What Is Gross Margin?
Every business wants to make a profit, but you have to spend money to make money. To successfully run a SaaS business, you should strive to keep your costs below your revenue. You can do this by measuring your company’s profitability through its gross margin. It’s essential to do this for all of your streams of income.
That can include revenue from your subscriptions’ gross margin, professional services margin, or transactional and hardware margins. This article will teach you how to calculate your company’s gross margin and understand the sustainability of your business.
The gross margin of your business is the total revenue minus the COGS, which is the cost of goods sold. COGS is the cost to produce the goods your company sells. When figuring out your COGS, include the cost of labor related to packaging and delivery, materials, packaging, and delivery. However, indirect costs like salaries, sales commissions, and rent aren’t included.
There aren’t any Generally Accepted Accounting Principles (GAAP) for COGS; this is unfortunate because gross margins are essential to profitability, value, and performance. To learn more about COGS, check out this website.
To calculate the gross margin, we use a formula; we’ll teach you the formula to calculate your company’s gross margin specifically made for SaaS companies.
The general formula of total revenue minus COGS to get your gross margin works well to figure out your overall margin. Still, there’s a better formula unique to SaaS companies. In this formula, COGS has been divided into four sections: support, services, customer success, and dev ops. These added sections allow you to calculate margins by revenue stream.
You can include your royalties, hosting costs, resold product expense, and research and development amortization (if you have any), into your dev ops. But what you include in your COGS to calculate your gross margins depends on your business model. Every department you include in your COGS calculation should be responsible for the expenses coming from their operational activities. The leaders of these departments should be accountable for the expenses in their control. Don’t dump all your costs into general and administrative.
Why Are Gross Margins Important?
As a SaaS company, your gross margin is an essential metric. During times of rapid or slow growth, your gross margin gives you a chance to fund significant investments in products and sales while still keeping a profit.
There are multiple factors that contribute to your company’s ability to maintain a high gross margin; they can include a product that gives the customer high ROI, pricing discipline and power, a product that’s easy to use and requires little ongoing support from the vendor, and an efficient and scalable infrastructure.
Your company’s gross margin impacts your ability to invest in sales, marketing, and R&D, which can decide who wins in a competitive market. It’s surprising how little attention people pay to gross margin in SaaS businesses, because it’s a vital valuation driver. From what we’ve seen, founders, venture capitalists, and sometimes even public investors seem to overlook the significance of gross margin. In this article, we’ll provide you with the information to understand the impact gross margin has on your SaaS business.
Build Your Brand
As a SaaS business, your brand is vital to your success. Knowing your company’s gross margin is necessary because these dollars are essential to reinvest into your brand. Whether that’s through a spokesperson, new packaging, couponing program, or marketing campaign, you won’t be able to perform brand-building activities and won’t have success without a gross profit.
Small Changes, Big Impacts
Having a small gross margin doesn’t leave a lot of room for error. Consider this: if a company is generating $10 million of revenue, with 20% gross margins and its COGS totaling $8 million suddenly increases by 30%. This company would go from having $2 million in gross profits to losing $400,000.
Investors will need gross profit dollars to fund brand-building activities. These investors would be wary of companies with gross margins so small that a slight increase in COGS could cause it to go under. Over the last six or seven years, 30% COGS swings have become normal. Investors aren’t going to want to invest in a company losing funds at the gross margin level.
Hard to Improve
Gross margin is a difficult thing to improve. It’s a common assumption that as a company grows, the gross margin will improve. But in reality, there’s very little in a business owners’ control to move their margins in reality.
In SaaS businesses, reaching scale first doesn’t give you leverage. Instead, downward pressure is applied to your gross margin as the difficulties of running multi-tenant apps increase. For public SaaS companies, they’re locked into their gross margin profiles by the time of IPO.
By looking at the gross margin of many public SaaS companies, you can see the average trends slightly positive and that any improvement is marginal. Usually, this is the result of a decline in professional services as a percent of revenue.
Valuation and revenue growth are closely connected. Investors are more than willing to pay high prices for assets that are rapidly growing. A less obvious part of gross margin is that it can meaningfully impact value by showing the profit capacity of a business when it becomes mature. Gross margin, in our view, offers insight into how much cash a mature SaaS company can potentially generate.
