Downward trending cost of goods (COGs) benchmarks are improving SaaS gross margins. Competitive service offerings and new technologies are driving down costs to maintain SaaS infrastructures. As SaaS gross margins are rising, investors are becoming a bit more savvy about gross margin analysis, with increasing scrutiny of SaaS financials, especially in the wake of the WeWork, Peleton and Uber IPO disappointments, some of which is blamed on gross margins below those of true SaaS vendors.
To see how COGs and gross margins are changing, take a look at these charts showing SaaS companies that IPO’ed in 2008 versus 2018.
- Average COGs in 2008 was 40% of revenue at the time of IPO, and gross margins averaged 60%.
- For companies IPO’ing in 2018, average COGs had dropped to 31% of revenue and average gross margins had increased to 68.5% with a number of companies at over 80% gross margins.
Gross Margin Analysis
Digging into what you are putting into COGs is critical. Eric Mersch, CFO and partner at FSG puts it this way:
“The methodology for reporting subscription gross margin is so well established that using a non-standard approach will cost you several multiples of ARR in valuation. If your subscription gross margin exceeds the 70% median for smaller companies, and 78% for larger companies, as shown in the OPEXEngine database, investors will dive in to make sure that you are not manipulating the data. If your margins are too low, investors will not believe that you are a SaaS company.”
SaaS companies typically include the following expenses in COGs:
- Third-party hosting
- Customer support
- Cloud operations / Platform Maintenance
- Third-party fees
Employee expenses associated with the above are also included. A review of 18 public companies confirms that employee activities included in COGs are for customer support and for platform operations. The latter is also described as hosting, managed services, cloud operations, functionality of the platform/data centers, and computing infrastructure often provided by third parties.
Looking at each of the major categories going into COGs, there are some nuances to what is a direct cost of producing the goods sold by a SaaS company.
A third-party cloud provider hosts the software and provides processing power, storage, and band-width, along with tools and monitoring services. Most companies run at least two environments in their hosting platform. The first is a production environment which handles all customer activity, the second is a development environment which handles all of the internal software development and testing. Third party hosting expense should be split between these two environments. The development environment is a much lower percent of the total expense but it is significant enough to matter.
Customer support is a widely misinterpreted item because most companies have two internal departments that work with customers and both have Customer in their names. Cliff Rosell, founder Lazy Genius Solutions (an outsourced finance and RevenueOps firm) says,
“I’ve been seeing the difference between Customer Success and Customer Support defined as Reactive (Customer Support), Proactive (Customer Success).”
Customer Support is the call center support offering technical assistance. Such activities are referred to as direct since they provide value to the customer in the same period as that of the service. They are reactive because the customer contacts the company for support or help.
Customer Success is a different organization than Customer Support and usually is proactive in reaching out to customers. For many companies, the Customer Success organization provides services that benefit the company by increasing customer engagement. Such activities should be reviewed as to whether or not they generate revenue in the period when customer success activities were performed. If Customer Success is tasked with renewing contracts with customers, and has a quota for renewals, then its expense is usually accounted for under operating expense.
Cloud Operations / Platform Support
In general, companies classify activities associated with cloud operations and platform support as Cost of Revenue since their job is to maintain the operational efficiency of the hosted software.
Many companies have third-party fees such as transaction expenses and external data. Transaction fees are the direct result of a customer activity and should be treated as a direct expense. External data used in the software are direct if needed to provide the software with the full functionality as marketed to the consumer.
Benchmarking SaaS Cost of Goods and Gross Margins
SaaS COGs have been trending down, while gross margins have been trending up. It is critical to be careful and consistent in categorizing the expenses allocated to COGs and to benchmark against peers and market leaders as the benchmarks continue to evolve. Investors are expected to pay closer attention to both these metrics in 2020 and associate with company valuations.