How to Calculate SaaS COGS

COGS calculations are critical for venture-backed startups because they directly impact their gross profit margin, which in turn affects how they’re viewed by investors. Investors use the gross profit margin to gauge scalability and operational efficiency when reviewing financial models.

COGS also has a significant impact on valuation multiples through its effect on gross profit margin. Lower COGS translates to higher gross margins, which can result in higher valuation multiples — and vice versa. For example, SaaS startups with 85% and greater gross margins command up to 27% higher ARR multiples.

Compared to other types of startups, it’s fairly easy to calculate COGS for your SaaS startup — just add up all the direct costs of doing business. This includes costs such as hosting, infrastructure, third-party software and more. However, the stakes are high to be sure that you get COGS right. Miscalculated COGS is one of the most common red flags that derail funding rounds or reduce valuations during the investor due diligence process.

What Is SaaS COGS and Why Is It Different from Traditional Businesses

While calculating COGS for your SaaS startup may seem simple, there are various factors that also make it more challenging compared to other, more traditional businesses. For instance, SaaS startups typically lack any physical inventory, and must instead account for hosting, data storage, software and other costs — variables that significantly differ from other businesses. What’s more, these costs aren’t always easy or straightforward to identify, further blurring the line between the traditional formula that includes direct costs, indirect expenses and operational expenses.

Other unique factors that separate SaaS COGS from other business models include:

• There is no universally accepted accounting principle for calculating SaaS COGS, meaning startups have to develop their own consistent framework.
• Infrastructure costs can fluctuate, making it difficult to predict and track the exact cost of delivering the service.
• SaaS COGS don’t scale proportionally with new customers. That’s because the same software is designed to support an unlimited number of users.

Regardless of these challenges, it’s essential to get COGS right, largely due to its impact on determining gross margin, which in turn signals operational efficiency and scalability, and can make your startup more attractive to investors.

What Should Be Included in SaaS COGS

Here’s a closer look at what you absolutely want to be sure to include in your SaaS COGS:

Hosting and Infrastructure Costs

Hosting costs and infrastructure costs are the most straightforward COGS component. Cloud infrastructure tends to be the largest COGS line item, while third-party software, APIs embedded in product delivery, and security, monitoring and performance tools all combine to support the production environment.

Customer Support and Technical Teams

Customer support and technical teams should be included in your SaaS startup’s COGS if their primary function is directly related to service delivery. This includes customer support, onboarding and technical services for new and existing customers. Professional services for implementation, onboarding and training should also be included in COGS as direct costs involved in delivery.

Remember: If a support or technical team is required for product delivery, it should be included in COGS. If the team is selling, it’s not.

Customer Success—The Most Debated Classification

Customer success is critical for generating recurring revenue and driving retention and expansion, but there’s a significant gray area between it being a cost to deliver a product or service and a function that drives future revenue. The former should be included in COGS, while the latter is more closely tied to sales and marketing and influenced by pricing strategies.

Any customer success that’s focused on retention, satisfaction and enablement belongs in COGS, while renewals, upselling and expansion belong in sales and marketing. Early-stage startups often split customer success salaries between COGS and operational expenses based on time allocation.

DevOps and Production Engineering

There’s also a fine line between COGS and research and development. Engineers maintaining production environments, customer upgrades and SLAs belong in COGS. However, any R&D work dedicated to new features and future products should be classified as operational expenses. The fully burdened allocation of costs for COGS includes direct employee expenses and indirect overhead expenses such as payroll taxes, benefits and insurance.

What Should Never Be in SaaS COGS

While you should be cognizant of including various costs in COGS, there are also things that should never be included in your SaaS startup‘s COGS. These include:

• Sales and marketing expenses: Commissions, advertising and CAC always belong in operational expenses.
• R&D for feature development and product innovation always stays in operating expenses.
• General administrative costs, such as rent, insurance, HR and legal services are operational expenses.

Additionally, avoid any arbitrary allocation that inflates COGS and reduces gross overhead.

How to Calculate SaaS Gross Margin

Gross margin is one of the most important metrics that investors look at when weighing whether to get involved with SaaS companies. Calculate gross margin using this formula:

• Gross Margin % = (Revenue – COGS) / Revenue x 100

Direct costs should be grouped into four buckets to properly identify COGS. These buckets are hosting and infrastructure, support, customer success and development operations. It’s essential to ensure consistency to maintain reliability from month to month.

Remember, a higher gross margin is typically indicative of a more efficient overall operation, making it more attractive to investors and underscoring the importance of getting this metric correct.

SaaS COGS Benchmarks and What Investors Expect

Target Gross Margins by Company Stage

Investors evaluate your startup based on its current stage; however, SaaS startups differ slightly due to their unique business model. While it’s common for early-stage SaaS startups to have lower margins due to initial higher SaaS costs for development, margins should increase as your startup scales. For instance, eventually your SaaS startup should shoot for 75% to 90% gross margins (the median tends to be closer to the 70-80% range).

A best-in-class gross margin is considered 85% or higher, while anything below 70% can be concerning for investors and may indicate issues with pricing, higher delivery costs or inefficiency.

