Your complete guide to understanding and managing variable costs in SaaS

In the SaaS world, variable costs are corporate expenses that fluctuate directly to sales volume. Think of customer onboarding, customer support, and server usage as the ingredients for a SaaS product. As the company grows and acquires more customers, these costs increase. Conversely, these variable costs will decrease if customers churn and sales decline.

Understanding variable costs helps determine a SaaS company's profitability. It also helps maintain financial health and forecast future growth. In this article, we will learn more about how to monitor variable expenses and make strategic decisions to reduce them. 

We’ll also look at some variable cost examples specific to SaaS companies and how forecasting and managing variable costs can improve profit margins to help ensure the long-term success of your business.

Understanding variable costs

Variable costs are expenses that change in proportion to your production or business activity level. In the SaaS industry, these costs are closely tied to the number of customers and the extent of their usage.

When you acquire a higher volume of customers, there is a corresponding rise in costs associated with each new customer. These can include:

• Transaction fees: You must pay the payment gateway or platform provider a transaction fee every time a customer makes a purchase or a subscription payment. These fees fluctuate depending on the number of transactions processed.
• Customer success: Effective customer service requires tools and a knowledgeable workforce. It usually includes technology costs, such as subscription and maintenance of CRM, helpdesk ticketing systems, and chatbots. Salaries, benefits, and training for the customer success team are also variable costs that increase as you scale. 
• ‍Implementation and onboarding teams: Implementing SaaS products and onboarding new customers requires a large team. The onboarding team helps new customers set up and use the SaaS product effectively. The associated costs here include salaries, benefits, training, and travel expenses for implementation team members.
• ‍Cloud costs: SaaS companies use cloud services to host products and store customer data. Cloud costs are variable because they scale with usage. As the number of customers and data stored increases, so does the cost of using cloud services.

Variable cost vs. average variable cost

Variable costs can be compared to the fuel expenses for running your car. These costs change depending on how much you drive. You spend more on fuel, servicing, and maintenance when driving more. Similarly, for SaaS companies, variable costs fluctuate with each additional user.

In contrast, looking at average variable cost is like evaluating your car's fuel efficiency by calculating the miles per gallon, which is the average amount of fuel you use for each mile driven. 

For SaaS companies, average variable costs can be calculated by dividing total variable costs by the number of active users.

Variable cost vs. semi-variable cost

Semi-variable costs include both fixed and variable components. They remain fixed up to a certain production or business activity level and then vary with the output level. Their hybrid nature makes them more complex to analyze and manage than purely variable costs.

For SaaS companies, an example of semi-variable costs is customer support expenses when scaling. 

For instance, a SaaS company may invest in a customer support platform with a fixed monthly fee regardless of the number of customers. The fixed component of the cost remains constant even if the customer base fluctuates within certain limits. 

However, as the number of customers grows significantly, you may need to scale up the support infrastructure by adding additional support agents or upgrading to a higher service tier. This additional cost represents the variable component.

Variable costs vs. fixed costs

SaaS operations consist of both variable and fixed costs. Fixed costs remain constant and do not fluctuate with changes in business activity or output. These can include office rent, salaries for permanent employees, and software licenses. Variable costs are commonly considered part of your cost of goods sold (COGS), whereas fixed costs are not usually included in COGS.

Examples of variable costs in SaaS include cloud hosting fees, customer support expenses, and payment processing fees. 

Since they increase in proportion to business growth, it is important to maintain a relevant range of variable costs. To grow profitably, the increase in variable expenses must always be lower than the business growth rate.

Variable cost examples in SaaS

The nature of variable costs in SaaS businesses differs significantly from that in traditional businesses. They are closely tied to the customer base because, in a SaaS model, you are selling access to software rather than a physical product. 

Unlike traditional businesses, SaaS businesses are more aligned with service delivery and customer interaction rather than production and distribution.

As more customers subscribe to the service, the usage of server resources, bandwidth, customer support needs, and payment processing volumes all escalate. Consequently, these costs grow in direct correlation with the number of customers. 

Some examples of variable costs that SaaS business owners must look at are:

• SaaS tools or software that bill based on usage
• Product development software costs and maintenance fees
• Payment processing fees for online transactions and subscriptions
• Software licensing costs for increasing customer base and usage
• Salary of a large onboarding team to handle the influx of new clients
• Data analytics services to analyze customer usage and improve the service
• Cloud hosting fees for storing customer data and running the software service
• Customer support expenses for providing technical assistance and troubleshooting
• Infrastructure costs for scaling server capacity and bandwidth as customers increase

Challenges in managing variable expenses

Variable costs can increase profitability for businesses. However, due to the nature of their business model, managing variable expenses can be challenging for a SaaS business.

Here are the five main challenges:

1. Difficulty in predicting demand: One of the biggest challenges for SaaS companies is predicting customer demand. Unlike traditional businesses, SaaS companies typically operate on a subscription model. This means that revenue is based on recurring monthly or annual payments rather than one-time purchases. So, you must try to predict demand accurately while considering customer retention and churn rates.

