As the Software as a Service (SaaS) industry continues to see exponential growth, it is essential for SaaS companies to understand and capitalize on gross margin.

Through sustainable strategies, SaaS companies can have a competitive advantage and pursue more significant growth objectives.

For SaaS companies, it is vital to know the gross margin for each avenue of revenue which contributes to the overall gross margin for the company as a whole. Depending on the business model, there are many variables to consider when calculating and evaluating financial margins.

In the end, a good SaaS gross margin gives accurate information on the amount of money available for operating expenses and funds that can be reinvested into the company.

Why Gross Margins are Important

In the SaaS industry, it is important to monitor a company’s growth margins. The cost of delivering a product is more heavily concentrated on the front end of the business, unlike traditional software companies.

Because SaaS companies often operate with high costs initially, it is important to question whether the business model can be sustained once subscriptions and customers are established. The goal is to widen the gap between the revenue and the cost leading to higher returns and higher margins.

SaaS Gross Margins are also important because they are one of the first metrics investors and financial institutions want to see. The more clear, concise, and higher the numbers, the more interest those important financial backers may have. Excelling in mastering the gross margins, among other metrics like the Rule of 40, can help set a company apart from other companies.

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Financial Metrics

Gross Margin Definition

Gross Margin is the metric that determines how revenue that is produced from the software compares to the cost accumulated from producing and delivering the product. (Cloudzero). It is essentially the remaining revenue after the expenses of the product, or total revenue minus the cost of goods sold (COGS), also known as the cost of revenue. (thesaascfo)

Gross Margin is a focused way to evaluate the profit potential of a specific product, both current and future. The number can either go into the positive or the negative, with the negative meaning the cost of getting a product to the market cost more than the revenue product could generate. Positive gross margins are what every successful business should have its eye on. And it is those positive numbers that will catch the eye of investors and financial institutions.

SaaS Gross Margin Formula

For a software as a service company, the SaaS gross margin formula may be too broad for a complete understanding of the revenue and expenditure streams. It is essential to break down the stream into categories so that each revenue has its own calculations.

Gross Margin = (Revenue – COGS) / (Revenue) x 100%

COGS:

The cost of goods sold should be any source that pulls from the revenue. For some SaaS companies, expenses that should be considered would be:

  • Support
  • Services
  • Customer success
  • Development Operations
  • R&D

These departments should be responsible for the expenses they generate from their operational activities. Each section should include the wages, payroll, training, software that make up the entire whole of the department. For example, the wages and payroll for support should be under support, while the wages of the service department should go under service expenses.

A general and administrative expense dumping will not give a company a good picture of where money is coming from and why. Department leaders should have every expense accurately and appropriately accounted for.

Where the customer success department (CSM) should be categorized depends on the company operations. Should the CSM be solely focused on customer retention, then CSM should be listed under COGS. But if CSM conducts business in other parts of the organization, like seat add-ons and holds a quota, that department should be placed under the sales operating expenses.

This is usually unique for each company and should be carefully evaluated to understand where CSM expenses should be categorized on a company-by-company basis.

Recurring Revenue Gross Margins

For calculating recurring revenue gross margins, the formula is essentially the same but with a narrower focus. This formula only needs recurring revenue instead of total revenue and only has the departments that support them subtracted from that number like support, CSM (depending on company classification), and DevOps.

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What is a Good SaaS Gross Margin?

A good benchmark number is over 75%, while a healthy range is somewhere between 70% to 85%. Companies with higher gross margins consistently show strong.

How to Improve SaaS Gross Margins

One temptation to quickly improve gross margins is to slash costs and skyrocket prices to increase profit margins. However easy that looks on paper, it is more about balance than about a hefty profit margin at all costs. Too few customers because of a high product cost may mean too low quality for the price or too high a price to retain customers. Too low costs may produce a more inferior quality product and may hinder both acquisition and retention.

  • Price Increment – Though skyrocketing prices is not the answer, increased rates may be beneficial. Study the market and the competition and have a better offer.
  • Direct good cost reduction – reducing the amount paid for products sold is always a good business decision. Be on the hunt for better deals and negotiate for agreements with suppliers that will lower costs while maintaining good relationships with suppliers.
  • Reduce Waste Inventory – manage product stock to avoid loss, waste, spoilage, and pillage. This is a waste of money and resources. Though loss is part of the business game, careful strategy should help eliminate as much needless waste as possible, keeping costs down and profits up.
  • Monitor Cloud Costs – for SaaS companies, cloud services are some of the most significant components of COGS. Knowing how these costs translate to the cost and profitability is essential for keeping healthy gross margins.
  • Readjust the mix of sales – add product lines or services to existing services. Pick new items that will incorporate and represent the company well. Variety attracts a larger net of customers and can aid in current customer satisfaction and retention.
  • Leverage analytics – every software as a service company should have analytics that predicts possible cancellations. This type of information can show when there is a downturn in interest or a bad experience. Addressing pain points can help improve customer retention and gross margins.
  • Upsells – getting people to add one more thing to their service is an effective way to capitalize on the company’s customers. Upsells can come in the form of package or service upgrades or add ons that enhance their current service.
  • Expand Markets – having a multifaceted marketing campaign can help increase exposure. This, in turn, can lead to more conversions. Creating specialized versions of an existing product can also increase reach and sales.
  • Creative Marketing – referral programs, affiliate programs, a more extensive or more varied social media presence, and consistent and better branding are ways to reach the market and more customers.

It is hard to make decisions without the correct information on hand. Knowing revenue stream margins can impact how a company balances resource requests and investments in the business. A company can evaluate its scalability by having a good grasp of its gross margins. Investors are always interested in the gross margins, among other important metrics.

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Finding the balance between cutting costs and finding the right spot for the pricing of goods sold can take patience and persistence. But in the end, having healthy, sustainable gross margins can make the difference between a company barely hanging on or closing up abruptly and a viable company that will have a competitive edge in the marketplace.