Effective COGS Control: Optimizing Subscription Revenue

SaaS (Software as a Service) has transformed the way businesses deliver and use software. From small startups to large enterprises, SaaS platforms provide seamless access to powerful software without the need for extensive infrastructure. However, the success of SaaS companies largely depends on having solid control over Cost of Goods Sold (COGS), especially within the SaaS segment to optimize subscription revenue.

What is SaaS-COGS?

SaaS-COGS is an important business metric that represents the direct costs associated with delivering the software service. This includes infrastructure costs such as cloud servers and databases, licensing fees for third-party tools, and costs related to customer support and platform maintenance.

One of the core reasons SaaS is on top of many investors' minds is the scalability provided by the SaaS business model which often comes to show by the high gross margins, which in turn translates into high profitability (if done right). By subtracting SaaS-COGS from your activated Annual Recurring Revenue (ARR) you get the Gross Profit which translates into gross margin by dividing gross profit by ARR. Usually a SaaS gross margin is somewhere between 70-85%. If your company has a gross profit in the high 90's (like most SaaS start- and scale-ups claim), there are probably some costs you have not considered. If you have a gross margin sub 70% your offering may be too operations heavy (too many warm hands are involved - look to automate!), or you have simply mixed different revenue streams and get a blended gross margin for all revenue streams.

The Importance of Effective COGS Control for SaaS Companies

Maintaining effective control over COGS is crucial for SaaS companies for several reasons. Effective COGS management allows for margin improvement. By optimizing infrastructure and other direct expenses, SaaS companies can boost their gross profit. 

If you do not know your SaaS Gross Margin for the different products you are offering, you cannot possibly know which activities actually yields a profit. Understanding COGS on a per-product basis provides valuable insights into which products drive profitability. By comparing this data with the outcomes of a customer-centric approach, you can determine where to focus your investments and where to scale back to ensure long-term profitability.

There can be multiple reasons for some product being less profitable than others. Transactional services, for example SMS etc., typically has a fixed cost and as it is a commodity like product (a text message is a text message) there are strong market forces keeping the resale price down. In other words, it is hard to charge high prices for a text message. Another common case of lower gross margins is for old software products where the suppliers are heavily dependent on operations to be able to offer the service to customers. More warm hands, means lower scalability thus higher costs.

Analyzing COGS on a per-customer basis empowers the company to personalize offerings according to customers' requirements and financial constraints. This segmentation based on profitability allows for tailored subscription packages that optimize value for both the customer and the company.

For products that are too aggressively priced, having a sound understanding about the COGS will work as valuable input in terms of potential price adjustments to increase ARR Growth while remaining competitive in the market.

1. Margin Optimization: Effective COGS management allows for margin improvement. By reducing infrastructure and other direct costs, SaaS companies can enhance their gross profit.
2. Pricing Strategy and Competitiveness: To set competitive subscription prices, it is necessary to have a thorough understanding of COGS. By having insight into exact costs, SaaS companies can set prices that cover costs while remaining competitive in the market.
3. Customer-Centric Approach: Understanding COGS on a per-customer basis allows the company to better tailor its offerings to customers' needs and budgets. It also enables the segmentation of customers based on profitability and the customization of subscription packages to maximize value for both the customer and the company.
4. Product-Centric Approach: Understanding COGS on a per-product basis allows the company to better understand what products actually drives profitability. Comparing this with the outputs you get from the customer-centric approach you will get valuable input towards where you should double-down in terms of investing, and where to scale down your efforts to make your business profitable over the long-haul.

"Having good insight into these figures allows SaaS companies to identify profitable products and customers, as well as areas where costs can be reduced or streamlined."

By understanding COGS on a per product and customer basis, the company can make valuable decisions to ensure profitability is maintained or even increased, by cutting costs and improving liquidity. Isolating the areas of the business that is more profitable can help in strategic discussions on where to double down scaling the efforts that works, and where to scale back. An effective way of doing this is to introduce compensation plans or incentive models where the sales team is incentivized on focusing on selling the right product to the right customer. To make the results even more powerful, the company could consider incentivizing on a Gross Profit-level, rather than on revenue. You can discover several compensation structures here, and to get more inspiration on the possibilities that exists within effective compensation management consider visiting our glossary.

Calculating from Gross Profit to Net Profit

For SaaS companies, it is crucial to be able to calculate from gross profit to net profit per product and per customer. This involves considering not only COGS but also other operating expenses such as marketing, sales, and customer service.

Here is a simple formula to calculate net profit per product:

Net Profit = Gross Profit - Operating Expenses

And to calculate net profit per customer:

Net Profit per Customer = (Total Subscription Revenue from the Customer - Total COGS for the Customer) - Operating Expenses to Service the Customer

Having good insight into these figures allows SaaS companies to identify profitable products and customers, as well as areas where costs can be reduced or streamlined.

Conclusion

The SaaS model offers a sustainable revenue stream, but its success depends on effective COGS control. By understanding and optimizing the costs associated with software delivery, SaaS companies can maximize margins and increase profitability. The ability to calculate from gross profit to net profit per product and per customer provides valuable insights that can help shape the strategy and growth of SaaS companies.

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