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Cost of Goods Sold (COGs) refers to the direct costs of producing and delivering the products you sell. For a business selling physical products (like pens) this is easy enough. Simply add up the cost of materials (plastic, ink, rollerball) with the cost of manufacturing, packaging and delivery to buyers.
For SaaS companies…it can be a little more complicated. Because we don’t sell a physical product, we need to add up the cost of producing, delivery and supporting a service.
But it’s incredibly important to know your COGs because it helps determine your gross margin – how much money you have left for operating expenses, profit and reinvestment into your company.
Calculating Cost of Goods Sold
GAAP don’t provide any official guidance on calculating Cost of Goods Sold for SaaS companies. However, there are some generally recommended costs to include:
- Hosting fees
- Third-party licensing fees (content delivery networks, integrations, monitoring services, etc)
- Support personnel costs (ie. cost of the time spent supporting customers – if an employee only spends 50% of their time supporting the product, only 50% of their salary would be included in COGs)
- Customer onboarding costs (ie. personnel costs for implementation projects)
- Credit card processing fees (there’s some debate over whether this is a COGs or an operating expense. Do what you prefer, but the key is consistency)
You may have other costs associated with delivering your service unique to your business. When deciding whether or not to include an expense in COGs think “If I didn’t pay for this, could I still provide the service to my customers?” If the answer is No, then that expense should be included in COGs. Let’s take a look at calculating COGs for an example software company:
| Expense | Cost (Monthly) |
|---|---|
| Hosting Fees | $1000 |
| Customer Support Salaries | $4000 |
| Third Party Fees | $500 |
| Total Cost of Goods Sold | $5500 |
Notice that we use a monthly time period when calculating COGs. This allows us to compare our COGs with our MRR, and to calculate our Gross Margins.
Working with COGs
It’s basic economics. You need to bring more money in than you spend in order to survive. Otherwise, you go bankrupt.
COGs varies widely across businesses. It’s more important to consider the COGs in relation to the price and other operating expenses, because this tells you how efficiently you’re turning expenses into revenue.
However, it is important to keep COGs as low as possible – without negatively impacting your service. For example, it might be tempting to reduce the cost of supporting your customers. Paying less, or hiring fewer support agents might make your service cheaper to deliver, but it might also affect your churn rate if customers can’t get good service.
The same thing would happen if a pen manufacturer decided to reduce costs by using cheaper plastic, but still charge the same amount. If the quality decreases noticeably, the manufacturer would see a decline in sales.
Balancing COGs with quality is an ongoing process.
