Scalability is a searing hot topic among entrepreneurs and investors these days. Startups must have a firm grasp of how scaling a business is different than growing it, and why scalability in cost structure is an essential ingredient to business success, especially in today’s digital era.
Lucky for SaaS startups, software companies are already ahead of the pack, considering the relatively minor costs of replicating a software product for an ever-growing market. However, that cost is just one piece of the puzzle. To improve scalability in cost structure, we first need to understand what cost structure is and how it might affect the scalability of a business.
What is cost structure?
Cost structure refers to the set-up of fixed and variable costs carried by a business, which can be broken down by cost groups and relative proportions of costs that a company takes on. The cost groups can be determined by product cost structure, service cost structure, product line cost structure, customer cost structure, and even individual projects or customer segments. Each of these cost groups will have certain fixed and variable costs.
For example:
For a product cost structure, fixed costs may be direct labor and manufacturing overhead, while variable costs may be direct materials, sales commission rates, and production supplies.
For a service cost structure, fixed costs may be administrative overhead, while variable costs may be employee wages, bonuses, payroll taxes, entertainment and travel expenses.
The value of understanding cost structure for SaaS businesses is that it can be used to define product prices relative to a defined pricing strategy, as well as determine areas in which business costs can be reduced without impacting revenue stream. A core concept of cost structure is that it needs to define every cost incurred in relation to a cost group; for instance, key spending areas that impact overall growth – including cost of goods sold, research and development, sales and marketing, and administrative expenses.
Where are you spending your money?
The following are four salient expenses in relation to cost structures:
Cost of Goods Sold (COGS) is an accounting term defined as the direct costs attributed to the production of the goods sold by a company or the service provided. These are unavoidable expenses a business incurs to continue earning revenue. This will typically include expenses to maintain and deliver the existing software to clients, such as hosting costs, customer support, data fees, and even third-party license fees. One of the significant advantages that SaaS and other software companies have is that these ongoing costs tend to be relatively lower than companies in other industries, meaning that gross margin (revenue minus COGS) tends to be higher.
Research and development (R&D) expenses include all activities related to developing, improving, and updating software. In the early stages of growth, this will usually be the largest expense and quite possibly take up the entire budget. Even as a company evolves, R&D expenses will always be essential. After all, in a crowded software industry, technological evolution is paramount, requiring businesses to constantly adapt to the changing needs and desires of its customers to remain competitive and continue to grow.
Sales and marketing (S&M) expenses are necessary for a business to drive customer acquisition, drive revenue and grow your business. There are numerous activities and costs within S&M that affect client acquisition and retention, and each may be bucketed into different cost groups.
General and administrative (G&A) expenses are the behind-the-scenes operations that keep a company running. This cost structure can include fixed and variable costs, including hiring and paying employees, renting an office, paying for insurance, and any other day-to-day costs. G&A expenses will be lower for a startup in its early stages, as these investments are comparatively less essential for early growth. As a startup begins to build a company around its product, G&A expenses will typically increase in line with that growth.
These all incur costs to the business, and so gaining a complete picture of your cost structure – knowing which strategies are working and where the business should focus spending to maximize growth going forward – is a key ingredient to scalable growth.
What cost structure has to do with scaling your startup
The low variable costs of developing digital products enable software companies to exhibit a scalable cost structure. With no expensive physical materials or production supplies to hammer together to make new widgets, software companies have one of the most efficient production lines in history.
While software companies start out with this advantage, it’s not a given that the rest of the operation will have an effective cost structure. And with investors eager to see that companies are scalable but can also cut back in a downturn when needed, it’s essential to have a tight handle on the ins and outs of your company’s expenses.
How to improve the scalability of your cost structure
Improving the scalability of your cost structure requires keeping your fixed and variable costs that are necessary to create more products, or offer more services, as low as possible.
One way of doing this is to keep replicability in mind when designing your software products. If replicability is an afterthought, you may end up with a complex product that takes a lot of technical intervention or customer success coaching to operate, which effectively increases the variable cost of producing and providing the product to more customers.
