Being in the SaaS platform space, one of my passions (yes, really) is to breakdown the SaaS provider model and figure out where costs are. The one area that is most intriguing is cost of revenue (CoR) - that is, costs directly associated with delivering the service to end users. This cost generally includes, but is not limited to:
- Hardware(Amortized) & Hardware Related Expenses
- Operations Staff (if applicable)
- Backup & Recovery
- Co-location (real estate, electricity, cooling, etc.)
- Product Support
Basically, any cost that is proportional to and incremented with a rise in your subscriber base, is relatively predictable, and is directly responsible for service delivery is part of cost of revenue. Now, I’ve read blog posts and spoken with people that have made comments like “SaaS shouldn’t be very expensive, after all Web 2.0 is about starting companies in a capital efficient manner” or “Digg.com scaled to tens of thousands of users with only a couple of servers.” While I agree with those observations, they don’t really play into true SaaS. SaaS is not about applications with shoddy reliability, or about applications that have simple, repeated read/write transactions. SaaS is about stable, reliable, customizable, and robust business applications. As a provider to other businesses, you have an ingrained duty to provide fanatical (borrowed from Rackspace) service and uptime. These properties requirements do one thing and one thing well: they increase the cost of service. To drive costs down, you need to become operationally efficient, make wise architectural choices at both the software and hardware level, automate as much as possible, and meticulously maintain metrics. No programming language/framework combo (yes, not even the panacea of the day, Ruby on Rails) can save you from poor architecture, inability to automate, and nack for getting operations wrong.
So, as a provider, what does it cost to run a service? To answer that, we have two primary sources: (1) the financials of publicly traded SaaS companies and (2) discussions with some private SaaS companies. I’ll start with public companies. For public company’s I took a look at members of the SEG SaaS Index, including Taleo, Salesforce.com, RightNow, Workstream (not on index), and DealerTrack. I’ve extracted what they consider to be “Cost of Revenue” and generally have a description that goes like so:
Cost of application revenue primarily consists of expenses related to hosting our application and providing support, including employee related costs for network related staff, the depreciation expense associated with computer equipment and the cost of extra data center capacity.
Here is the breakdown for 2006 alone, accounting only for revenue and cost generated by subscriptions ($ in thousands):
As a percentage of revenue, there is a large amount of variation. TRAK is the only oddball because they factor in “revenue share”, which is some sort of commission paid to 3rd parties, thereby driving CoR up. The other data samples adhere quite closely to the aforementioned description. Interestingly, this provides some rudimentary evidence for economies of scale (factoring out TRAK): Salesforce.com has the highest revenue and best CoR percentage, with WorkStream having the worst and the other two falling in order between them.
Having had conversations with smaller, private SaaS providers, the picture is even bleaker. Many times, starting off requires a provider to overpurchase to provide availability and over-capacity, yielding CoR that is higher than revenues. Overtime, the companies I have spoken to begin reducing CoR as economies kick in, but even those in the $10 million – $30 million range are still in the 20% - 25% band for CoR. Delivering a SaaS application is not inexpensive.
This highlights something very important: the best in the industry manages 14% with others nearing 30%. Take that into account when analyzing your costs. Yes, costs have and will go down for things like hardware, bandwidth, etc., but remember that will means in the future, and that there is still uncertainty. Many SaaS providers are looking at utilizing service solutions such as billing or an entire delivery platform (disclosure, self promotion). The data above should give you a good baseline to work from when deciding if something is expensive or whether your projections are in-synch. If you’re a SaaS provider, is your CoR experience relatively similar? Do you factor in other things, or leave things out that I’ve included? I’m anxious to hear your thoughts.