A Crash Course in SaaS COGS, Gross Margin, LTV, and CAC

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Metrics are crucial in successfully planning and evaluating the performance of your SaaS business, but understanding them all and calculating them accurately can feel overwhelming. This post will explain a few key SaaS financial metrics with simple definitions and some best practices to help you get the most out of them. You can also check out our guide to SaaS revenue for an overview of SaaS sales and revenue concepts.

The examples and images in this post come from this Opstarts model (you can find a description of the model at the bottom of this post).

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Let’s start with a quick refresher on related metrics in traditional business finance:

One basic financial concept is unit economics: How much money are you making on each item you sell? In simple terms, that involves looking at the following items:

  • Revenue – the money people pay you for the stuff you sell
  • Cost of Goods Sold (COGS) – how much it costs (in materials, etc) to make each thing you sell
  • Gross Profit – the difference between the revenue and cost of goods sold (expressed in terms of percentage of revenue, Gross Margin)

So if you sell something for $100, and it costs you $15 to make each one, you have a gross profit of $85 or a gross margin of 85%. Now you have a measure of how much money you make for each additional sale you make.

A second important financial concept is how profitable your overall business is. To understand that, you calculate your Operating Income – take the Gross Profit from the items you sold in a period and subtract what it costs to run your business over that period. Those costs are called Operating Expenses, and typically include categories like Sales & Marketing, Research & Development, and General & Administrative. The bigger your Operating Income, the more profitable your business operations are (note that for bottom line Net Profit or Net Income you’ll also include financial adjustments like taxes, interest, etc).

What makes SaaS financial metrics different?

With SaaS financial metrics you’re looking to answer the same fundamental questions of unit economics of each sale and overall profitability of your business. What makes them different is with recurring revenue subscriptions you also need to factor in the added dimension of time. Unlike a traditional business where you just compare the costs to make a product and operate a business over a period vs the sales over that same period to assess your financial health, in a SaaS business you’re looking at both unit economics and overall profitability over the expected lifetime of a customer.

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Let’s take a look at the SaaS metrics that will help you answer those questions. We’ve provided a simple explanation and basic calculation guideline for each metric. We’ll also mention some additional things to think about as you’re building your metrics, which we’ll discuss in more detail in future posts.

SaaS COGS

In SaaS, COGS (some SaaS companies prefer to call this Cost of Revenue or something similar) is the cost required to provide your service to your customers. Think of this as what you’d need to spend in your company if all you needed to do was keep your existing customers up and running.

Types of expenses typically included in SaaS COGS are:

  • hosting/cloud/database etc costs – the delivery costs for your SaaS product
  • bundled/embedded/re-sold services/software that you offer in your product and have to pay license fees for when you sell your product
  • implementation/support/customer care costs (as companies grow, they sometimes break out some portion of this cost from COGS into a category of selling expenses focused on expansion revenue from existing customers)
  • payment fees – Stripe/CC gateways/bank fees/etc (there is some debate over this, with many classifying this as a G&A or sales operating expense. Like many items here, the key is consistency in your model.)

When calculating your COGS, keep in mind that some will be direct cost (things like license fees or hosting fees directly associated with a specific offering) and others will be indirect (like a head of support who manages all support operations) and will need to be allocated across all your offerings. You may also have some expenses that are partially allocated to COGS, like an engineer who works half-time on support and half-time on QA.

Calculating your COGS over a range of time will smooth out the impact of things like the specific date you add support hires, which can distort your metrics if you are only calculating point metrics for a single month. This concept of rolling periods for your metrics will apply to all of the metrics discussed in this post.

Once you’ve calculated your COGS, you’re ready to calculate your Gross Margin.

Gross Margin

Gross Margin is how much profit you make from your sales, expressed in percentage terms. Calculating it is simply (Revenue – COGS) / Revenue.

The higher your gross margin, the more valuable the revenue is to your business. SaaS companies typically have gross margins of 70% or higher.

Calculating COGS individually for each of your products will allow you to compare gross margins and see which lines of business are most profitable.