Around the web: what the experts say
Writing for the GreenBook blog, Laura Livers, CEO of Focus Pointe Global, summarized how SaaS startups benefit from replicability as a scalable cost structure, saying:
“Scalable growth is all about pairing exponential revenue growth with incrementally increasing costs. Software companies offer a strong example: Once the development stage is complete, they can infinitely replicate their end product and sell to the customer at little or no additional cost to the business. In short, the more efficient the mechanism for mass production, the more scalable your company will be.”
On the importance of scalability in software design, concepta, an agile web and product development company, advised:
“Scalability isn’t a ‘bonus feature.’ It’s the quality that determines the lifetime value of software, and building with scalability in mind saves both time and money in the long run.”
As this concept drives home, it’s best to think through scalability from the very beginning when designing a new product or starting a new company. At Deloitte, Global Strategic Cost Transformation Leader, Omar Aguilar, is leading a three-part series on “creating sustainable and scalable improvements to a company’s cost structure.”
According to the series, three actions are essential in doing this:
Hitting on the right cost structure business model
Clarifying decision-making
Taking action on decisions
These factors aren’t technical or pie-in-the-sky; in truth, they’re the very fundamentals of business operations. As it turns out, improving the scalability of your cost structure is just as much about building scalable business operations from the ground up as it is about cutting corners on cost or designing your products with replicability in mind. Aquilar summarized this challenge as follows:
“When improving their cost structure, many companies jump directly to action. However, the results are generally disappointing and, even if they are acceptable, usually hard to sustain.”
Ultimately, then, a scalable cost structure is best when baked right into the cake. An investor-friendly SaaS business that can scale when needed and draw back when times are tight needs good management as much as it needs good product design.
Success metrics to improve your cost structure business model
To ensure your company is on the right track, it’s imperative to regularly review your company’s performance through metric analysis and customer feedback. Metric analysis is not a single shot effort – performance metrics tell you very little in a vacuum. To improve your cost structure business model, you should continuously track success metrics to determine over time which areas need improvement. By adjusting your spending on different company initiatives and monitoring metric changes over time, you can determine if your targeted efforts are having a positive impact on your performance.
Revenue growth and long-term stability is a paramount goal for all startups. For this reason, below we cover some of the most important metrics founders should be tracking in order to improve your cost structure business model:
Customer acquisition cost (CAC): measures the average cost of a company to gain one additional customer. Minimizing your CAC is one of the best ways to increase the profitability of your SaaS company, regardless of industry or stage of growth.
Revenue retention: the revenue generated from your previous month’s (or year’s) customers. Two of the key calculations you can use to measure churn is by way of revenue retention: net revenue retention (NRR), and gross revenue retention (GRR).
Customer lifetime value (LTV): represents the total amount of revenue, on average, you expect your company to earn per customer over the entire relationship with them. Put another way, LTV is an estimate of the total value of an average customer for their lifetime with you as a customer.
Annual contract value (ACV): represents the average annual contract value of a customer subscription. This metric is used by SaaS companies that have a primary focus on annual or multi-year subscription plans.
Recurring revenue: represents the amount of total revenue that’s subscription based and recurring in nature and highly likely to continue into the future. There are several metrics used to gain an accurate benchmark for the core growth of the business, including: monthly recurring revenue (MRR), annual recurring revenue (ARR), committed monthly recurring revenue (CMRR), and average revenue per customer (ARPC).
Evaluating your cost structure for growth
Successful SaaS companies track and measure the above metrics to determine long-term growth and momentum, as well as for use in financial forecasting and planning. Beyond gaining insights into the core growth of the business, scalability in cost structure also matters to investors should founders seek growth financing. Just as founders and CEOs can use success metrics to improve scalability in cost structure, investors will weigh these variables (among others) to determine whether a business is gaining traction or starting to stall.
For fundraising purposes, an important takeaway is that revenue is tied directly to funding models of revenue-based financing (RBF) lenders in which loans are repaid by taking a percentage of revenue every month. The success metrics can also be used as pricing mechanisms, as understanding the core baseline and growth in the core business enables alternative startup financing lenders (such as Lighter Capital) to more accurately price a loan – which means better pricing for the borrower.
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