Cost of goods sold for Software-as-a-Service (SaaS) startups seems like it should be a straightforward topic but there are a number of different conflicting reports online. According to Wikipedia, cost of goods sold “refers to the inventory costs of the goods a business has sold during a particular period.” Of course, due to the nature of software, there is no inventory but there are costs to deliver the application.
Here’s what we include in our cost of goods sold calculation:
- Hosting fees (our highest expense after salaries and benefits)
- Third-party web fees like content delivery networks, embedded software, etc
- Support personnel costs
- Customer on-boarding costs (e.g. client implementation personnel costs)
- Note: Credit card fees and other billing fees often are not cost of goods sold for SaaS companies and are instead general and administrative fees
Notice things like software development costs, customer acquisition costs, and more aren’t included since they are not required once the customer has already been signed. SaaS cost of goods sold is an important metric so that gross margin can then be calculated.
What else? What are some other items that should be considered as part of cost of goods sold for SaaS companies?
David Cummings on Startups 
Those are exactly what we include. Thanks for sharing. I’ve heard a few SaaS folks say their gross margins are 100%, and when pressed, insist that it’s simply not worth the extra effort to account for hosting or support under COGS. For us, gross profit margin is an extremely important number, and well worth the minuscule extra effort to track COGS.
Thanks for detailing this. I had to search longer than I probably should have even to find out how to calculate gross margin.
Hi David, Thanks for your details here. In reviewing your prior post from a few years back, I was struck by the different treatment of credit card fees. It seems like there’s mixed opinion on this cost category for saas operators. Seems like a direct, reoccurring cost that is central to product delivery. Seems pretty COGS-y to me. Can you help us understand your shift in perspective? -Sam
I reached out to publicly traded companies to see how they did it and they treat credit card fees that way, so I followed their lead.
We include credit card processing fees in COGS, though I can appreciate why some don’t. Credit card processing fees aren’t required for one to earn the money; they merely help one collect it.
Thanks for the post! Very, very helpful!
I had a question for you that relates to how we treat certain customer spend.
We have a growing number of customers for whom we spend an initial sum of money ($5-$10k) in what we call an exploration phase where we don’t collect any margin. So the money we collect goes straight to the media costs of buying the impressions. We do this as a way to co-invest along side our customers in the initial learning phase of the campaign and allow our customers to gain the insights around their users without have the financial risk.
In one extreme example, co. X which we are about to turn on, signed a $200k IO, of which the initial $50k is at 0% margin so we can help them learn more about their user characteristics and then transition to the optimization phase and start to charge margin.
I would like to place this initial exploration spend, when it is done at a 0% margin, in a marketing Opex line item and not in the current traffic partner fees line for two reasons: (1) the nature of this spend is marketing-related in that we are using the 0% margin as a marketing technique to allow the customer to become more educated about defining characteristics of their user base, and (2) this would otherwise drag down our net revenue margin.
Does this argument make sense? Any holes in it?
Thanks for your help!
Grace
Hi David, Thanks for sharing on this interesting subject.
I have seen COGS calculations that include an amortized element of product development. What is your opinion of including this?
Thanks,
Miceál
I think that makes sense for installed software applications but is less applicable for rental software delivered over the web.
David,
Thanks very much for this valuable post. My company is a B2C Saas. We have a Customer Success Manager as well as a full-time technical support rep. Given our zero-touch model (users sign up for a trial and then convert all on their own), would you say we nee to include the CSM and tech support rep in our COGS? The sale can (and does often) occur without them. Would love your thoughts on this.
Stephan
For internal reporting purposes I would always want to know my true COGS irrespective of semantics such as “rental” and “Access Fees”. For external reporting purposes I would caution readers to at least consider including the yearly amort of software development fees, which when spread over 10 years would not have a huge impact on the COGS kpi. I would also show the two different scenarios so readers are aware of both. One suggestion I read somewhere else suggested including “Internal Engineering Support” which once again is playing semantics and is referring to software development costs. The same writer suggested adding Professional Fees to COGS which I think is going overboard. To me, what makes the most sense and does a good job of finding the middle ground is
1. Yearly amort of Sofware Dev costs
2. Hosting Fees
3. Third party licensing fees
4. Customer Support and Retention Fees (ie salaries)
I would cover my ass and show readers both. If they want to be aggressive and not include software dev, then that would be their call and I would follow their wishes. However, the decision is around their neck, not mine. What makes this the prudent approach is that there currently are no GAAP standards in place for this issue so be ready to make a stand for your argument one way or the other. Investors and CEO’s push hard. Be the voice of reason.
Previously we did not report any COGS and are a start up. We have just seen an increase in COGS due to hosting costs,and we therefore want to begin recording. Is there any issue with timing on when we can and cant make this change?