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Successful SaaS startups, by necessity, usually have well-rounded, competent founders and executives focused on growing the business. Without a deep understanding of the industry, it’s unlikely that a business owner could guide and shape a business from an idea into a thriving company.
However, business leaders rarely have in-depth knowledge of multiple industries at once. In particular, they may only have a cursory understanding of SaaS business models. Even those experienced with traditional business accounting can stumble over the many differences between SaaS operating expenses and the expense categorizations used by other business models. You don’t have a physical product sitting on a shelf in a warehouse or a retail store. Instead, your product racks up digital costs that scale with usage. Determining which expenses belong in which categories can become a complex issue.
Though it’s possible to get by for a while without learning how to allocate SaaS costs properly, it will eventually become necessary to streamline the process and make sure all expenses are correctly categorized. Failure to do so could result in inconvenient and troublesome audits, inaccurate financial statements or problems completing the due diligence phase during future business transactions.
The following guide breaks down the differences between cost of sales versus expenses in other areas to help you make sure that you properly allocate every item.
What’s the difference between cost of sales versus expenses for SaaS startups?
Before we jump into some practical examples of categorizing your SaaS startup’s expenses, we first need to define and compare a few accounting terms.
The following terms represent categories into which startups typically allocate specific costs associated with running a business. While other categories exist — financing costs, for example — the following are the direct costs involved with operating the business on a daily basis.
- Cost Of Sales (COS): The cost of sales category is reserved for any costs involved in sourcing or manufacturing your product and getting it into the hands of your customers. Cost of sales is also sometimes referred to as cost of revenue (COR). Hosting fees, payroll, and overhead for employees that build and deploy your software are some examples of costs of revenue for a SaaS company. They all contribute to the delivery of your product.
- Cost Of Goods Sold (COGS): When a company incurs costs related to physical product inventory, they record these as the cost of goods sold. COGS includes things like raw materials, direct labor costs, overhead and inventory storage.
- Overhead: Overhead is used to categorize general expenses, which may need to be allocated to Cost of Sales, Cost of Goods Sold, and Inventory. If the company dedicates a portion of its facilities to holding inventory, shipping products or customer service, it must allocate this portion to COGS, COS or Inventory. Other examples of overhead that companies should assign to COS and inventory include: depreciation on manufacturing equipment, insurance purchased for inventory loss, and licenses and fees associated with manufacturing and shipping of hazardous materials such as batteries. Because you may not have any physical products, materials or storage to list under cost of goods sold, sold, COGS may not apply. However, if your company is selling hardware as part of the subscription service, you should record COGS upon shipment of the product to the customer.
- Operating Expenses (OpEx): Operating expenses are typically classified as Research & Development, Sales & Marketing or General & Administrative expenses. These expenses are associated with activities that keep the business running. For SaaS companies, this means that you should record costs not related to delivering your product and services as OpEx. You’ll want to include items such as general insurance, marketing, advertising, legal, and sales as operating expenses. Interestingly, learning what SaaS companies should not count in OpEx is often trickier than finding items that qualify.
Cost of sales versus cost of goods sold
Though some businesses consider cost of goods sold as an extension of the cost of sales category, COGS traditionally has to do with the cost of physical inventory. In a SaaS company, the product does not take up physical space on a shelf, so the overhead costs most non-SaaS companies incur for storing inventory do not apply. However, overhead costs for customer support and customer success teams would apply.
There are a few exceptions to this rule. Suppose your service requires proprietary hardware to run (think an Apple watch, which is both a hardware and software product), or you sell hardware that accompanies your software service. In that case, you must record the costs associated with these physical goods as COGS.
Cost of sales (Or cost of revenue) versus operating expenses
In a SaaS company, if a cost is associated with the delivery of a product, that cost should be recorded as COS. If you have a team of employees who work with customers and have costs directly related to serving those customers, those costs would be included as COS. This extends to software and phone lines used in customer-facing roles, as long as those items directly tie to improving the customer experience.
Let’s take Zeni’s accounting team as an example. Each team member provides an accounting service to our clients, which directly impacts the customer experience. The costs associated with supporting that team fall under COS.
OpEx, on the other hand, would cover costs related to commissions, sales, and other items not directly tied to specific customers.
Many SaaS companies may need to address whether to classify customer success expenses as sales costs, (which should end up under the OpEx category) or as customer experience expenses under COS. Since customer success tasks are directly related to the customer experience and therefore can tie directly to delivering the product successfully, these expenses should be classified as COS and not OpEx.
If you have costs associated with cross-selling and up-selling customers, these costs should be reported as OpEx because they are sales-related. This is true even if the cross-selling and up-selling is performed by employees who otherwise contribute directly to customer support.
Where are SaaS companies going wrong in classifying costs vs. expense?
Whether you should classify costs as operating expenses versus cost of revenue or cost of sales is an important distinction to make. Unfortunately, SaaS companies often struggle with this distinction because of the non-traditional model of services and software-based products.
In particular, many companies incorrectly classify certain things as operating expenses that should instead be classified as cost of sales. To illustrate, let’s continue with Zeni’s accounting team example.
If one accountant serves customers directly as part of Zeni's subscription service, it is fairly easy to classify the costs as COS because this direct relationship has a huge impact on customer satisfaction. Apply this principle to Zeni's internal accounting team, and each accountant’s costs should be categorized as General & Administrative expenses.
Many companies go wrong in allocating overhead and other indirect costs involved in this scenario that aren’t quite so clear. What about the supplies the customer service team uses? Or the fees for each person's software license? These things don’t directly impact the customer, so they often get miscategorized as OpEx. But, you should still record them as COS because these expenses make or break the company's ability to serve customers, even though they are indirectly related to the customer’s experience.
How does miscategorizing your expenses impact your business?
If you are miscategorizing your expenses, you may have to answer some questions from an auditor about where overhead items such as the accountants’ licensing fees and facility costs appear in your reports. If your costs look inappropriately allocated, you will likely have to complete a year-end adjustment to rectify the problems.
Additionally, if these COS items are instead classified as OpEx, this will impact the budgets of unrelated teams such as human resources, administrative expenses and IT. These teams’ expenses are OpEx, so long-term, they could wind up incurring the costs from the customer facing team if recorded in the wrong place.
Miscategorizing COS as OpEx will make your margins appear better than they are in reality if allocations are inappropriate or misleading.
Say that you reported a margin of 60% with the majority of your expenses listed as OpEx. Many companies try to explain those gross margin numbers by saying they can cut costs and increase margins with volume or scale. In reality, you should have listed some of those OpEx costs in COS, so your company's margins are misleading to investors.
It could throw a wrench into the due diligence process if an interested buyer or investor realizes that your COS should be much lower than you’re reporting, because you have incorrectly allocated costs. The primary basis for your company’s valuation may be incorrect. From the buyer or investor’s perspective, a mistake like this is a huge red flag, and they could wind up halting the entire transaction.
See Also: 4 Tips To Optimize Expense Management
Stop stressing about how to categorize COS, COGS, and OpEx. Use Zeni to classify expense items appropriately
For all the reasons above, correctly recording your company’s expenses in the correct category is extremely important and very complicated. When business owners don’t have an in-depth background in financial reporting for a SaaS company, they’re likely to get hung up on trying to distinguish where certain expenses belong.
Thankfully, you don’t have to learn by trial and error. Zeni uses AI algorithms to recognize and sort COS, COGS, and OpEx based on the type of transaction. This categorization of your expenses happens through AI and is reviewed by our team of experts without you having to learn the minute details of the process. You can face your auditors, prepare your year-end reports confidently, and save time and money.
