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Everybody loves a high gross margin company. Entrepreneurs love it. The venture capitalists love it. Public investors love it. Everyone wants to have a high gross margin company, but when you start loading a lot of expenses into the cost of goods sold that by nature reduces your gross margin. The equation for gross margin is revenue minus cost of goods sold equals gross margin.
Thus, everyone should be very careful about loading expenses into cost of goods sold. Now, of course, you want honestly allocate your customer success costs following GAAP rules, and that’s how we do things at Kruze Consulting, and that’s why this guidance is so helpful.
Companies look at customer success in two different ways, which drives different account treatment. Some companies treat it purely as a support organization. Others treat it as a sales organization, they’re in charge of upgrading, renewing or upselling clients and that’s how they pay for those people to work at the company.
On one hand, if your company treats it as purely support, and there are no commissions, there are no revenue targets, then that should be in cost of goods sold. The types of activities that your help team is doing are mainly answering support questions, resolving issues and possibly even implementing new features or API connections for the customers, then put those support costs in cost of goods sold because it’s part of the cost for delivering your service.
On the other hand, if your Customer Success Organization has milestones and commissions and revenue targets, then that is definitely a sales and marketing expense. If they have quotas or upsell responsibilities, that’s sales and marketing. It should go into sales and marketing in the operating expenses category. It’s not going to impact your gross margin.
Now, there’s something really important here to point out, which is in early-stage companies, oftentimes, the people who are doing support also have like three other jobs. This is the beauty of working at an early-stage company. You get a lot of variety. At Kruze, we see a lot of times where the head of operations is answering questions or the software development team is actually answering support questions. Or maybe there’s one support person, but they’re doing something completely different half of their time.
In those cases, you really want to be smart and you really want to allocate only the portion of the time equivalent to the portion of the salary for that person or those people into COGS. That said, if someone’s doing half their time in operations and half their time in customer support, allocate half of their salary into customer support in COGS, you do not want to fully burden the COGS with people salaries who are doing other things. The danger in that is it could make your gross margin look really low or even negative.
There are various components that startup founders often throw around when they talk about “customer success.” So look at these and figure out where they go, into COGS or some other part of operating expenditures.
Professional Services are integral to COGS. This category includes services like software implementation, customization, and training, often outlined in contracts with separate deliverables. These are typically charged separately from the software tool, so you may have a specific revenue line associated with them. Their inclusion in COGS is widely accepted, and when material in amount, their gross margin should be reported separately due to their distinct profitability profile compared to subscription revenue. Some companies have developers who do R&D, and then who do implementation when a new client is signed - if possible, their expenses should be broken out between these two activities and accounted for separately. However, if a developer is working 50, 60 hours a week on R&D and just spends a couple of hours a week on implementation, then this implementation work probably doesn’t meet the definition of materiality and their salary should be kept in R&D, not COGS.
Support functions are essential in software companies and other technology startups, handling support and bug issues. This category, sometimes contractually defined and included in the software’s price, is a clear component of COGS. In some cases, companies offer a premium support tier at an additional cost. However, at small companies it is possible a founder (or developer) is doing support if it’s only a couple of hours of work a week. In these cases, the support probably doesn’t reach the materiality threshold, and it’s not worth the effort to account for the portion of their salary into COGS. Founders should be aware if they are growing and spending more and more time on support activities, as this means that the company will eventually need to bite the bullet and hire a dedicated support person. One other item with support costs - they tend to move up in a jumpy fashion, as startups need to make a hire, then that hire deals with support until there are too many issues, at which point an additional person is hired.
The categorization of CSM in COGS varies, depending on the company’s stage and the specific role of the CSM team. In early-stage companies, CSMs might fill product gaps and act similarly to support staff. Whether CSM expenses are included in COGS depends on how the company utilizes its CSM organization. If these people are doing a lot of sales or if they have a commission for upgrades, repurchase or renewals then it is possible that they fall into sales and marketing.
Costs related to cloud services (like AWS, GCP, Azure) for hosting customer accounts, along with any third-party software used for integration or additional services, are straightforwardly included in COGS.
Initially, DevOps costs might not be included in COGS, especially when engineers partake in these tasks part-time. However, as the company grows and a dedicated DevOps team is formed, these costs should be allocated to COGS. It’s all a question of does the company have a person who is dedicated, at a material amount, to maintaining customer servers/infrastructure. Like the other items, is it material.
Sometimes, we have companies coming from other accounting firms that sell a SAAS product that should be very high gross margin. And we look into the cost of goods sold, and we see that they’ve got tons of salaries and stuff that’s not applicable loaded in cost of goods sold, which again, depresses the gross margin. And this is a big deal for investors. When they’re looking at your profit and loss statement and thinking about the potential of the company, they are absolutely not going to invest in a company with a negative gross margin. That’s the old thing where you’re selling $100 bills for $90. You cannot scale that business. You can’t make up in volume. It’s a bad business. People are not going to want to invest in it.
That’s why, at Kruze Consulting, we take such care and we really focus on what needs to go in the cost of goods sold and customer success is really one of those big ingredients. And that’s why we are experts in the various business models - and their related accounting complexities. Check out our SaaS accounting page or eCommerce accounting pages to see some examples of our specialization.
Be careful, be smart, make sure you do it on a GAAP accounting basis, fully load the cost of goods sold where appropriate, but also be careful because if people are revenue producing and have commission structures, they should be going into sales and marketing in the operating expense category.
Not every founder knows accounting terms like COGS or “gross margins.” So let’s learn a bit more about gross margin - a metric investors really care about (and so should founders)!Gross margin is a critical financial metric, especially for startups looking to demonstrate their efficiency and potential to investors. It represents the proportion of each dollar of revenue that the company retains after incurring the direct costs associated with producing the goods or services sold. These direct costs are collectively known as the Cost of Goods Sold (COGS). Gross margin is calculated using the formula:
Gross Margin = ( Revenue − COGS) / Revenue x 100%
A higher gross margin indicates that a company is more efficient at converting sales into actual profit.
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