Note: this was originally published at https://alexoppenheimer.substack.com/‍

As you step down an income statement, the first thing you see is revenue. Revenue is the amount of money a company earns for delivering goods and services. The next stop is cost of goods sold (COGS). These are the costs associated with the specific things that you sell. In economic terms, COGS is variable expenses - the more you sell, the more you pay. Below that comes operating expenses: Sales & Marketing, Research & Development, General & Administrative. In economics terms, these are fixed costs - meaning that they are not directly tied to the volume that you sell. As I have mentioned before, there are times when accounting definitions don't evolve fast enough to keep up with business innovations and therefore things can get incorrectly categorized, creating a chasm between the proper accounting and the economic reality of a business.

In the world of recurring revenue businesses, the company invests upfront in customer acquisition with the hope that the customer will continue to pay them long into the future. Those upfront costs are considered customer acquisition cost and include the associated sales and marketing expenses: one-time expeses. But there are other costs included in bringing on a new customer and keeping them: implementation, service, customer success, etc. Things like marketing are clearly one-time costs and things like service are clearly recurring costs. Implementation is a one-time expense and customer success is a recurring expense.

But what if the same department or individual is handling multiple elements of the customer life cycle? A very practical example is customer success - sometimes they are working on a providing a service to keep customers happy and other times they are working on upselling customers. Allocating the expenses here is not so clear. One good option is to figure out their time split and divide the expense accordingly. The goal is to accurately represent the business so that you can plan and project correctly.

One of the big mistakes people make is putting ongoing expenses into the sales and marketing line where they are treated as a one-time expense. When you do a basic calculation on unit economics for a SaaS company, you usually look at ARR, Gross Margin, and then CAC (some combination of Sales & Marketing). If you incorrectly allocate expenses into S&M, then the gross margin will be higher but the CAC will also be higher. Over long periods of time this has a big impact on the unit economics of the business and the long term profitability.

I built this model in Causal to illustrate this impact - check it out.

https://my.causal.app/models/14830

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