Software as a Service (SaaS) is a software distribution model in which a third-party provider hosts applications and makes them available to users over the internet. SaaS has in recent times revolutionized how software is consumed in a cost-effective, flexible way. Many SaaS firms are growing rapidly, adding new customers month on month.
HOW DOES A SaaS COMPANY WORK?
Most SaaS companies host the software on their servers in the cloud which is then sold to customers through different subscription-based pricing models (usually customers don’t own the software). Customers access this software remotely via the internet (using any web browser).
HOW IS THE BUSINESS MODEL DIFFERENT COMPARED TO A TRADITIONAL SOFTWARE FIRM?
The entire business model of software firms offering SaaS products is different from traditional software companies that would make software for customers which they would have to install on computer hardware after making a one-time payment for the same (thereby becoming owners of that copy of the software). Hence, a SaaS company needs to calculate its COGS (Cost of Goods Sold) and operating expenses differently than the traditional company.
A SaaS company provides a service that a customer rents, instead of owning. More so than a goods manufacturer or even for that matter a traditional software company; for a SaaS company, there may be some confusion determining whether an expense is to be marked into the COGS or the operating expenses column in the income statement.
In that case, the question to ask is whether that particular expense would have been an expense at all, even if no sales were generated. If the answer is yes, then likely it is to be included in the operating expenses.
Expenses that will be included while calculating the COGS or cost of services for a SaaS company:
- Hosting: This will be the data center costs that will be paid by the SaaS company to hosting service providers like Amazon Web Services. The SaaS company may also have to separately hire vendors to provide services like E-mail, monitoring and Domain Name Service (DNS).
- Account Management : Expenses on the upkeep sales team personnel responsible for taking care of current customers
- Billing Platform: SaaS companies might need to hire a vendor for processing payments from customers. These vendors typically charge a commission along with a refund fee, foreign exchange charges, and transaction fees.
- Technical support: Expenses of running and staffing the call center handling inbound customer calls
- Research and Development (R&D) amortization: The reduction in the value of the companies R&D over time. This is a depreciation of a non-tangible asset like the value of the R&D of the company.
- Cost of maintaining current software(s)
Expenses that can be included in operating / other expenses:
- Cost of developing and testing new software to make it market-ready.
- Personnel costs: Salaries and benefits of employees who are not associated directly with current product maintenance/customer handling. Training and travel expenses and new recruiting/ hiring costs may be included.
- Rental / Property costs: Renting (or buying) a corporate office, furnishing it, paying for its utilities like electricity, water; will cost money which will only increase as more people are inducted into administration and the office becomes bigger.
- Marketing and advertising: This may include costs like creating brochures; travel to trade shows and digital ads. During the initial start-up phase, the company may make do with something basic on a shoe-string budget like a blog and social media presence, but as the company scales marketing may need to be more professional and thereby costs for producing and disseminating content may increase.
- Legal and accounting: Drafting Employee Stock Exchange Options (ESOP’s) and employee contracts, compliance with the tax regime (GST), bookkeeping, auditing, and tax advice will be necessary for operations of the company.
Calculating the COGS accurately is extremely important for a SaaS company, especially when it is just starting. A SaaS company needs to divide the COGS by the total number of customers to get the Average Cost of Service (ACS). The ACS is used with other metrics like Average Recurring Revenue (ACR – the annual monetary value of the subscriber base of a subscription-based company like a SaaS company) and Customer Acquisition Cost (CAC- the total cost of acquiring new customers in an annual year divided by the number of new customers) to determine if the company will succeed with its current model in the market place.
The Average Cost of Service (ACS) will answer questions of economies of scale like :
1) Is the company’s pricing models sustainable? If not, then by how much do the prices that customers pay for various services increase?
2) How will revenue and costs be affected when the company doubles its subscriber base.
3) Are costs too high even if the number of customers (the subscription base) is quite large and increasing all the time?
4) By how much is the subscription base to increase to enable profitability at the current pricing models?
5) If the amount of customer are doubled in an annual year then what will be the change in unit costs?
A SaaS company must not only focus on its technical R&D, product development, marketing, technical support, and all-round customer satisfaction but also correct accounting of costs and revenues. Accurate accounting can enable the firm to build accurate models essential to determine if the current business model is sustainable. Costing and pricing are critical in this highly competitive marketplace where customers count every penny. Once you as a SaaS firm can develop accurate models by correctly bifurcating the cost of goods sold and expenses, you shall be in a better place to demonstrate that your business is sustainable and ripe for growth — thus pleasing customers and investors alike.
Everyone needs assistance sometime or the other. If you would like to get your COGS and expenses right for your SaaS company, get in touch with us: 044-46315959 or drop us a note: [email protected]