

Knowing your COGS is necessary to understand how profitable your business is. In SaaS, profitability is commonly measured in terms of the gross margin, which is expressed as a percentage. 

The relationship between COGS and gross margin is reflected in the basic formula for gross margin:

‍Alt text: Copy from gross margin article. 

As you can see, COGS is one of the variables in the equation. Thus, having an accurate value for COGS is necessary to reliably measure your profitability.  

The accepted benchmark for SaaS companies is that their gross margin should be 80-90% with their COGS between 10-20%. Higher COGS are generally influenced by more complex software implementation or service costs (and result in lower gross margins). 

The lower your COGS, the higher your gross margin will be, and higher margins translate into more investment and growth opportunities.

Challenges of calculating SaaS COGS 

There are a number of challenges associated with calculating SaaS COGS, including:

• Defining direct costs: It can sometimes be difficult to make a distinction between direct and indirect costs, including some R&D expenses and OpEx costs. For example, sales and marketing costs are typically considered OpEx. But, in a SaaS model, costs related to customer retention (e.g., renewal commissions) are sometimes included in COGS, while expenses for customer acquisition are not.

• Allocating production costs vs. R&D expenses: This can involve estimating the percentage of time product engineers spend on maintaining the product vs. developing new features. SaaS companies should develop a methodology for allocating these costs accurately.

• Determining cloud hosting and server costs: These costs can be difficult to predict accurately as they fluctuate based on usage and the cloud provider’s pricing models.

• Assessing third-party software license or data fees: On average, SaaS businesses today rely on more than 100 different software tools. With this many tools, it can be pretty difficult to track who is using what. However, for COGS, it is critically important to distinguish which software tools are being used for delivering the product/service to customers and which are being used internally by other teams (not associated directly with product delivery).

A thorough understanding of your COGS can help you gauge your SaaS business’ financial health, maintain accurate financial records, and can also provide a basis for setting pricing strategies that ensure profitability while remaining competitive in the market.

Using FP&A software for analyzing and reporting SaaS COGS

While determining what should be included in your COGS can be challenging, doing so is critical for accurate financial reporting and sound decision-making.  

Fortunately, there are robust financial planning and analysis (FP&A) tools on the market today that can integrate directly with your accounting and other financial software to remove most of the complexities associated with tracking COGS in SaaS. And Drivetrain is one of the best tools you’ll find. 

Drivetrain is a strategic FP&A software solution built for B2B and SaaS businesses. It  significantly simplifies setting up the detailed charts of accounts necessary to accurately define and track all of the expenses that go into your COGS.

With Drivetrain, you can quickly and easily consolidate all your financial and operational data into a single platform. With more than 200 integrations, you can get real-time access to your data from all the different systems that hold data related to your COGS including the systems you use to track software licensing and expenses and human resources information. Check out how Drivetrain can help you easily and accurately track your COGS!