How COGS Impacts Valuation During Fundraising and M&A

Optimized cost of goods sold can also have a significant financial impact on your startup’s valuation during fundraising and any subsequent mergers or acquisitions. Strategic investors and buyers use gross margins as a proxy to gauge operational efficiency and scalability.

Studies show that startups with gross margins of 85% or higher receive 22% more offers and 27% higher ARR multiples.

On the other hand, misclassified COGS can result in a valuation reduction of millions during investor due diligence.

Common COGS Mistakes That Trigger Due Diligence Red Flags

The most common COGS classification mistakes are issues related to operating expenses, inventory valuation and record keeping. Such mistakes can raise red flags with investors and have the potential to sink deals. Here’s a closer look at some of the common mistakes that your startup should be sure to avoid:

Inconsistent Classification Methods

Various warning signs invite deeper scrutiny, and many are the result of inconsistent classification methods. For instance, if your gross margins are wildly inconsistent from month to month, it suggests poor tracking. Other warning signs include inflated sales commissions and R&D expenses and the impact they can have on your COGS. Missing documentation for COGS allocation methodologies is another big problem.

Separating Subscription vs. Professional Services Revenue

Avoid mixing revenue streams when calculating your COGS, as doing so can obscure the economics. Investors want to see subscription gross margin separately from any professional services; therefore, it is best practice to report services’ COGS and gross margin on a separate line.

Strategies to Optimize SaaS COGS and Improve Margins

How can your startup optimize COGS and improve gross margins? Here’s a look at some strategies.

Rightsizing Cloud Infrastructure

Cloud infrastructure is the largest COGS component, and optimizing this can have significant benefits on your COGS and gross margins. Some ways to address cloud infrastructure include:

• Implementing cloud cost monitoring to identify waste.
• Negotiating reserved instance pricing for predictable workloads.
• Conducting regular infrastructure audits to eliminate any bloat.

Automating Support and Success Functions

Efficiency improvements can drive margin expansion. There are various ways to automate certain functions. For instance, consider building self-service knowledge databases to reduce the volume of help tickets. You can also implement AI chatbots to help resolve common customer needs. Identify areas that require more customer support and allocate resources more strategically within your SaaS business.

Building a Chart of Accounts for Accurate COGS Tracking

It’s also essential to ensure your startup has the necessary infrastructure for consistent COGS reporting, which can be achieved by establishing a chart of accounts. Consider creating separate cost centers based on categories such as Support, Services, Customer Success and Development Operations. Ensure that you’re coding expenses on a full-burdened basis, including payroll and tax benefits, software licenses, and other software implementation costs, and regularly review departmental allocations on a monthly basis to identify and correct any misclassifications, thereby better supporting your startup accounting.

When to Bring in Fractional CFO Expertise for COGS Optimization

Another way to improve your SaaS startup’s COGS and gross margins is to work with a professional. Graphite Financial is a full-service professional accounting services firm that partners directly with startups to help them establish a financial foundation and optimize various aspects of their operation, such as COGS and gross margins. Graphite’s Fractional CFO services are designed to help startups develop robust COGS methodologies without the full-time CFO cost, helping ensure better fundraising success during Series A and better valuation with M&A activity.

As experienced professionals specializing in working with SaaS startups, Graphite’s Fractional CFOs can help navigate complex classification challenges and avoid many of the common pitfalls that can raise red flags and erode investor confidence. For more information on Graphite’s Fractional CFO services and how we can take your SaaS startup’s COGS optimization to the next level, contact us today to schedule a consultation.

FAQs

How do you calculate COGS for a SaaS startup?

In most startups, the formula is Beginning Inventory + Purchases – Ending Inventory. However, SaaS startups typically don’t have to account for inventory due to their business model. To calculate COGS for a SaaS startup, simply add up all the direct costs of doing business (i.e., hosting, infrastructure, third-party software costs, etc.).

What is a good gross margin for a SaaS startup?

A good gross margin for a SaaS startup typically ranges from 70% to 85%. Anything above 80% is considered to be excellent, while lower margins may indicate issues with pricing, higher delivery costs or inefficient operations. It’s common for early-stage SaaS startups to have lower margins due to initial higher costs for development, but margins should increase as your startup scales.

Should customer success be included in SaaS COGS?

Yes, customer success should be included in SaaS COGS because it constitutes a direct cost of delivering a service, specifically with a focus on retention and product usage. Costs often include support, onboarding and implementation, which differ from sales and marketing expenses.

What’s the difference between COGS and operating expenses?

COGS are the direct costs associated with producing or delivering your startup’s goods or services. Operating expenses are the indirect costs of running a business on a day-to-day basis. Think of it like this: COGS ties to production, while operating costs are reflective of the entire operation and exist whether there are sales made or not. Making the distinction between the two is important for calculating gross profit and net income.

How does COGS impact SaaS valuation?

A lower COGS tends to translate to a higher gross profit margin and, thereby, a higher valuation. This is because it’s evident of better financial health, scalability and overall profitability. A higher gross margin is typically indicative of a more efficient overall operation, making it more attractive to investors.

What are the most common COGS classification mistakes?

The most common COGS classification mistakes are issues related to operating expenses, inventory valuation and record keeping. Miscalculating operating expenses is one of the most frequent errors. Other common errors include failing to include all direct costs, ignoring shrinking and obsolescence, counting errors, or incomplete or missing documentation.