For any business to sustain and scale, it has to know and work around its profit margin. While different industries have different profit margins, knowing the cost of goods sold (COGS) is a common deciding factor in all to calculate those margins. And when it comes to the software industry, SaaS COGS is comparatively one of the least ones, leaving a large scope for lucrative profit margin.
Before even thinking of starting a business, entrepreneurs must know the industry-wide average profit margin of a business. While the margins may differ, that is not the only factor deciding the growth of a business. The scalability and how commonly used products a company manufactures also play a crucial role in deciding the business growth.
Nevertheless, it is worth having a quick look at a sample data of different industry’s profit margin in the below exhibit.
As you can see above, the Tax services industry has the highest gross margin of 90%. Since, it is hardly dependent on manufacturing any product but solely on services, it is understandable.
But the SaaS industry, despite being product-based, has interesting information to reveal. Ideally, SaaS margins should be in a range of 80 to 90%. To delve deeper into this, let us first understand the definition of COGS.
What is SaaS Cost of Goods Sold (COGS)?
SaaS COGS is the total cost incurred in the production and delivery of the SaaS product. While there are many types of costs associated with a SaaS company, COGS doesn’t include all of them. Below are costs included in COGS of a SaaS product:
- Web hosting cost
- Cost of using third-party services embedded in the product
- Website development cost
- Manpower used for production and delivery of the product
- Customer support and account management cost
- Professional services cost
In a typical SaaS product, if the ideal profit margin is around 80 to 90%, it means SaaS COGS benchmark should be around 10 to 20% of the total product price.
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What is COGS used for?
For running a business, there are two types of costs involved – essential and variable. Essential cost is something which is must for starting and sustaining a business. This is the cost associated with the production of your core product. Hence, COGS is an essential cost.
Variable cost is something around which you can improvise depending upon the availability of funds and the business goals you set. These are also essential for a business but the cost can be variably disbursed depending upon the size and need of the business and the availability of funds.
Essential costs like COGS are needed to keep the business running. Whereas variable costs are needed for the future growth of the business.
Few variable costs which are not included in COGS are:
- Sales commission
- Overhead charges
- Customer success cost for customer retention and account expansion
- Operations cost
So, the point of describing all of the above points is that by knowing COGS, you would know what budget you can allocate to other areas of your business for further growth. These costs may include operational excellence, debt management, or re-investment.
Understanding the nuances of COGS vs Customer Success Cost
One thing that sets apart a SaaS business from other businesses is the recurring revenue. It’s not a one-time sale of the product you are after in a SaaS business. Until you set a model for generating repeated revenues from the same customer over time, you cannot reap the fruits from a SaaS business model. It is much similar to the royalty music producers earn over lifetime for a song they create only once.
Two ways of measuring revenues
To differentiate the cost of customer success from COGS, you must first understand the difference between two kinds of revenues a SaaS company generates:
- One-off sales revenue
- Customer Lifetime value
One-off sales revenue is earned when the product is sold for the first time to a customer. It may or may not recover the total cost incurred in the production of the product, that is, the COGS.
But Customer Lifetime Value is the total revenue an average customer generates during their entire tenure of being in relationship with the company. This revenue includes revenues from the following sources:
- First purchase
- License renewal
- Account expansion through upsells/cross-sells.
What is relevant in SaaS?
Obviously, out of the two kinds of revenues mentioned above, the Customer Lifetime Value (CLV) is more relevant in SaaS industry because of its subscription-based delivery model.
Now, to maximize the CLV you need to work towards customer retention and account expansion. And this is where customer success comes into picture.
Customer success is the business function responsible for helping the customers achieve their goals by using the company’s product. If the customer is successful and satisfied with the product, retention becomes natural. And when this goal is achieved, the existing customer becomes a primary target for selling more products of the same company.
Justifying the cost of Customer Success
To run customer success as a separate business function in your organization, it involves a cost factor. There are many kinds of costs involved with customer success, be it the employee cost, the CS software cost, or the operational cost.
But when the overall revenue generated by increasing CLV surpasses way beyond the relatively low cost of maintaining Customer success, the cost associated with customer success can be justified.
What more, investing into customer success has a compounding effect on the returns it generates over time. As the customer matures, their revenue size starts growing by buying more products from you. And since the cost of CS remains almost constant (except the minor inflation adjustment), the profit margin expands over time.
So, a more accurate measurement of SaaS margin should be done throughout the entire lifetime of a customer.
SaaS Profit Margin = CLV – CS cost – COGS
For a company having an efficient CS team, if you compare their SaaS profit margin over entire customer’s lifetime, it becomes much larger than the initial margin of one-off purchase.
And these are just the tangible and measurable benefits of investing in customer success.
There’s another benefit involved with customer success that is worth mentioning here. Through customer success you are able to create brand advocates who in turn market your product and bring more customers to your business.
When strictly going by the definition of COGS, customer success cost may not be included into that. But applying the same cost principle in a SaaS product might be erroneous.
SaaS basically means Software as a Service. It has the characteristics of both a product and a service. Hence, if COGS is the cost involved with the product, the CS is the cost involved with the service part.32
For gaining a holistic view of your SaaS offering (product + service), you cannot leave CS from the calculation. When you combine COGS with CS and compare the relative returns, you get a more realistic picture of SaaS margin. And that gives you an edge in front of your investors or in the valuation of your business.
Shivani is a talented CS manager with the skillsets to elicit, scope and manage end-to-end B2B SaaS project delivery. She has a keen interest in depicting her learnings in customer success by writing resourceful blogs and articles.
Published January 13, 2021, Updated February 22, 2023