Virtual Coffee with SEG: Understanding the Importance of COGS

Coffee with Jonathan Christie, Manager in Transaction Services, Grant Thornton

Cost of Goods Sold (COGS) is something that all business owners should be familiar with as it impacts each company’s profit and provides insight into company operations. While it may seem like a straight-forward accounting principle, many SaaS companies can frequently misunderstand and miscalculate it. In a recent “Virtual Coffee with SEG,” SEG Senior Associate, Austin Hammer, had coffee with Jonathan Christie, Transaction Services Manager at Grant Thornton. Grant Thornton is one of the world’s leading organizations of independent audit, tax, and advisory firms.

Jonathan and Austin discuss the topic of COGS, including its importance and best practices for software companies. We hope this discussion can help clarify the concept and calculation of COGS for SaaS businesses, as it’s a crucial operating metric to measure operational efficiency and drive scalability for SaaS companies.  

Below are some highlights from the discussion. To view the entire video, select the link below.

Austin: What are COGS and gross profit margin? Why is it important for businesses to track them?
  • Jonathan: COGS are your direct costs required to “service the revenue.” For a manufacturing company that produces a tangible product, this is the raw labor or raw material costs and labor that go into producing each product. Gross profit is revenue, less those costs. This metric is incredibly important for potential investors to understand the first view of profitability. An earlier stage company may not be profitable, but understanding what potential the company has in terms of profitability is important.
  • Jonathan: For a SaaS business, you have an intangible product, so you don’t necessarily have raw material costs for each product or widget you’re selling. You have development costs to create the product, but then from there, it is just servicing. From an investor’s perspective, it’s important to understand what pricing power the company holds. Are there any fixed or variable recurring costs that are recurring that are required to service that revenue?
Austin: For SaaS companies, what should typically be included in the COGS calculations from both a labor and non-labor perspective?
  • Jonathan: This is where GAAP [Generally Accepted Accounting Principles] is not clear, so there is little discretion here in practice. Generally, from a labor perspective, include any employee that is needed to get the customer in operation with the product. For SaaS, this includes one-time implementation services, training, onboarding, and customer support. Afterward, any add-on to the customization or upgrades where labor is required to fulfill and provide for those services should be included. The challenge for most smaller-middle market businesses is they may have employees wearing multiple hats. For example, they may be doing some development work, but also, they are on implementation or customer support teams. Take a step back and ask if development costs should be part of the recurring cost to services revenue. Those are typically part of R&D and fall under Operating Expenses, so that is where it is important to understand which employees have a portion of their time spent on services revenue.
  • Jonathan: From a non-labor perspective, you don’t have those raw material and tangible costs. However, you do have hosting costs, third-party license fees, and more. There aren’t a lot of costs here, but it’s important to understand the costs that are instrumental in allowing the product to operate.
Austin: What are some of the most common mistakes companies make when calculating COGS?
  • Jonathan: I don’t want to use ‘mistakes’ in a negative sense. At certain stages, a company might not have enough accounting heads to allocate costs. Generally, we see all labor costs flow down into operating expenses. When thinking about customer support, services, and training, salaries would fall into operating expenses. Typically, that’s why we see all labor ending up in operating expenses. Those companies and operators are good about having some of the direct costs or hosting costs recorded in COGS or Cost in Revenue. Those are easy to identify and track separately.
  • Jonathan: In terms of non-labor, though, we see companies presenting technology costs in one bucket. It is typically not detailed enough to identify other software costs in the cost of revenue, but it’s part of the technology bucket which flows into the cost of revenue. Because of that, you end up understating either gross profit and under-positioning what the company could achieve.
Austin: For labor COGS, what are the best ways to determine which employees’ compensation should be included in COGS? If an employee splits time, what is the best way to approach this?
  • Jonathan: First, get the number of employees who are in that direct category. Maybe they do support, customer onboarding, and implementation, but also wear a developer’s hat as well. Have that list of employees that split time between those functions and gain an understanding of those core functions. Afterward, it’s important to understand what percentage of time they’re spending on those functions.
Austin: For a SaaS company considering an exit over the next few years, what can they do now to make the process easier and smoother when they choose to exit?  
  • Jonathan: From a labor perspective, understand what existing capabilities your accounting system has at the moment. What we often see is that operators or companies aren’t aware of what their accounting system could do. They might have the functionality to split certain departments by payroll. They could bucket those employees between maybe Sales and Marketing, General & Administrative, Customer Support, etc. At a high level, having some labor costs route to COGS can be helpful. Second, you need an understanding of which employees are essential in servicing that revenue. From a non-labor perspective, it’s helpful to have the granularity by vendor and understand what each of your software costs and third-party software costs are providing.

See pages 19 and 22 of our 2021 Annual SaaS Report for more details on how gross margin impacts valuation.

“Virtual Coffees with SEG” are conversations with industry experts, providing real-time insights into the current market and self-help advice to SaaS CEOs and operators. View our last Virtual Coffee with SEG: SaaS Technology Preparedness for Due Diligence.