2. Server and infrastructure costs: SaaS companies rely heavily on servers, databases, and IT infrastructure. As the number of customers or demand for your service increases, so does the need for additional infrastructure. While these costs can be difficult to predict, the goal here is to stay within budget while ensuring uninterrupted services for all customers.

3. Third-party integrations: SaaS companies often rely on third-party service providers for everyday operations, such as payment processing, invoicing, and product development. These integrations can be expensive because their cost is based on usage or subscription plans. It’s important to routinely monitor these expenses and re-evaluate plans on a regular basis to ensure they are still necessary for the business.

4. Pricing strategy: Your pricing strategy directly impacts variable expenses. If your pricing model is not carefully structured, you may be overcharging or undercharging customers. Regularly evaluating and adjusting your pricing strategy if necessary according to market trends and customer needs can help you ensure that your variable costs associated with new customers are not eating too much of the revenue growth you’re getting from them.  

5. Data availability for decision-making: SaaS businesses rely on data to make informed decisions. However, as you scale, the volume of data also grows, and maintaining its accuracy becomes complex. You must have systems that can effectively collect, cleanse, store, and analyze data.

Calculating average metrics over different periods, such as three months or six months, can help you better understand the trends in your variable expenses. You can track your company's growth by calculating average metrics over different periods. 

For instance, an average of your customer acquisition costs over the last few months can smooth out anomalies and provide a clearer picture of the upward or downward trajectory. 

Additionally, applying linear regression techniques to historical data can help forecast future variable costs more accurately.

Forecasting variable expenses in SaaS

Managing variable expenses requires a proactive approach. Demand forecasting can help you reduce their variability and increase efficiency in your cost models. 

Accurate demand forecasting helps:

• Anticipate future costs
• Allocate resources efficiently
• Prevent unexpected spikes in expenses

Forecasting and planning

When forecasting, it’s important to fully and accurately account for all the different types of variable expenses in your business in order to plan for them. Miscalculations can lead to unexpected financial shortfalls or missed opportunities for cost savings.

For instance, if you project a 100% increase in revenue for the next year, detailed planning must include the corresponding rise in variable costs. 

Consider a scenario where your current 100 customers utilize 1 TB of cloud storage. To accommodate an additional 100 customers, you initially assume you will need 2 TB of cloud space. However, due to the increased volume you’ll need, strategic planning allows for you to possibly negotiate better rates with your cloud vendors. 

Historical analysis

You can analyze historical data to find opportunities to reduce variable costs. Begin by evaluating your historical storage needs. Are there datasets that are no longer relevant or needed? A cleanup exercise can eliminate obsolete data, minimizing storage requirements and associated costs. 

You can also evaluate your customers' actual usage and needs can reveal opportunities for cost-saving efficiencies. 

For example, if an initial analysis suggests a need for 1 TB of cloud storage for 100 customers, a deeper dive into historical data might show that only 70% of that storage is actively used. By eliminating unused or minimally-used data, your required storage might drop to around 700 GB.

What-if analysis

Simulating different scenarios allows you to predict the financial impact of various changes in your operations. Begin what-if analysis by identifying key variables influencing your expenses, such as the number of users, server capacity, or third-party service fees. You can then adjust these variables to simulate potential conditions. 

Let’s say you anticipate a 10% increase in customer usage. In this case, a what-if analysis can help determine your new variable costs. For example, if your current monthly cloud hosting fee is $5,000 for 1 TB of data storage, a what-if analysis will help you calculate the additional costs incurred. Adjusting your model to account for different proportions of expanded storage needs allows you to foresee how your expenses might vary.

You can refine your predictions by forecasting depending on your business needs and the volatility of your variable expenses. The timelines could be quarterly to rectify emerging issues, half-yearly to support your long-term decisions, or ad hoc to manage unexpected changes.

Simplify variable expense management with Drivetrain

In SaaS businesses, it’s critically important to optimize your spending wherever possible and to make data-driven, smart decisions for business success. 

Keeping a close eye on variable expenses is crucial for determining a product's contribution margin, the metric used to determine a company's break-even or target profit level. SaaS companies must track variable costs as they scale with user growth. Efficiently managing variable costs helps them sustain long-term profitability. 

Using an advanced FP&A software, such as Drivetrain, helps optimize resource allocation through :

• Efficient expense management: Drivetrain helps you more precisely budget, manage, track, and analyze your expenses. Real-time data allows you to monitor spending patterns and proactively make data-driven decisions to optimize costs.
• Cost optimization and profitability: The integrated platform helps analyze data and provides actionable insights, such as highlighting areas where you can reduce costs without sacrificing quality. These assist in enhancing your profitability through strategic adjustments and better financial planning.
• Consolidated data platform: All your financial data is made easily accessible through a unified view. It helps you model different scenarios, perform sensitivity analyses, and report actionable insights. 

Ready to gain better control over your variable expenses? Check out Drivetrain!