SaaS Economics

SaaS Model Economics 101a | Aggregating Customers for Low Cost Advantage

In my very first post to this blog, I made the assertion that software-as-a-service is a commodity business. My intention was to make the essence of the SaaS model easy to understand, but also to make it clear that the reality of doing what you need to do to achieve SaaS success is a little difficult to swallow. I mean, who wants to be in a commodity business anyway, especially in software? It’s all about innovation and differentiation right?

You can achieve very strong differentiation in SaaS.  The next post in this series will explore that.  But, before you differentiate around the edges of your software-as-a-service offering, you must commoditize it at the core.  Otherwise, your cost structure will not support your pricing, and you will not be profitable–at least not for a very very very long time, like many of the of the recent SaaS “success” stories and IPOs. (Disclaimer: having received my economic training from the University of Chicago, I have a strong bias toward the idea that a business should turn a profit, especially public companies.)

I’m not going to go into the technical details of multi-tenant architecture.  I believe that this element of SaaS is well understood.  What I do want to emphasize here is that the SaaS competitive cost advantage arises from the general principal of aggregating customers to achieve new economies-of-scale, not the specific technology used to accomplish it.   Multi-tenant architecture is simply a means to an end for relational database-driven applications, like

The concept of aggregating customers onto a single infrastructure to lower costs extends far beyond the database.  It impacts the entire application infrastructure.  You are aggregating customers onto a common set of servers, a common user interface, and a common set of business processes.  And, it extends beyond the application to the entire business. You are aggregating customers into a common communication channel, a common purchase process, common pricing and a common support process.  You are Wal-mart.  Online. It is in the second half of the cost equation, customer acquisition and support, where most SaaS companies lose their way, or rather find their way to long term unprofitability.

If all your customers are identical: identical business needs, identical communication needs, identical purchase process, identical support needs, etc. then you will have no trouble aggregating them onto a common business infrastructure for an enormous cost advantage.   But, to the the extent that they are different, or simply believe that they are different, then you have your work cut out for you.

For example, how much website content do you have to present to get a customer to register for trial?  Is it a single, simple message for all customers, or do you need pages and pages that detail your benefits for each industry segment in the specific vernacular of that segment.  To maintain your cost advantage you must do your best to streamline all this complexity without losing customers, and ultimately walk away from customers whose needs are so unique that you cannot meet them.

Luckily, while this may sound like your own customers are the roadblock to achieving your ordained cost advantage, they can also provide you with the secret weapon to overcome the roadblocks.  It’s the one aspect of your single, uniform, vertically integrated infrastructure that can be customized  without limit and without eroding your cost advantage.  Data.  Unique data.  Customer data. In the Web 2.0 world they call it user generated content.  In SaaS, you should think of customer data as the user generated application.  Whether you capture it on your website to personalize the purchase process or you capture it in your application to customize security roles, it is the enabler of mass customization and it may allow you to push the economic boundaries of the commodity-based SaaS cost advantage through the complexities of the SMB market all the way out to the idiosyncrasies of the long tail.

This is the second post is a series concerned with creating competitive advantage in SaaS entitled SaaS Model Economics 101.

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  • Great post. your point of “…walk away from customers whose needs are so unique that you cannot meet them” is great advice to aspiring Saas providers, and startup companies in general

  • Joel, good stuff.

    One thing that I have noticed is that no template exists for creating a macro view of the economics of a SaaS business. Sure I have worked on detailed spreadsheets that analysis a monthly P&L for an existing business where revenue and expenses are known but if you are trying to get started and need a reference point for financial planning then a template would be good.

    Many speak of a 3- 5 year plan to break profit and that is scary.

    If you are new to SaaS then many costs that are borne for SaaS may not be known or even understood just as costs in a software licensing/services business sold via a direct salesforce may be overstated for a SaaS business.

    Have you with your economics background dug into this and developed a financial template to get the cost base covered so you have a reliable foundation to build a pricing model and revenue plan?

  • Joel,
    Let me first say, good blog post series – SaaS Model Economics. I enjoy your posts.

    I agree with your that (from the individual service provider’s/supplier perspective) the core software features of a SaaS offering is a commodity. In other words, all features should work similarly across all buyers. Therefore, like other commodity sellers who stay profitable from high volumes SaaS providers need high volumes to achieve the core tenet of low TCO and profitability.

    My view is that product differentiation exists in the eyes of the buyer. This differentiation in the case of SaaS is achieved through superior service. The cheesy example, is Starbucks in Coffee. The product is a commodity, but the service is highly differentiated.

    The perspective I have about SaaS is as follows: The first S – software, software features, infrastructure, etc – is a commodity. The second S – service, customer service – is the differentiating element.

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