SaaS CoGS vs. Opex

P&Ls of the SaaS startups I talk to (~2-10M ARR) are usually not that complicated. Still, there are often inconsistencies.

One of the hotly debated topics is the question of what counts as Cost of Goods Sold (CoGS) vs. Operational Expenses (OpEx). And thus the question of how high the actual Gross Profit (GP) and Gross Profit Margin (GPM) of your business is.

GPM is an indicator for the scalability / long term profitability of your business and used to calculate important SaaS KPIs like LTV and CAC Payback, so you should make sure that the split is reasonable.

Unfortunately, we didn't get to cover this in yesterday's AMA session with Ben Murray, so I thought I’d write a short article about it.

Refresher on relevant P&L items

CoGS = Total of all costs related to creating and delivering the product and/or service to the customers.

OpEx = Ongoing costs incurred by a SaaS company in its day-to-day operations.

GP = Total Revenue - CoGS.

GPM = Gross Profit / Total Revenue x 100%

Typical CoGS items in SaaS

Since GPM has an impact on valuation, many founders (and even more so M&A brokers) often send us P&Ls with overstated GPMs by coding several costs as OpEx rather than CoGS.

You can’t really blame them, as GAAP does not clearly define what should be included in CoGS. But there are at least best practices that you should follow.

Traditional CoGS items of a pure-play SaaS include:

1. Hosting costs (e.g. AWS).

2. Costs related to keeping production environment running (DevOps).

3. Costs for Customer Support/Success (if no sales component, more on that below).

4. Cost of any 3rd-party software that may be included in your product.

5. Costs related to Professional Services offered.

6. Transactional / payment fees, e.g. from Stripe → Arguable, I also sometimes see it in G&A.

So the upper part of your P&L should look similar to this one:

Benchmarks

If you are just starting out, especially with a PLG model, you may only have costs for hosting plus payment processing if you put it in CoGS.

However, if your business is beyond the early stages (say $1M+ ARR), it's not impossible but unlikely you'll have a GPM of 90%+.

On the other hand, if your GPM is super low (<70%), it is is usually an indication for one of the following points:

1. The application is super (cloud) resource-intensive (see example here)

2. Expensive third-party software / services integrated into the product (e.g. SMS API providers)

3. There is a larger service / agency component (e.g. because you are offering project-based customization)

It may be a specialty of your business and shouldn't necessarily worry you, but it means you cannot expect a typical SaaS valuation multiple that is based on revenue or ARR.

Below is a chart from Crunchbase (with data from 146 companies) showing that SaaS companies with higher gross margins tend to trade at better multiples.

The following benchmarks by SEG provide some orientation in which range your GPM should ideally be.

You can expect your GPM to decrease slightly over time and be lower at $50M ARR vs. $1M ARR. Especially if you transition from pure PLG to Product-Led Sales (usually more CS resources & increasing professional service revenue).

Where to put Customer Success?

This is a tricky and frequently asked question, and the answer is: it depends.

It depends on what your CSMs are actually doing. Yet there is no black or white, but rather gray.

My personal view (as a person without a finance/accounting background), and that of SaaS financial experts like Ben, is as follows.

Customer Success belongs in CoGS if:

• It’s purely focused on onboarding / customer retention

• Variable compensation includes retention targets, but not sales targets

• Leads will be passed to Sales, not closed by CSMs

Customer Success belongs to OpEx (S&M) if:

• There is a sales component as they are driving account renewals / expansions

• Variable compensation includes commissions for closed deals

• There is a quota for expansion / cross-selling

There is a simple categorization test from OnlyCFO that you can take:

When CSMs do what they are meant to do → S&M. A middle way could be to split the costs appropriately between the two items based on CSMs’ tasks.

Key takeaways

1. Ensure that your CoGS vs. OpEx split is appropriate based on best practices so that GPM is calculated correctly.
   

2. GPM of 75-80%+ is considered good. The higher the better (can mean a better valuation at exit).
   

3. Customer Success should be put in OpEx (S&M) if there is a sales component and as CoGS if there is not.