Average Cost of Service and Economies of Scale

ACS Economies of Scale

Average Cost of Service (ACS)

Average Cost of Service (ACS) is another important SaaS metric for finance to track and to educate the company about.  When used in isolation, it doesn’t tell us much.  When used in combination with annual recurring revenue (ARR) and customer acquisition costs (CAC) to name a few, it is very powerful.  It can help answer questions about pricing effectiveness, margins, and payback.

Excel template can be downloaded below

What is Average Cost of Service (ACS)?

With many SaaS metrics, there are no set definitions or standards.  Your company may have a slightly different business model or department structure that will determine how you calculate ACS and make it relevant to your business model.

I calculate ACS using the following components.

  • R&D Amortization – the economic cost of your current release(s)
  • Technical Support – typically, your call center handling inbound customer questions
  • R&D Net of Cap – I look at the expenses in my development cost center and exclude software capitalization.  What remains, in my mind, is the cost of software maintenance and supporting current releases.  Not new development.
  • Account Management – the sales team responsible for taking care of current customers.
  • Hosting – your hosting and data center costs.
  • Customer Success – I could see this as either an ACS expense or in your Service department and counted in your service margins.

Simply put, I sum up these expenses on an annual basis and divide by customer count to derive ACS.

Average Cost of Service Calculation

Taking It Further – Economies of Scale

Once you have ACS, you can run scenarios to determine how your variable and unit costs will change when you add more customers to your cost structure.

Will adding 100 customers drive down your unit costs significantly?  Or will it take 1,000 customers?  Calculating economies of scale helps me answer these questions and educate the leadership team about our cost structure and the impact of customer growth on our unit costs.

Maybe, your customer growth is great but your cost structure is so bloated that your unit costs are not improving like you thought they would – i.e. insensitive to customer count changes.  The Excel model I built helps me understand the balance between cost structure and customer counts.

Please post your comments or questions below.  I would love your feedback in this area.

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7 Comment

  1. Hi Ben,
    Practically speaking, how do you differentiate your software CAPEX in order to exclude it from your total development cost center expenses? What exactly are you cointing in there? (Theoretically your approach seems absolutely right, by all means.)
    Thanks for the nice spreadsheet.
    Regards,
    Kalin

    1. Hi Kalin,

      Thanks for the great question. When I credit the P&L for software capitalization, I credit the R&D cost center (department). So when you sum R&D’s total expenses, it nets out the software CapEx (i.e. new development). My chart of accounts is structured so that I have cost centers or departments for the major areas of the business (sales, R&D, support, etc.).

      Regards,
      Ben

  2. Regarding this post, I received some great questions which I wanted to share with all.

    Question – Do you consider your Cost of Service as being the same as your Cost of Revenue (Cost of Sales) in your internal management accounts or do you consider them different metrics? For example, I would normally consider Account Management costs to be Sales & Marketing related and not include it in the calculation of my Cost of Revenue. If Cost of Service is different it would mean that your Revenue less your Cost of Service (ie Customer Contribution Margin) is then different from Gross Margin (Revenue less Cost > of Revenue/Sales). Would this cause any confusion with Management?

    Answer – I consider Cost of Service (SaaS measure) different from your traditional COGS/Cost of Sales. Although there might be some overlap, Account Management would traditionally be below the gross margin line on a software P&L, for example. So I have internal reports that show a traditional P&L but when I talk about cost of service to management, it is usually in unit economic terms, not in gross dollars such as a new P&L with a cost of service line. But I agree, two P&L’s would cause some confusion if shown this way.

    Question – Your model assumes a linear development of costs. In reality, however, the Fixed Costs are not likely to stay “fixed” with different levels of customers, ie the Admin costs required for a business with 2,000 customers is likely to be different from the Admin costs for a business with 100 customers. I would argue the same for ACS also. For example, your Support and Hosting costs are likely to be different for a 1000 customer business than when you grow to 3000 customers and not likely (hopefully) to be three times as much. If it were, then it means you are not, in fact, getting any efficiencies with volume. I know that you cannot build this “automatically” into a model like this but I think one needs to be careful with the interpretation.

    Answer – Yes, I agree with your fixed cost statement. All fixed costs are variable in the long run. I think this is more of an “economics” lesson to show what it would take to move significantly down the curve. In reality the curve would be moving as well b/c some fixed costs would be increasing. A takeaway lesson for me is the impact of your fixed costs on your overall cost structure and do you have some imbalance in how much fixed costs it takes to serve the company and external customers.

  3. […] Model in Excel. Over the past few months I have released various Excel models covering forecasting, SaaS metrics, and personnel expenses. I combined some of these models into one and developed version one of my […]

  4. […] or SaaS metrics such as average revenue per account (ARPA), customer acquisition costs (CAC), and average cost of service (ACS) to name a […]

  5. […] None of this incremental revenue is covering your cost of service or cost of operations.  Therefore, you need another year to reach a revenue level that covers both your S&M and your cost of service. […]

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