Cost of Revenue (COR) is the second highest expense bucket for most SaaS companies, yet it often gets overshadowed by the highest expense category, Sales & Marketing.
Sales and Marketing gets a lot of deserved attention since it can make or break a company’s revenue growth. Yet, COR spending directly affects the customer and losing a customer is the quickest way to lose money. And spending too much on COR directly impacts Gross Margin. As one of a SaaS company’s largest investments, managing the components of COR has a meaningful impact on customer retention and customer satisfaction, key metrics focused on by managers and investors to value a SaaS company.
Delivering high performance cloud-based apps AND retaining an exponentially growing subscriber base costs a pretty penny and drives up costs beyond what many companies may be modelling.
Gross margin, directly affected by Cost of Revenue, takes the hit if companies aren’t carefully calibrating their costs. In addition, fast growth companies need to invest in advance of the growth curve and tend to have the highest COR. Why? Because if a highly productive sales organization is adding new customers at a fast pace, it is a wasted investment if the customers hit a wall using the product.
Average COR for public SaaS companies last year in the Bessemer Cloud Index (with revenues between $100M - $500M) was 30% of recognized revenue with almost 40% of those companies spending over 30% of revenues on COR.
What about economies of scale? Will the percentage go down as a company grows? One of the promises of the SaaS model is that as you bring on more subscribers to the same platform, the cost per subscriber will go down, increasing gross margin and the profitability of your model.
A Little History of SaaS COR
A long time ago, in the early days of SAAS – say at least 10 years ago – conventional wisdom had it that SAAS COR was a somewhat fixed cost, with efficiencies of scale as you grew your subscriber base, leading to highly profitable businesses. Costs per subscriber would go down as users increased and revenues went up. You might incur some additional costs for increased loads and to manage performance, but not at the same rates as revenues would increase. However, early SaaS companies found that COR, especially around hosting expense, in part due to international expansion and increasing security requirements in the Cloud, found COR to be tougher to reduce than they may have expected.
SalesForce
Take a look at SalesForce. When SalesForce went public in 2004, with revenues of $100M, COR was 18% of revenue. 10 years later, at $4B in revenues, COR was 24% of revenue.NetsuiteA few years later, in 2008, the first year after Netsuite went public in 2007, COR was 32% of $152M. In 2014, Netsuite’s COR was about the same 32% on $556M revenues.
Netsuite
COR Is Going Down With Today’s Lower Hosting Expense
In 2019, we find the benchmarks for COR for both public and private companies to be going down. We think this is for two reasons. Firstly, hosting expenses have gone down with the huge impact of AWS on the hosting market, increasing offerings and competition among hosting service providers. Secondly, many SaaS companies put Customer Success either entirely in Sales expense (or some other Operating Expense category), or partially, splitting it between COR and OpEx.
Okta
Let’s take a look at Okta, a highly valuable SaaS company, which went public in 2017. Three years before IPO, in 2014, COR was 45.7% with revenues under $50M. In their IPO year, COR was 31.5%, and has continued to drop, especially with a very large increase of revenue to $400M.
Private Company COR
We see private SaaS companies reducing COR from the higher levels 5 and 10 years ago. For all private SaaS companies, median COR is 33%, but the fastest growth private companies (under $100M) are already reducing COR to a median 30% and top performers in this area with no professional services revenues are closer to 25% of revenues.
When comparing COR to your own company, it is important to compare by stage of growth, and business model, to get the most accurate benchmarks.
Defining COR For SaaS
For SaaS companies without a lot of professional services (one off implementation and consulting services), COR is primarily the cost of hosting, some or all of Customer Success and all of Customer Support and Professional Services, plus depreciation and amortization of capitalized software, if applicable. Here’s a summary of the Cost of Products definition we use in the OPEXEngine benchmarking:
“All direct expenses related to making or acquiring products that have been sold, including compensation associated with product management and administration, plus direct overhead for the production of Software or SaaS products. For SaaS companies, cost of subscription revenues primarily consists of expenses related to hosting the service and providing support, the costs of data center capacity, depreciation or operating lease expense associated with computer equipment and software, allocated overhead and amortization expense associated with capitalized software. SaaS companies may include Customer Success if not associated with Sales as an expense.”
