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Learn a better way to calculate COGS for your SaaS company so you can better understand your costs and gauge profitability.
For most SaaS companies, COGS (which stands for cost of goods sold) is used to calculate gross margin and profit.
COGS is an accepted term with a specific definition under U.S. Generally Accepted Accounting Principles (GAAP) — and is widely used as part of calculations to gauge the health and valuation of a company.
Like many accounting practices, COGS stems from the industrial era, when most businesses were concerned with the creation of physical goods. Cost of goods sold (COGS) was used to determine the cost of production to calculate profit.
Traditionally, that made sense: Calculate how much it costs to make your product and take that out of how much you earned to know your gains.
Yet, in the digital age, we’re still using the term, despite the fact that the business model of SaaS companies hardly resembles those of the industrial era.
While COGS isn’t going away anytime soon as a standard reporting metric (and is still useful to many businesses that have inventory or physical products), I’d argue that purely digital companies should look to additional metrics to gauge profitability. These metrics can help provide additional insight about the health of the business that might otherwise be missed if they’re only looking at COGS.
In the industrial era, businesses produced physical products, which required a certain amount of materials for each.
For example, a factory that produces shoes might need a certain amount of leather, fabric, rubber, etc. Once that shoe is produced, the factory has spent the money on materials. They don’t incur any more costs once the shoes have been shipped off to the buyer.
SaaS companies invest heavily in research and development upfront, but they don’t need to pay for their “materials”, or hosting costs, until a customer makes a purchase.
Then, once the customer starts using the software, they begin to drive costs that the company pays for. The costs can vary significantly month to month and customer to customer, depending on how the customer uses the product.
For example, if the customer heavily utilizes storage or analytics features, it may drive significant costs, while a customer that logs in monthly to visit a dashboard might be far more affordable to support.
Just looking at a topline COGS fails to capture these dynamics.
Another challenge with COGS is that there's no consensus about what should be included in COGS in a SaaS P&L, which leads to inconsistency across different companies.
While there are a number of models companies can follow, most finance teams revert to whatever makes their gross margins look strongest — which may or may not be an accurate representation of how healthy the company is, especially when benchmarked against other companies.
For example, finance professionals have to decide whether to include line items such as the cost to hire software engineers. Software engineers create code, which serves as the basis for the “good”, then the code provides an online service. The code is repeatable and infinitely scalable in theory.
Questions like these have no straightforward answers. Most companies, however, do not include the cost of hiring engineers as part of COGS; instead, they’re included in operating expenses.
There are a number of other considerations, which lack consensus:
All this is to say — at a minimum, what COGS represent is confusing — and it’s certainly not consistent at every company. Whether those costs are spent as COGS or operating expenses, they are still expenses necessary to run the business — and that the bottom line is what matters most.
So, is COGS a valuable metric for the way we measure a SaaS company's success today?
The answer is still yes. It’s a standard metric that stakeholders, such as the board and your investors, will expect to see. You can also drive more value from this metric by being intentional with what is included.
COGS is used to calculate gross margin, which has real implications for your business because it can affect your valuation, and there are certain public market expectations for the gross margins of certain businesses. From that standpoint, measuring your COGS isn’t going away — nor should it.
However, I’d argue that when it comes to SaaS and technology companies, there are better ways to help you measure business value you’re driving — and better suited for the digital, rather than industrial era.
So what should digital companies use to measure cost and value — if not for industrial era accounting metrics?
I’d recommend adding depth and context to your cost by measuring unit economics.
If your goal as a business is to grow and scale efficiently (which in my experience is the case for most SaaS and digital companies!), you’ll want to ensure that your costs are scaling appropriately with your business.
There are a number of ways to measure unit economics, so you’ll need to figure out which ones make sense for your business. However, a good way to get started is by choosing one that represents the growth of your business.
For example, you could track cost per customer onboarded. Alternatively, if there’s another utilization metric, like cost per message or delivery, those might be better suited for your business.
Then, you can get even more granular – for example you can consider looking at dimensions like average cost of a feature per customer onboarded, and track whether or not it goes down over time.
Unit costs will add nuance to your cost metrics that will help you to make better decisions over time. They’ll also help you decide when it makes sense to pull back on costs or when to invest more.
And while COGS isn’t going away anytime soon — unit economics can be a great way to benchmark and track cost in the digital age.
Here are a few resources to get you started:
Patrick McCarthy is a seasoned Fractional CFO and Angel Investor working primarily with SaaS and technology businesses.
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