The anatomy of software cost structure
In times of discipline and efficiency, a granular P&L analysis is key to identify profit expansion opportunities
In times of discipline and increased weight on profits, a granular analysis of software P&Ls is key for founders to find optimization and profit expansion opportunities.
The typical cost structures of a software business are:
COGS (devs, support, systems & infrastructure, 3rd party, and professional services related to onboarding or implementation).
R&D (devs and associated sandbox costs to run innovation, current features, or tech stack evolutions).
S&M (sales, marketing, and customer success).
G&A (executives, administrative, HR, finance, accounting, or internal professional services).
Let’s take a look at a typical cost center for a US public software company growing 0-50% YoY.
What can we learn from it?
S&M is the most important cost center.
COGS comes second.
R&D comes third.
G&A forth.
Profits don’t look so good :(
What are the potential ways to increase profits?
To increase Gross Margins, the most powerful triggers are value-based pricing tactics. We may aim to increase developer productivity or seek gains from infrastructure optimization (e.g. cheaper cloud contracts) but what really transforms the bottom line is your ability to price the value delivered to your client or continuously land and expand.
R&D is more sensible, you can’t cut spending otherwise you might deteriorate existing moats or increase tech liability that will eventually hit you in the jaw. Moreover, you gotta be pragmatic to avoid overinvesting in moonshot features that don’t pay off. A rule of thumb is experimentation before doubling down new bets.
G&A tends to offer the quickest wins, as companies will grow leaving opportunities to streamline operations, look out for more efficient processes, and protect profits from increased overhead. However, it’s also important to consider that costs will rise and you gotta build and keep leadership incentivized (often embedded in SOP for VC-backed or public companies).
What about S&M?
There are many opportunities to increase S&M efficiency and exhaustive lists for S&M cost rationalization …
However in my opinion the key drivers lie in more focused growth initiatives.
A careful and diligent planning of revenue drivers and prioritization of segments, products, channels, and features, are key to increasing NRR (or LTV) with minimal counter impact.
What produces higher growth at better margins?
After reaping these benefits, optimizing sales organizations, and drawing incentives that work, will help you to evolve your current GTM motion.
“Earn the right to grow”
I also believe that the best approach to accel or slow down S&M investments is to compare your company with an “efficient frontier” of Rule of 40.
It expands the internal analysis with a relative comparison that helps one evaluate where it sits among peers.
Often speculative (growth at all costs companies) or those specialized in SMB sales tend to defend the narrative that profitability will improve as they are able to scale sales.
However, that doesn’t seem to be the case…
LTM <30% growth and zero or negative profits: Asana, AppFolio, Lightspeed POS, SEMRush, Fastly, Appian, Weave, WalkMe, Workiva, Couchbase, BigCommerce, Zuora, Domo, C3.ai, CS Disco and Blend Labs.
We may set aside temporary issues with fundamentally weakened unit economics. But it will take time (for a new post).
The search for efficiency should be constant and leaving it to tomorrow will (eventually) backfire.
Next in line: LatAm bootstrapped companies vs. US Public companies growing 0-50%.
What can we extrapolate from it? (to be continued)