For example, imagine two companies that are identical; the only difference is their gross margin. Company two generates twice the company’s operating profit even though their operating cost structure, unit economic, and revenue are the same. In trying to value these two companies, we would value company two more than two times the value of company one.
Usually, when a big company buys a small company, they pay close attention to their gross profit, not EBIT, net income, or EBITDA. These large companies will use their sales force’s administrative functions to plug in your company’s product data, eliminating all the costs below your gross profits.
It’s All Relative
The category of business you’re in determines the level of gross margins you’ll see. For example, medical device gross margins are over 80%, and private label manufacturers usually see less than 25%.
At the same time, personal care companies have margins around 65% because they have to invest a lot into creating samples. Ice cream companies’ gross margins range from 30% to 40% due to their frozen distribution, which can be expensive. Your business’s gross margin is less significant than how your company compares to other companies in your category. Investors understand this and are more concerned with how your company performs within your category.
What You Can Do
General and administrative isn’t something you can control; you can’t remove research and development without losing business in a competitive market. Finding new customers requires you to make considerable investments in sales and marketing.
There are a few things you can do to improve your gross margin. First, pay attention to the metric with which you started the company. Like Salesforce and Shopify, great SaaS companies have gross margins greater than 85% for their products. Second, if you’re having trouble keeping a gross margin of more than 70%, reconsider your product’s price and how you’re trying to bring in new customers.
Using the traditional direct sales model to break even in 18-24 months through customer acquisition costs probably won’t work. For example, Twilio has built a giant company with a product that has a low gross margin. They were able to do this because they had a great developer-focused sales strategy where customers could buy the product without having to talk with the company. In our opinion, the best strategy for your business is to always take in your gross margin.
As your business continues to grow, having revenue with a high gross margin will help you get non-dilutive capital to increase your growth further and rise above your competitors. When your company matures, you’ll be rewarded by investors for your company’s earning potential.
Impact on SaaS Profit & Loss
The profit and loss statement is something you should be creating on a periodic basis: monthly, quarterly, and annually. You may have seen people refer to this as the Income Statement when discussing critical financial statements.
The basis for any business is financial management. The goal of companies is to make a profit for the founders and the investors who are expecting a significant return. Depending on your company’s size and the layers involved, project managers will have some control over managing profit margins at a target level.
With the amount of control that project managers have, it’s important for them to understand basic terminologies and concepts. We define profit as what you earn over the amount it costs to develop and deliver your product. You can use the formula to figure out your profits. In this equation, profit is in the currency being used:
profit = product price – development costs = revenue – development costs
The margin, on the other hand, is the percentage of profits over sales. You can use the formulas below:
margin = [product price – development costs] * 100 / product price
margin = [revenue – development costs] * 100 / revenue
For example, you may have a ten-person team working on a project who are billable on a time and material basis. You would then charge the client, assuming there are different rates for each team member. You would take their rate per hour and multiply it by the time worked to the projected cost.
The result of this calculation would be the projected cost for the client, and for your business; it would be your projected revenue. In larger companies, the price of resources is confidential and managed by the finance team through a financial system. However, in smaller ones, the PM knows the salary and can calculate the cost.
We’re using basic terms and definitions of cost and revenue. These terms can be defined further by the philosophies, models, and accounting standards used in your company. There might also be additional costs while working on a project not related to the cost of resources.
Margins are a better way of showing business growth when the economy is in a phase of development, and the market is expanding globally. But when constraints are placed on business operations both externally and internally, margins might only show financial stability indicators and not business growth. Understanding your company’s financial model will help you meet your various goals and become a successful SaaS company.
What profit and loss can’t tell you about is how well your teams and operating processes work. For example, consider a company spending $1M on sales and marketing during a quarter and generating $2.5M in revenue. If this company doubles sales and marketing spending to $2M, some may expect them to start generating $5M in revenue. But it’s not that simple. There are several operating processes between sales and marketing.
This is where you should consider SaaS metrics. When you thoroughly track and analyze your company’s key operating metrics over time, you can see the sensitive relationship between spending and new sales.
Gross margins can be a challenging topic to wrap your head around if you’re running a SaaS business. But it’s important to care about because it represents the amount of money your business is creating to cover the costs of operation.
With a higher margin, you’ll be able to reinvest more money back into your company to increase the rate it’s growing. It may seem tedious and unproductive to allocate and categorize your various costs, but doing so will pay back dividends.