The Definitive Guide to Cost of Goods Sold (COGS) for Software Companies

👋 Hi, it’s CJ Gustafson and welcome to Mostly Metrics, my weekly newsletter where I unpack how the world’s best CFOs and business experts use metrics to make better decisions.

The allure of SaaS is that you can build software once and reproduce it over and over again for basically nothing.

While this is theoretically true, the rubber hits the road by examining a company’s gross margin (if it’s burdened properly). As a company grows it’s revenues, it’s cost of goods sold as a percentage of revenue should go down. This means the company becomes more efficient in providing it’s services to customer’s over time, as certain elements of it’s cost structure do not scale linearly with money coming in the door.

This is what the experts call “operating leverage.”

SaaS companies strive to reach +80% gross margins at scale. That means for every $1 of revenue the company brings in, there’s still 80 cents left over to pay for operating costs (like selling / marketing the current products, and building new ones).

I’ve highlighted the median gross margins by sector that I track on a weekly basis here at Mostly metrics:

With that target in mind, there’s a constant pull and push between CFOs and their finance teams as to what should go “up there.” Arguing that teams like Customer Success or certain elements of cloud infrastructure (BI tools!!!!) should go in OPEX alleviates the pressure you put on your gross margin, and make the company look more efficient.

People try to game the system in whatever way is more useful to them. And they also “play dumb” when it comes to shuffling stuff downward on the P&L.

This guide dives into what should be included in a software company’s COGS, how to handle nuanced cases like Customer Success, and how to avoid common pitfalls in categorizing costs. Don’t leave home without it.