By Patrick Laurance, SEG Analyst
While COGS is a seemingly straight-forward accounting principle, it is frequently miscalculated by many software company operators. Cost of Goods Sold (COGS) is a key metric private equity investors and strategic buyers use to evaluate companies. It’s a very important operating metric to measure how well a company can scale and how much money is available for operating expenses.
In layman’s terms, a SaaS company’s COGS is simply the cost the company incurs to deliver its solution to the customer. It is a variable cost that will grow as the company sells more of its solutions. Revenue minus COGS is gross profit. If a company has $10M of revenue and $2M of COGS, the gross profit is $8M. The gross profit margin is 80%. More than likely, if this company grew revenue to $20M, gross profit margin would remain close to 80% and COGS would be $4M. Gross profit would be $16M. Gross profit minus operating expenses is net income or profit. As a company grows, we will often see some economies of scale in COGS such that gross profit margin will naturally increase. However, because COGS are largely variable costs, the increase is typically not too material.
So, with just this basic understanding, which company is more valuable all else equal… a company with 70% or 85% gross profit margin? It should be obvious the Company with 85% gross profit margin is far more valuable. But by how much? Over a five-year period, and with a 20% revenue growth rate, Company A in the table below is able to generate $22M more of cash-flow for operations, which can be used to drive additional growth, improve product, or distribute profits. Company A could easily fetch one turn of revenue or more on a revenue multiple basis vs. Company B.
|Company A: 85% Gross Profit Margin|
|Company B: 70% Gross Profit Margin|
|Gross Profit Difference|
Frequently, we come across software business operators who claim they have more than 90% gross profit margin. This is a certain cautionary flag. While these operators have a deep understanding of their business, many are not aware of the necessary inputs to properly calculate COGS and therefore have a poor sense of the business’ gross profit margin.
Expenses to include in COGS are expenses directly attributable to the delivery of the goods sold by a company or the services provided. Common COGS expense line items for a modern software company include:
- Hosting expenses to deliver the actual software. Think Rackspace or AWS expense.
- Costs for third-party software that is part of the product delivered to customers. This could be a third-party expense for a reporting software application used in the company’s product and delivered to the customer.
- Personnel costs tied to the employees responsible for managing/ running the servers and data center delivering the SaaS application to customers.
- Personnel costs for the professional services team responsible for getting a customer live on the product (i.e., implementation, consulting, data migration, training, etc.).
- Personnel costs for the customer support team responsible for supporting customers once customers are live on the application.
Benchmarking SEG’s SaaS clients over the past few years, the median gross profit margin is near 80%. If you have any questions about your COGS, please don’t hesitate to reach out.