Calculating COGS for a Software Company: Subscription and Hosting Costs

Editor’s Note: This is the third post in a series that combines to compose a best practices process on calculating the Cost of Goods or Services Sold (COGS or COS) for a software company. While this series is not meant to be an authoritative guide to all GAAP principles that should be followed when accounting for COGS, it will help a company figure out its COGS and gross profit by product line, geography, etc. This will be especially helpful to companies looking to raise expansion capital, as many venture capital firms ask for this type of information during due diligence. Ideally, it will also allow expansion stage software companies to optimize their sales and marketing spend by investing more resources into more profitable geographies and lines of business.

Software as a service companies that deploy their software over the Internet will have a large portion of their COGS come from subscription and hosting costs. Subscription and hosting costs are typically broken down into the following line items:

• Bandwidth costs: Whether a company hosts its application in-house or in a data center, it will have to pay monthly bandwidth fees to providers such as AT&T, Verizon, etc.

• Data center costs: Most SaaS companies host their applications on servers in data centers, meaning that they are paying for monthly rent/rack space, along with power and cooling (which often cost more than the IT equipment they support).

• Depreciation of data center equipment: If a SaaS company buys its servers, racks, and other data center equipment (instead of leasing it), it will have periodic depreciation costs to include in COGS. There is a number of methods that a company can use to calculate depreciation of data center equipment, and a company should refer to the relevant GAAP pronouncements when determining their depreciation policies. The two most common methods used to calculate depreciation are the straight-line method, and the declining-balance method. Both will be covered in detail in the next post.

• Leases of data center equipment: If a SaaS company leases its servers, racks, and other data center equipment (instead of buying it), it will have periodic lease expenses to include in COGS.

• Royalties or expenses related to 3rd party software used in data center: If a company uses 3rd party software on its servers, its costs should be included in this line item. If the company subscribes to the software, the period expense is simple to calculate. If the company buys a perpetual license of the software, the company needs to estimate the useful life of the software license (typically between 12 – 60 months), and amortize accordingly.

• Royalties for 3rd part components used in product offerings: The exact amount for this COGS line item will depend on the agreement between the software company and the 3rd party component vendor.

• Data center staff payroll, taxes and benefits: Many SaaS companies have at least a part-time systems administrator that maintains the company’s servers in the data center. The data center staff payroll, taxes and benefits line-items covers cost of these employees.

• Credit card processing fees: The vast majority of SaaS companies allow customers to purchase and maintain a subscription to their software by credit card. The credit card processing fees the company incurs belong in this line item within the subscription & hosting cost category of COGS.

Ready for more? Read the fourth post here.