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Estd 4.22.2023
Introduction
In the fast-paced SaaS industry, pricing strategy can make or break your business. While focusing on customer acquisition and growth metrics, many executives overlook a critical component: the true cost of delivering their product or service. Without a clear understanding of your Cost of Goods Sold (COGS), you risk setting prices that appear competitive but actually erode your margins and threaten long-term viability. This oversight is particularly dangerous in the SaaS sector, where the illusion of "near-zero" marginal costs can lead to systematic underpricing. Let's explore why knowing your COGS is essential for sustainable growth and how to calculate it correctly for your SaaS business.
Why COGS Matters in SaaS
Unlike traditional businesses with obvious inventory and manufacturing costs, SaaS companies face a more nuanced cost structure. Many executives mistakenly believe that once software is developed, the cost to serve additional customers is negligible. However, this perspective neglects critical operational expenses that scale with your customer base.
According to a 2023 KeyBanc Capital Markets SaaS survey, companies with a clear understanding of their COGS maintain gross margins approximately 8-12% higher than those without this visibility. This difference directly translates to millions in available capital for high-growth companies that could be reinvested in product development or customer acquisition.
The True Components of SaaS COGS
The first step to avoiding underpricing is recognizing all elements that constitute your COGS. For SaaS, this typically includes:
1. Infrastructure and Hosting Costs
Cloud infrastructure isn't free, and these costs scale with usage. AWS, Google Cloud, or Azure expenses should be carefully monitored and allocated to your service delivery. As your customer base grows, so do these expenses—often non-linearly during expansion phases.
2. Customer Support and Success
While some consider this a sales expense, the resources required to onboard, support, and maintain customers are direct costs of delivering your service. Research from Gainsight indicates that customer success costs typically represent 10-15% of revenue for enterprise SaaS companies.
3. Third-Party Services and APIs
If your product relies on external APIs, data services, or third-party components, these costs accumulate with each new customer or increased usage.
4. Implementation and Professional Services
For complex B2B SaaS solutions, implementation costs can be substantial. Even if charged separately, understanding the full cost basis ensures appropriate pricing of both the software and services components.
5. Data Storage and Processing
As customers generate more data, storage and processing costs increase. This is especially relevant for analytics, AI, or data-heavy applications where these expenses can grow exponentially with usage.
Calculating Your SaaS COGS
To properly calculate your COGS, follow this structured approach:
Identify all direct costs: List every expense directly tied to delivering your service.
Separate fixed vs. variable costs: Understand which costs remain stable and which scale with customer growth.
Allocate shared resources: For resources that support multiple functions (like engineering teams that handle both new development and maintenance), determine what percentage supports existing customers versus new development.
Track unit economics: Calculate costs per customer, per user, or per usage metric relevant to your business model.
According to OpenView Partners' 2023 SaaS Benchmarks Report, healthy SaaS businesses typically maintain gross margins of 70-85%. If your calculations show lower margins, it's a strong indicator of potential underpricing or operational inefficiencies.
Common COGS Calculation Mistakes
Even when attempting to calculate COGS, SaaS executives often make these critical errors:
Ignoring Infrastructure Scaling Costs
As you add customers, infrastructure costs rarely scale linearly. Usage spikes, redundancy requirements, and performance expectations can cause cloud expenses to increase at a faster rate than customer growth.
Underestimating Customer Success Requirements
Enterprise customers often require significantly more support than anticipated. According to Totango, the average enterprise SaaS company spends approximately $1,000 per customer annually on success and support functions.
Miscategorizing R&D Expenses
While new feature development is typically not included in COGS, maintaining and scaling existing features for current customers is. Many companies incorrectly categorize all engineering expenses as R&D, skewing their understanding of true service delivery costs.
Pricing Strategies Based on Accurate COGS
With a clear understanding of your COGS, you can implement more effective pricing strategies:
Value-Based Pricing with Cost Floors
Rather than using costs to determine prices directly, use your COGS to establish minimum price floors while pricing based on the value delivered to customers. This ensures you never price below profitable levels, even when facing competitive pressure.
Tiered Pricing Aligned with Cost Structures
Design pricing tiers that reflect your actual cost differentials between customer segments. If enterprise customers cost 3x more to support than mid-market customers, your pricing should reflect this reality.
Expansion Revenue Models
Implement expansion revenue strategies where pricing scales with the customer's usage of cost-driving elements. This aligns your revenue growth with your cost increases.
Real-World Impact: A Case Study
Consider the experience of Dropbox, which famously revised its pricing strategy after deeper cost analysis. Initially offering generous free storage tiers, the company discovered that storage and bandwidth costs were significantly impacting profitability. By adjusting its pricing model to better reflect actual costs, Dropbox improved gross margins by over 15% between 2015-2018, contributing significantly to its successful IPO.
Conclusion
In the competitive SaaS landscape, accurate pricing is a strategic imperative that begins with a thorough understanding of your COGS. Without this foundation, even the most innovative products risk being underpriced, creating an unsustainable business despite strong customer adoption.
Take the time to rigorously analyze all components of your service delivery costs, implement systems to track these expenses as you scale, and use this data to inform pricing decisions. The difference between a SaaS business with healthy 80% gross margins and one struggling with 60% margins often comes down to this fundamental understanding of costs and corresponding pricing discipline.
Remember: sustainable growth isn't just about acquiring customers—it's about acquiring them at prices that reflect your true costs of delivery and the value you provide. Your investors, employees, and ultimately your customers will benefit from the long-term stability this approach creates.