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The importance of COGS for SaaS businesses

Although in many ways, cost of goods sold (COGS) is just a simple accounting principle that measures the costs your business incurs when producing and delivering products and services, it holds a special level of importance for businesses in the SaaS space. Explore the importance of cost of goods sold for SaaS businesses with our simple, comprehensive guide.

What is cost of goods sold (COGS)?

The cost of goods sold are the direct costs associated with the production and delivery of goods sold by your company. But which of your expenses should be counted as part of COGS for SaaS? Working this out may be trickier than you’d imagine, as COGS excludes indirect expenses such as certain overheads that don’t contribute to the production/delivery of your products. Here are some of the key costs you need to include in your cost of goods sold equation:

  • Housing costs

  • Software licensing costs

  • Website development costs

  • Employee costs (for employees directly involved in production and delivery)

  • Customer support and account management costs

  • Professional services costs

If you’re unsure what to include in your SaaS COGS equation, just ask yourself one basic question: could I still deliver this service if I don’t pay for this expense? If the answer is no, then it needs to be included. If the answer is yes, then the cost probably isn’t directly related to production/delivery and it would be better to leave it out of your cost of goods sold equation entirely.

For the avoidance of doubt, here are some of those costs that probably aren’t relevant for SaaS COGS:

  • Sales commissions

  • Product development costs

  • Specific overhead costs

  • Third-party software used for in-house applications

  • Customer success costs related to up-selling/cross-selling

Understanding the cost of goods sold equation

To learn how to calculate COGS, you’ll need to know your way around the cost of goods sold equation. Before we get started, here’s the formula you’ll need to use:

COGS = Beginning Inventory + Purchases During the Period – Ending Inventory

For example, imagine if a clothing company had a £10,000 cost of inventory at the beginning of the year and spent £6,000 on the purchase of raw materials, wages, third-party software programs, and so on. With an ending inventory of £7,000, you can work out the figure for SaaS COGS like so:

COGS = £10,000 + £6,000 - £7,000 = £9,000

What are the benefits of cost of goods sold for SaaS companies?

COGS is particularly important for SaaS businesses because it helps to calculate your gross profit margin. If you know your gross margin, you can work out how much revenue you’ll have left over to service other costs, such as debt, operating expenses, and re-investment. Simply put, it’s a great way to evaluate how efficiently your business is able to manage labor and supplies throughout production, as well as the potential profitability and scalability of the business.

So, how do you calculate your gross profit margin? Well, after working out COGS for SaaS, you can use the following formula:

Gross Margin = (Revenue – COGS) / Revenue

Businesses in the SaaS industry should be aiming for a gross margin of around 80-90%, which means that you should have a COGS that’s roughly equivalent to 10-20% of revenue. If business owners claim they have a gross profit margin that exceeds 90%, it may indicate that they have an inaccurate understanding of which expenses are meant to be included in a cost of goods sold equation.  

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