Calculating the Cost of Goods Sold (COGS) in a Software-as-a-Service (SaaS) business is a unique challenge. Unlike traditional businesses with physical inventory, SaaS companies focus on costs tied to technology infrastructure, cloud hosting, and essential support services that keep the software running smoothly.
Getting these calculations right is important—they directly impact your gross margin, which investors use to evaluate your company's efficiency and potential for growth. Whether you're a startup seeking funding or an established company planning for scale, understanding and accurately tracking your SaaS COGS can mean the difference between demonstrating a highly profitable business model and missing key opportunities for optimization.
This introductory overview of SaaS COGS looks at the components you should include in your COGS calculation, helping refine your financial approach and enhance your company’s bottom line.
SaaS COGS 101: Understanding the Basics
Let’s start at the beginning: what are COGS in the context of SaaS accounting?
SaaS COGS represents the direct costs of delivering and maintaining software services to customers. Think of it as the cost you incur each time a customer uses your product rather than the cost of creating the software in the first place.
Traditional businesses calculate COGS through tangible inputs like raw materials, labor, and manufacturing overhead. SaaS COGS, however, focuses on the technological infrastructure and support systems that keep your service running.
Your COGS directly impacts your gross margins, a key metric in determining your business's efficiency and scalability. Lower COGS translates to higher gross margins, signaling a more profitable and potentially more valuable company.
Key Components of SaaS COGS: What to include in SaaS COGS Calculations
If you want an accurate COGS calculation, you need to understand the clear boundaries between direct service delivery costs and other operational expenses. For SaaS companies, COGS should reflect only the expenses directly tied to providing your service to customers.
Hosting and Infrastructure Costs
Your cloud hosting expenses through providers like AWS or Azure represent a significant portion of these costs. This includes the basic hosting fees and costs for data transfer, storage, and specialized services within these platforms. Server maintenance and operational costs, whether for cloud or on-premise infrastructure, also fall into this category.
Direct Labor Costs
Labor costs require careful consideration. Include salaries and benefits for teams directly involved in service delivery and maintenance, such infrastructure personnel. Customer support and customer success teams also count as COGS since they directly facilitate service delivery. Other costs, such as DevOps, are often allocated between COGS and product development.
However, development costs for new features or products don't belong in COGS calculations—they fall under R&D expenses.
Third-Party Software and Services
Third-party tools and services essential to your core product delivery count toward COGS. This encompasses licensing fees for integrated technologies that power your service and API costs for external data services your platform requires to function. Include only the software and services directly contributing to delivering your core product to customers.
Other Direct Costs
Additional direct costs include payment processing fees for customer transactions, data storage expenses for customer data, and security measures directly related to service delivery. These costs must directly relate to your service delivery to qualify as COGS. Remember to review these costs regularly as your service evolves and scales.
What to Exclude from SaaS COGS
Many expenses vital to running a SaaS business don't belong in your COGS calculations. Sales and marketing expenses, including advertising costs, the salaries of your sales team, and promotional activities, should remain separate from COGS. While these activities drive customer acquisition, they don't directly contribute to service delivery.
General administrative costs, such as office rent, executive salaries, HR expenses, and professional fees, also stay out of COGS calculations. These overhead expenses support your overall business operations but don't directly connect to service delivery. Similarly, legal fees and insurance costs belong to your general administrative expenses, not COGS.
Product development requires special consideration. Only include infrastructure and some portion of DevOps costs in COGS. Exclude:
-
- New Feature Development
- Product Improvements
- Innovation Initiatives
- Software Testing
- Product Management
COGS should only reflect costs that directly scale with service delivery. This separation helps you accurately assess operational efficiency and maintain clear financial metrics for your tech business. A good rule of thumb is that if the cost doesn't increase directly with customer usage, it likely doesn't belong in your COGS calculation.
Instead, these costs are classified as operating expenses and impact a company’s net margin, not its gross margin. Depending on how your company reports these costs, operating expenses may be classified as General and Administrative Costs (G&A Costs) or Selling, General, and Administrative Costs (SG&A Costs).
Calculating SaaS COGS
To calculate COGS for your SaaS company, add all direct delivery costs. This formula looks like:
Hosting and Infrastructure Costs + Direct Labor Costs + Third-Party Software and Services Costs + Other Direct Costs = COGS
Once you’ve calculated COGS, you can use it to calculate gross margin and gross profit.
Let’s put the calculation into action with two examples.
Company 1 is an infrastructure-heavy SaaS company that processes large amounts of data. Their monthly COGS total is $150,000. The breakdown looks like this:
-
- Hosting Costs: $50,000
- DevOps Team (4 People): $40,000
- Third-Party Services: $15,000
- Support Team (6 People): $45,000
- Monthly Revenue: $500,000
COGS: $50,000 + $40,000 + $15,000 + 45,000 = $150,000
Gross Profit: $500,000 - $150,000 = $350,000
Gross Margin: = $350,000 / $500,000 = 70%
On the other hand, Company 2 is a customer support-heavy SaaS platform focusing on enterprise clients and has different cost distributions. Their total monthly COGS is $157,500.
-
- Hosting costs: $20,000
- DevOps team (2 people): $20,000
- Third-party services: $5,000
- Support team (15 people): $112,500
- Monthly revenue: $450,000
COGS: $20,000 + $20,000 + $5,000 + 112,500 = $157,500
Gross Profit: $450,000 - $157,500 = $292,500
Gross Margin: = $292,500 / $450,000 = 65%
Common Calculation Mistakes
Overinclusion of Indirect Costs: Don’t include costs that don’t scale directly with service delivery. Common mistakes:
-
- Including entire engineering team costs
- Adding product management expenses
- Incorporating general IT support costs
- Factoring in administrative software licenses
- Adding office space and utilities for technical teams
- Not including payroll taxes, benefits, and other costs associated with DevOps and customer success teams
Expense Misclassification: Watch out for these frequent misclassifications:
-
- Customer success strategy vs. direct support costs
- Platform development vs. maintenance costs
- General security measures vs. direct service security
Remember: COGS calculations should reflect a direct relationship between costs and service delivery. When in doubt, ask whether the cost increases specifically because you're serving more customers.
Take a Better Approach to Tech Company Metrics with G-Squared Partners
SaaS COGS calculations require careful attention to detail and a deep understanding of which costs directly contribute to service delivery. Success hinges on properly categorizing expenses—from hosting infrastructure and support teams to third-party services—while avoiding common pitfalls like including development or general administrative costs. The key to getting these calculations right is having a comprehensive Chart of Accounts and maintaining clear visibility into your financial data.
Accurate COGS reporting has implications far beyond basic bookkeeping. Your COGS calculations directly impact gross margins, influence investor decisions, and reveal crucial insights about your business's scalability and efficiency.
Getting it wrong could mean missing optimization opportunities or sending incorrect signals to potential investors about your company's potential.
Ready to ensure your SaaS metrics tell the right story? G-Squared Partners specializes in helping tech companies build robust financial frameworks and accurate reporting systems. Contact us today to transform your approach to financial metrics and position your company for success.
