The Blog of Ian Mercer.

Defining Cost of Sales for a SaaS or Software business

I was asked today how to go about defining "cost of sales" for a software startup, here's what I wrote:

From the perspective of constructing a useful financial model for your business the key issue is Fixed Costs vs. Variable Costs.  If you sell more units / licenses does the cost scale accordingly (either linearly or step-wise)?  Items like support, bandwidth, EC2 instance hours, commissions, ... might all fall into this category.  But if you only need just one email server ever then it's clearly a fixed cost.  As a startup you might want to model cost of sales as zero - you've bought a server, you have bandwidth to spare, nobody is on commission, ... but eventually you'll get to the point where these things do scale with the number of customers and should be modeled as variable costs.  "Cloud computing" can also help move fixed costs to variable costs and can reduce your burn rate early on.

Separating variable costs from fixed costs allows you to figure out your gross margin, to understand how the business will scale and to find your break-even point.  If you have a negative gross margin and no way to make it positive later you will never make a profit (net margin) so quit today!  If you have a positive gross margin, how large do you need to scale your customer base to cover your fixed costs too and thus reach break-even?   Of course nothing is ever that simple: you will still have some 'fixed' costs that move up in steps as you grow your sales making the break-even analysis slightly harder.

Constructing a financial model using "Variable Cost Accounting" like this helps you understand the business and helps you compare it to other businesses using standard ratios and terms.

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