LTV

LTV is the lifetime value of a customer to your business. In its most basic form, LTV is simply the average revenue per account divided by churn rate. That provides a decent quick approximation of lifetime value for a product, but it generally way overstates the amount of revenue you’re likely to capture from a customer. To get a more accurate number, you’ll need to take the following factors into account as well:

  • Gross Margin – the higher your gross margin, the higher the lifetime value of your customer. If you haven’t calculated your COGS and gross margin, you can just use a reasonable proxy value in your LTV calculations, like 70-80%.
  • Discount Rate – applying a discount rate accounts for the cost of capital and uncertainty inherent in future revenue. Guidelines for startups range from 20-30% annual DR. The LTV posts linked below go into way more detail on this.
  • Months Cap – Basic LTV calc assumes potential infinite lifetime of customers, which is obviously unrealistic. We recommend setting a cap of 36-48 months maximum customer lifetime depending on the maturity of your business.

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Like COGS, looking at LTV just for a single point in time can be distorted due to factors like seasonality. That’s one of many reasons we recommend looking at a rolling average vs just point-in-time LTV calculations. And you can choose to have that rolling period cover historical performance, future expected performance, or a combination of both. Here’s a good post on that topic: Rolling estimated LTV calc (Tunguz/Singh).

CAC

CAC is your cost to acquire a customer. Calculating this is simply the sum of your sales & marketing costs divided by the new customers acquired. Typical sales and marketing costs include:

  • Advertising/marketing costs
  • Employee costs (not just salespeople, but all people on the sales and marketing teams)
  • Travel/etc costs associated with sales and marketing
  • Tools/products/services like CRM to support sales and marketing

Using the rolling period approach discussed in LTV will help smooth out the impact of new hires who will be able to handle far more sales over time and can make your CAC artificially high early on.

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Another thing to consider is what periods to compare for your costs vs the new customers acquired. In lower-priced self-service subscriptions, sales cycles are often very fast and the sales and marketing costs are associated with sales in the same period. On the other hand, companies with large enterprise sales often calculate CAC using the costs from a prior period vs customers acquired in the current period. However, even though some of your costs like lead generation may only apply to future sales, your employee costs will apply all the way through close. For that reason, it often makes the most sense to use a longer rolling period when sales cycles are longer, and simply compare total costs vs total new customers over that whole range. Once again, the most important thing here is consistency in your approach so you can see how your metrics are trending over time.

An important note for companies with multiple products/tiers/subscription types

For all of these metrics, you’ll get the most value out of them if you first calculate them individually for each product/tier/subscription type. Then to get an aggregate figure across your entire business, you can blend the results together in a weighted manner. Otherwise you risk ending up with averages that don’t really reflect the reality of your business. As a simple example, you may have one wildly profitable product and another money losing one that average out to slightly profitable. Without calculating metrics for them individually, you may not realize that allocating sales and marketing resources to the first product line will have way more positive impact on your business.

Benchmarks/ratios:

There are many useful benchmarks and ratios utilizing the metrics we just covered. Two of the most basic ones are:

  • LTV:CAC Ratio – the higher this is, the more efficent your sales spend. A common recommended guideline is for this to be at least 3.
  • CAC Payback Period – how long it takes you to make back your CAC, calculated as CAC / (Average Revenue per Account * Gross Margin). A common recommended guideline here is for this to be 12 months or shorter.

The posts linked below describe other useful benchmarks/ratios like the Quick Ratio, SaaS Magic Number, and many others.

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Other resources

There’s a wealth of great SaaS resources out there. Here are a few excellent blogs and posts that explore some of these topics in more depth:

General SaaS blogs

SaaS Metrics posts

Opstarts SaaS Metrics example model

The examples and images in this post are from this basic example model we put together in Opstarts. You can check out the model and see how the metrics are impacted by changing various parameters in the model.

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Go to Analytics->Metrics to view all the SaaS metrics calculated. The model includes the following items:

Products 

  • $10k annual product sold by an AE
  • Self-service $100/month product.

Employees

  • Support employee tagged as COGS
  • VP Sales tagged as CAC
  • AE that is automatically included as a direct CAC expense for the $10k annual product.

Expenses

  • Marketing tagged as CAC
  • Leads for AE linked to sales funnel and automatically included as CAC
  • AE Commission automatically included as CAC
  • Hosting expense linked from both products and automatically included as COGS

We hope this guide has been a useful overview to help you understand these SaaS financial metrics and how to approach calculating them for your business. If you have questions or feedback, please email or tweet us.

 

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16 comments

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