Guest post by: Jaren Nichols, Chief Operating Officer at Zipbooks

Keeping accurate books may seem sleep-inducing, but it’s actually a fundamental that can keep your business growing. Accurate books lead to accurate reports that lead to smart business decisions. You simply can’t grow your business without minding your chart of accounts.

One account (or category) that has grown 20x within the last five years is SaaS spending. This represents an amazing improvement for businesses who have been able to increase productivity, innovation and even revenue by taking advantage of SaaS applications. However, these spending trends also have the potential to wreak havoc on your books.

Businesses can better categorize their accounts and use that data to manage the money they spend on SaaS apps through careful bookkeeping.

Costs of Goods Sold vs Operating Expenses

If you can thoughtfully determine where to categorize your SaaS spending, you will have a cleaner picture of your business. Most businesses who take advantage of SaaS applications will categorize their spending in either Cost of Goods Sold (abbreviated COGS, and frequently called Cost of Services) or Operating Expenses.

In order to determine how to best categorize your books, take a look at all of your SaaS spend.

If a particular SaaS that you’re paying for is integral to providing your revenue-generating product, then it will be a COGS expense. For example, at my company, ZipBooks, we’ve built an alternative to QuickBooks that is enhanced by digital bank connections. We pay third-party SaaS providers to provide bank connections for our users. The more users we have on our product, the more bank connections we have to pay for. Because this expense is a critical part of the product we deliver, it falls under COGS in our books.

If a SaaS application you’re paying for is not an integral part of your revenue-generating product, it will be categorized as an Operating Expense. These expenses don’t necessarily scale as you increase your own revenue. Though they may be correlated (e.g., as you grow, you increase headcount, and therefore have to pay more for HR software), they are not a key part of delivering your own product or service.

What This Means for Gross Margins

The way you categorize your SaaS spending will impact the numbers you see on your Income Statement, particularly your Gross Profit.

SaaS expenses that are categorized as COGS expenses will directly impact your gross profit; operating expenses do not.

Because gross margin says so much about the quality and scalability of your business, it is important to identify which SaaS products that fall under COGS expenses are actually integral. Companies should optimize their SaaS spending as often as possible in order to improve these numbers. Any SaaS spending that falls under COGS expenses will typically scale along with your revenue as you grow. On a percentage basis, this means that you have a lower gross margin, and potentially, a less exciting business—because it simply costs more to generate more revenue.

It’s important to note, however, that not all COGS expenses will scale at the same rate of your revenue—services with a flat fee or resource costs, etc.—so don’t write off all COGS expenses as bad. They help you create a valuable, revenue-generating product. And besides, gross margins can get better over time as you start to recognize volume discounts and other economies of scale.

Operating expenses, on the other hand, do not affect your Gross Margins, nor do they have to scale with your revenue. Operating expenses, instead, affect only your operating income and net income. When you can categorize SaaS spending as some type of operating expense, your gross margin will remain higher, potentially giving you a more “exciting” business. This is because, in the case of operating expenses, you can grow revenue without necessarily incurring additional direct costs.

Categorize for Growth, Not “Good Looks”

Yes, being an “exciting” business is great and there is some real flexibility in categorization. That being said, there’s an important caveat: don’t just categorize SaaS spend as operating expenses purely to look better on financial reports. Correctly categorizing SaaS spend will help you more accurately grow your business—by identifying areas of wasteful spending and targeting the integral parts of your business that provide true value.

There’s an ethical and legal question here as well: when you’re raising money from equity investors or increasing debt, your gross margins will be evaluated. You need to be honest—both to accurately present the strength of your business, and to avoid potential fraud.

The strength and scalability of your business is reflected in your books, and those numbers matter. But remember, SaaS applications aren’t the only thing affecting your COGS or Operating Expenses and there are many other ways to grow or optimize.

SaaS spending will continue to grow, which is why it’s so important to be deliberate, thoughtful, and accurate in your use of and categorization of SaaS spend.

Jaren Nichols is Chief Operating Officer at ZipBooks, free accounting software for small businesses. Jaren was previously a Product Manager at Google and holds an MBA from Harvard Business School.