In this article, we take a dive into what gross margin is, how to calculate it, and how to achieve the optimal gross margin for your SaaS business.
Gross margin is one of the essential financial metrics that contributes to the healthy evaluation of your SaaS business’ growth potential. It acts as a growth indicator that lets you know of your standing on a profit scale and also influences your growth decisions. As a result, it is one of the important metrics that should be reviewed monthly.
However, knowing your SaaS business’ gross margin is one, what makes your gross margin a good one for your SaaS business? In this article, we will take a deep dive into optimal gross margins, and you will learn how to identify, establish and calculate the best gross margin for your SaaS business.
Gross Margin Definition for SaaS
Gross margin is the percentage of revenue retained after deducting the cost of goods sold (COGS) or cost to deliver. The cost of goods sold refers to the cost of producing and delivering a product to the final consumer. As a result, the higher the cost of goods sold, the lower the gross margin and vice versa. To calculate our gross margin, it would be total revenue minus COGS, then divided by the revenue.
Mathematically, Gross Margin = (Total revenue – COGS)/ Revenue.
SaaS companies typically have a higher gross margin than other business sectors because they don’t produce physical products, so the cost of operation and production is not as high. However, a high gross margin still doesn’t make it a good gross margin because there are still some other factors to be considered, which will be discussed later in this article.
Why Are Gross Margins Important?
Determining your SaaS business’s gross margins is essential for a number of reasons:
Profit / Loss Breakdown:
Your gross margin gives you an insight into how much money your business is earning as profit or how much it is losing. It gives you a thorough breakdown of the amount of money that goes into the production and distribution of your products/services and the amount you gain at the end of every successful transaction.
Your gross margin also alerts you of any overpayment or underpayment that you are making. You might be spending too much or too little in the development phase, of which you are not getting the expected results. You might also be getting underpaid by your customers. All of these will reflect your business’s profit margin, and you can make optimal decisions from its results.
Gross margin tells you a lot of information that you need to know regarding revenue generation. With your business’ gross margin, you can know how big your revenue is concerning how much you put into the business. It lets you know how big or small the impact of every revenue stream that you have is on your business.
If you are making enough to cater for your expenses and still have extra to reinvest into the business, or you are barely surviving with the revenue you are currently generating, gross margin will let you know. That’s because not only is it a growth indicator, but it is also a financial health indicator for your business and, as such, assists you in making financial decisions for your business.
How to Calculate Gross Margin for SaaS
To calculate the gross margin for your SaaS, you can use the mathematical formula;
Gross Margin = (Total revenue – COGS)/ Revenue
The resulting gross margin that you get will depend on the expenses that you include in your cost of goods sold (COGS). Many SaaS businesses tend to relieve their COGS of a few expenses, and this would inevitably affect the result you have as your gross margin. Some businesses do this to raise their gross margin by a few notches, but this doesn’t do any good for the company in the long run.
To effectively calculate a good and more accurate gross margin for your business, below are examples of expenses that you need to include as part of your COGS:
- Payment processing fees
- Cost of operations
- DevOps and support
- Hosting costs
- Costs of data migration and implementation
- Customer Success( Check out this article to see if you should include your customer success here or not).
Including these expenses as part of your COGS will not only give you an accurate gross margin but will also put you positively in the face of prospective investors looking to invest in your business.
Service margin is also an essential KPI to watch out for while discussing gross margin for your SaaS business. It is a measure of the total service revenue that is used to cover the total operating costs for your business. And when I say total, I mean everything from salaries, benefits, incentives, taxes, and travel expenses to software and equipment, labor, data charges, and other direct costs.
To calculate your service margins, it will be total service revenue minus service expenses, all divided by the entire service revenue.
Mathematically, Service Margins = (Total Service Revenue – Service Expenses)/ Total Service Revenue.
Recurring Revenue Margin
Recurring revenue margin is also a SaaS financial metric that is not often talked about but should also be vehemently considered. It measures the difference between your business’ recurring revenue and recurring costs.
Your recurring revenue is the revenue your business constantly generates from a set of revenue streams (or customers) monthly or yearly. They are usually in the form of a subscription format that your customers renew monthly or annually to gain access to your services. Your recurring costs are expenses that your business can’t do without monthly or yearly. These costs contribute to the growth and sustenance of your business.
To calculate your recurring revenue margins, it would be your recurring revenue minus your recurring costs, all divided b your recurring revenue.
Mathematically, Recurring Revenue Margins = (Recurring Revenue – Recurring Costs)/ Recurring Revenue.
In summary, a good gross margin for your SaaS business is, of course, a high gross margin. However, reducing the burden of our COGS to achieve this doesn’t look very good for your business’s future. It is essential to consider every element to attain an accurate gross margin and to aid in making precise growth and financial decisions for your business.
Intrepid Finance provides growth capital to new SaaS companies, like yours, based on your recurring revenue. Interested In hearing more about us? Contact us via intrepidfinance.io