Understanding Gross Margin For Software Companies

As an investor, understanding the gross margin profile of software companies is crucial when evaluating a business relative to its competitors.
United States Corporate/Commercial Law
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As an investor, understanding the gross margin profile of software companies is crucial when evaluating a business relative to its competitors. Unfortunately, many companies may track their margins inconsistently or even incorrectly. This is partly due to the lack of guidance from U.S. GAAP (generally accepted accounting principles) regarding the software industry and which expenses should be considered as a cost of goods sold (“COGS”). 

This blog post discusses best practices for COGS classification for software companies, including grey areas that require additional consideration when assessing industry standards.

COGS for Software Businesses

For a software company, COGS typically include the following:

1. Hosting costs: These are costs primarily related to storing and hosting software and customer data, usually through third-party vendors.

Considerations

Some companies may own their data centers and hosting infrastructure hardware (e.g., servers, rack space) instead of using a third-party hosting provider. Additionally, companies may choose to lease the hosting hardware and a data center at an offsite third-party co-location provider. Under U.S. GAAP, the hardware purchased is capitalized to the balance sheet and expensed over time via depreciation. The related depreciation costs and potential rent expense are expensed within COGS.

Software hosted via owned hardware requires lump sum capital expenditures and ongoing maintenance. This may result in higher margins compared to hosting through third-party vendors, but it comes at the expense of greater complexity, risk and larger spend to refresh the data center hardware periodically. In addition, this may include additional employee costs to maintain and manage the data center.

When assessing EBITDA and normalized gross margins, it is important for investors to consider the data center and infrastructure cost (including depreciation or cash outlay) when calculating gross margins. Investors should evaluate how cash flows are affected when companies own their data centers, as there is a timing gap between when equipment is bought and when the related depreciation expense shows up in the income statement. 

2. Support personnel costs: Software companies employ support personnel to ensure that customer service tickets are resolved as needed. The fully burdened costs (e.g., salary, bonus, fringe benefits) of these employees should be recorded within COGS.

Considerations

Companies may use different approaches to determine which positions within the support department are included in COGS. Senior executives and manager level-positions within the support department should also be included within COGS, consistent with the rest of the department. 

There may also be different departments included in COGS, such as the customer success department. Individuals in customer success may be client-facing and focus on customer onboarding and support tasks. These roles are included in COGS, but if the customer success department is sales quota-bearing and focuses on customer renewal and upsell, such roles are typically included in operating expense. 

3. Cost of any third-party software or data: Any third-party software or data used in the delivery of a software product should be recorded within COGS.

4. Any other direct employee costs or third-party services required for delivering the ongoing service.

5. Allocation of overhead costs: Some companies may decide to add overhead costs, like rent expense, in COGS, but it's not required. Typically, companies do not include these costs in COGS, however each company should be evaluated on a case-by-case basis to ensure that margins are comparable to other companies in the same industry.

These are all direct and primarily variable costs required to sustain a software product. If these expenses did not exist, the provisioning of the product and service to customers would stop or deteriorate rapidly. 

COGS for Software Companies Offering Professional Services

For software companies that offer professional services such as customization of the software, implementation, or training, the following costs also belong in COGS:

1. Professional services salaries and benefits: This includes the salaries and benefits of the company's professional services employees that are directly involved in delivering the services for which revenue has been recognized. If there are expenses related to third parties fulfilling these services, they should also be included in COGS. 

Considerations

It is important to note that not all software companies follow the same accounting practices regarding the allocation of employee time between COGS and operating expenses. Some companies may choose to exclude the cost of unutilized employee time from COGS, treating it instead as an operating expense. This strategy can reduce their reported COGS and increase their gross margin, making their business appear more profitable and efficient.
 
Although there is no definitive methodology, the industry standard generally involves including unutilized employee time in COGS to measure the efficiency and profitability of a company's professional services. This practice helps investors to model the scalable costs of a business more appropriately and prevents the inflation of gross margins. Also, for companies that don't charge customers for implementation, the cost to implement is still included in COGS, even without generating incremental revenue.

Additionally, it is more common not to allocate employee time between COGS and operating expenses in general, unless an organization is very lean and requires employees to serve multiple functions. Therefore, as an investor, you should always check the notes and disclosures of the financial statements to understand how the company calculates its COGS and which costs are included or excluded. 

Lastly, U.S. GAAP permits companies to capitalize implementation cost, including both internal labor and external costs, if the implementation and customization service is deemed significant and is directly tracked for individual projects. In this case, the cost is capitalized on the balance sheet and amortized over the average customer lifespan. However, the accounting guidance is subjective, and the amortization duration may vary from period to period. Therefore, it is important for an investor to understand the methodology used and consider the cash cost of associated implementation costs. 

Conclusion

These are general guidelines, and the specific costs included in COGS can vary depending on the specific business model and practices of the software company. As an investor, understanding these nuances can help you make more informed decisions and potentially uncover hidden value or risks in your potential investments.

Originally Published 20 May 2024

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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