Paired with gross margin (GM), cost of goods (COGs) tells investors in a single glance about the profitability of revenues, SaaS business model purity, and company efficiency. However—against the backdrop of ever-changing reporting guidance and a myriad of morphing elements in recent years—easily distinguishing COGs from OPEX is anything but seamless or intuitive today.
Just as SaaS companies are aware that hosting, professional services, customer support, and third-party licenses, sit squarely in COGs—so too are there continuing questions about whether customer success, sales commissions, and R&D expenses should sit in COGs or should be in OPEX. In the absence of formal reporting guidance, what remains in the middle are hazy stretches of uncertainty that can skew gross margin.
Why Does It Matter?
Why does that matter? SaaS investment pioneer Todd Gardner says, “A SaaS business with a gross margin a few points above or below the median of 74% may not notice a significant difference in its valuation multiple.” Yet, GM—when viewed in the context of its growth rate—illustrates the importance of GM. He continues, “However, the data suggest a real impact. A one- or two-point difference in the multiple drives millions of valuation changes.”
Referencing public stock data pulled from OPEXEngine’s EdgarEngine from the second half of 2021, he explains, “The correlation between a SaaS company’s growth rate and its revenue multiple is 0.71. Growth rate has always been the biggest driver of the valuation multiple and likely always will be. However, if you multiply the growth rate by the gross margin, the correlation improves to 0.78. This seemingly small difference has a significant impact on many companies.”
Determining What COGs Is and Is Not
As we and others have written before, there are a few main categories of expense that typically are included in SaaS COGs:
- Hosting and hosting infrastructure
- Professional Services
- Customer Support
- Cloud Operations and Platform Support
- 3rd Party Fees
- Capitalized internal-use software and purchased technology
Hosting & infrastructure expenses span processing servers, data storage, internet connectivity, and any third-party software that supports SaaS security, control, and monitoring. Accurately splitting these hosting and infrastructure expenses between SaaS company operations and SaaS subscriber solutions is a grey area that varies widely from company to company. The gamut of these expenses include third-party hosting services like Google Cloud, Amazon Web Services, and Microsoft Azure that support SaaS product delivery to subscribers, (COGs expense), web and platform hosting that support SaaS company R&D initiatives which promise to benefit customers at a later time (OPEX), and the portion of hosting that makes it possible for a SaaS company to conduct its regular operations (also OPEX). Self-hosted SaaS environments that don’t leverage third-party vendors must also proportionally split their self-hosting expenses between company use for business operation and customer subscription platform usage.
Professional services are billable implementation and customization services sold to customers. Fully loaded professional services personnel expenses should be included in COGs. In addition, systems used to manage professional services, such as project management software like Monday.com, or portions of ERP systems like Intacct which manage time and expense for professional services personnel should be included in COGs.
Customer Support spans any on-demand assistance outlined in subscription contracts, support staff payroll and associated expenses, and subscriber message and support ticket platforms. Nuance creeps in for intermittent engineering and customer success expenses incurred to resolve high-level subscriber service issues. Without the presence of high-volume issues requiring regular customer success and engineering team intervention, these would otherwise be classified as OPEX. Other expenses to closely evaluate that tow a fuzzy line between OPEX and COGs are those related to customer support software leveraged by both the customer support and success teams—such as Gainsight and Zendesk, and the proportion of time that staff devotes to customer success and customer support when individual staff members fill both roles.
Third-Party Licenses and Fees – As the functionality and sophistication of SaaS solutions has evolved in recent years, a myriad of expenses have made their way to the COGs line—from third-party licensed data, and content management systems, to platform integration solutions. In fact, the cost of any third-party solution that delivers on the functionality of a SaaS solution promised to customers is also fair game for COGs classification. One example is third-party data intelligence feeds—which are artificial intelligence (AI) collected data streams filled with threat information from vendors such as DeCYFIR, ThreatFusion, and IntSight—that assess outside threats. In addition, credit card processing fees are typically included in COGs expenses.
Benchmarking COGs Against the Bessemer Index
Just how those cost of goods reporting nuances playout for SaaS companies is highlighted in the chart below. It includes the 2020 fiscal year COGs and gross margin data of Bessemer Cloud Index companies, with annual revenues ranging from $250M-$500M. The prevalence and extremity of outliers reflected within this cohort highlight the substantial differences in business models between SaaS companies in 2020. Some of these Cloud companies are traditional enterprise SaaS companies with high gross margins, some are Cloud infrastructure vendors with high product costs and some are Cloud solutions that incorporate a number of 3rd party products and feeds. We selected this group of companies because they represent established business models, so the differences are not due to a lack of clarity about COGs reporting. The bottom line is that Cloud business models vary, so benchmarks for Cloud COGs or gross margin can vary.
- For fiscal year 2020, Bessemer Cloud Index companies with revenues between $250-500M reported COGs at an average of 29.10% of revenue, and gross margin average of 74.29%
- The highest cost of goods as a % of revenue reported by a $250-500M Bessemer Cloud Index company for fiscal year 2020 was 56.65%—and the lowest was 17.62%
- 21% of Bessemer Cloud Index companies with revenues between $250-500M reported a COGs % of revenue greater than 40% for fiscal year 2020
- 21% of Bessemer Cloud Index companies with revenues between $250-500M reported gross margins of less than 60% for fiscal year 2020
The Devil is in the Details
With so many expense classification nuances and reporting differences among companies today, it’s not just important to benchmark COGs, but to benchmark against a truly representative sample. To identify and benchmark against SaaS companies most closely aligned with your own, the following examples of Cost of Revenue expense summaries are excerpted from each company’s 2020 10-K filing, found under ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Each of these examples illuminates the variety of expenses that can be included in COGs, depending on how the products are maintained and customers are supported. With the increasing complexity of models and ways to develop and deliver Cloud products, it is even more vital for SaaS companies to benchmark against peers in the coming year. Benchmarking reduces the risk that you are not calculating COGs correctly for your business model. Investors will be looking closely at your gross margin to support valuation models, and you will want to make sure that you are calculating COGs correctly. Properly benchmarking your company against peers is one tool to help you manage your metrics for better decision-making. Benchmarks also help you set expectations internally with management and externally around valuations.