Why Benchmarking Hosting Expense Matters to Gross Margin and Average Cost of Service

May 22, 2018

Company X is a fast-growth SaaS company, surpassed $20M ARR in 2017, and is on a plan to hit $35M ARR in 2018, and $50M ARR in 2019.  Their growth plan is based on:

  • more enterprise customers;
  • opening an office in Europe/UK and increasing European revenue to 15% of total revenue; and
  • adding new functionality and features to the product to increase Average Contract Value (ACV)

The product team and CTO have presented Finance with a proposal to hire additional headcount and capacity to manage the associated hosting complexity, security requirements, and international delivery anticipated to be necessary within the next year.

What Finance Needs to Do

The Finance department of Company X starts to validate the expense assumptions in the product team’s proposal.  Rather than trying to second guess the product team’s proposal by looking at detailed service offerings from other hosting service providers, they compare the total cost to total hosting expense benchmarks in order to see if comparable companies are spending similar amounts.  If the numbers are in the right ballpark, then it is more efficient to move ahead with the business case analysis.

The business case analysis includes comparing the proposal to benchmarks for total hosting expense, as well as benchmarks for Cost of Revenue and Gross Margin, for companies at a similar size, stage, and with a similar business model.  Vendors delivering a low-priced, high-volume service will have different hosting expenses to vendors delivering high-priced subscription services to a smaller number of enterprise users with high security and integration requirements.

Finance will need to model out the combined impact of Cost of Revenue and the anticipated increase in revenue will have on Gross Margin.  In addition, management and the board are asking the Finance team to include the Average Cost of Services as a new metric they want to track in their quarterly management KPI tracking for themselves and the board.

What is the Average Cost of Service?

SaaS companies and investors want to know what the cost of software delivery and after-sales support after acquiring a customer will be for the company.  There is no sense in investing large amounts of resources into acquiring customers if the average cost of service to maintain the customer after the acquisition is too high.

The easiest way to calculate the company’s overall Average Cost of Service is to divide the Cost of Revenue by the number of customers.  The cost of revenue for a SaaS company primarily consists in the cost of hosting, any after-sales support, professional services, and training, as well as any capitalized internal software expense.

Cost of Service = Annual Cost of Revenue/ Customer #

The customer number is defined as the number of companies at the end of the previous year. Any company that started in the current year will be used to determine Average Customer Acquisition Cost (CAC).In OPEXEngine’s 2018 Benchmarking, we have included the Average Cost of Service as a new metric we are collecting this year for the first time.

Total Cost of Hosting

The total cost of hosting includes all service charges from a hosting services provider, such as Amazon Web Services, as well as all internal charges and headcount associated with managing hosting. If a vendor is running its own servers for hosting, then all costs associated with the hardware and management would also be included.

The total cost of hosting is by far the largest component of the Cost of Revenue for a SaaS company and therefore one of the prime drivers in a company’s gross margin.

Gross Margin = Total Revenue minus Cost of Revenue (largely cost of hosting) / Total revenue

Putting It All Together

The management team wants to see a business case that shows the total costs for hosting customers, not just the AWS bill. It often will fall to Finance to make sure that the proposal covers all costs, not just what is in the bill. Then the business case will need to look at how changes to the hosting environment will affect the Cost of Revenue, and ultimately how that rolls up to the company’s gross margin.  SaaS company gross margins typically run anywhere from 70-90% depending on stage and business model.

In the end, the critical question is:  how does this compare to the Costs and Margins at comparable companies?   Accurate and comparable SaaS benchmarks complete the business case to help the company make the best decision for its growth plan.