Your gross margin is one of the most appealing things about your startup.
Sounds confusing?
We’re talking SaaS gross margin — a key profitability metric measuring the difference between the direct cost of providing a service and the revenue it generates.
You express it as a percentage of total revenue.
And when it comes to SaaS, having a healthy gross margin is like having a solid foundation for a house. You can’t build a successful and sustainable business without it.
In this article, we’ll explore what SaaS gross margin is, how you can calculate yours and what’s considered a good gross margin to have.
We’ll also discuss why gross margin matters for a SaaS company’s financial health.
Finally, we’ll provide eight practical strategies that SaaS companies can implement to improve their gross margin, as well as five related metrics to track overall business performance.
This Article Contains
What Is SaaS Gross Margin?
How Is SaaS Gross Margin Calculated?
How Frequently Should You Calculate SaaS Gross Margin?
What Is a Good Gross Margin for SaaS?
Why Does Gross Margin Matter for SaaS?
8 Effective Ways to Improve Your SaaS Gross Margin
5 Related SaaS Metrics to Track
Improve Gross Margins for Sustainable SaaS Business Growth
Let’s get started.
What Is SaaS Gross Margin?
The SaaS gross margin (or gross profit margin) shows you what percentage of your revenue is gross profit.
It considers revenue and cost of goods sold (COGS) to determine the profitability of a company’s core business operations when you exclude overhead costs and other operating expenses.
So which costs fall under COGS?
COGS is the total direct cost incurred by a company to deliver its product. In SaaS, it typically includes any fixed or variable cost associated with hosting, server maintenance, customer success, onboarding, software development, etc.
COGS is not the same as your operating expense, which includes any variable or fixed cost not directly related to product delivery (e.g., research and development, taxes, general overhead costs).
Let’s now look at the formula you can use to calculate SaaS gross margin.
How Is SaaS Gross Margin Calculated?
The formula for SaaS gross margin is as follows:
Gross Margin = ((Revenue – COGS) / Revenue) *100
What SaaS Gross Margin Looks Like In Action
For example, if your company makes $200,000/month in revenue and spends $50,000/month to deliver the SaaS product, your gross margin is 75%. This means that you retain 75% of the revenue from your SaaS product after deducting direct costs.
However, remember that part of your gross profit will need to be allocated to overhead and other operating costs.
Let’s discuss how the gross margin compares to other profit metrics like net profit and operating profit.
What’s the Difference Between SaaS Gross Profit, Net Profit and Operating Profit?
This is how it differs:
- SaaS gross profit is the difference between your revenue and COGS. For example, in the example above, the gross margin percentage is 75%, but the gross profit is $150,000.
- Net profit is a company’s total profit when all expenses are subtracted from revenue, not just COGS. It includes operational expenses, payments on debts, interest, and taxes. The net profit margin is then profit expressed as a percentage of total revenue.
- Operating profit and operating profit margin refers to the profit amount and percentage after deducting all costs except tax.
But, which one is a better indicator of profitability?
Well, that depends on what you’re looking at.
- Your gross profit margin will reveal the profitability of your product.
- Net profit (and net profit margin) shows the profitability of your entire company, not just a product or service.
How Frequently Should You Calculate SaaS Gross Margin?
SaaS companies should calculate their gross margin regularly on a monthly, quarterly, and annual basis. Doing so helps you track growth over time.
Additionally, you should calculate gross margin when you’re making strategic decisions, such as launching a new product, entering a new market, or changing pricing strategies. In these scenarios, gross margin can inform decisions about the financial viability of these initiatives.
This leaves us with the question of how to benchmark SaaS gross margin.
What Is a Good Gross Margin for SaaS?
Typically, SaaS business models allow for a higher gross profit margin since the COGS are usually much lower than other industries.
According to a 2022 benchmark report by Finmark, the median SaaS gross margin percentage is between 70-80%. The best-in-class SaaS companies would have a gross margin of 80-90%.
And, anything under 70% would raise eyebrows among VCs, investors, and financial analysts. However, the numbers do vary based on companys’ annual recurring revenue (ARR).
Moving on, let’s explore why it’s important to track gross margin for your SaaS company.
Why Does Gross Margin Matter for SaaS?
We’ll give you four important reasons why you should track and optimize gross margin:
1. Indicates Profitability and Financial Sustainability
In the SaaS industry, the costs of delivering a product are usually focused on activities like software development and maintenance. So, only your gross profit margin will give you a better picture of the earning potential than the net profit margin.
If your gross profit margin is low, your business won’t be sustainable in the long run. You need to strategize how to increase product revenue and decrease costs.
Many companies tolerate a low or negative early gross margin, hoping to turn things around later on. Without optimizing delivery costs, however, even if you continue growing and making more sales, your gross margin will remain low.
For example, if you experience a 50% revenue growth, your COGS will also increase proportionally (e.g., due to higher demands for hosting, customer support costs, etc.) Any cash flow troubles you had will continue, just on a larger scale.
2. Helps Understand Which Products/Services Contribute to Overall Gross Margin
Some SaaS companies have multiple revenue streams, products, and services. You can calculate gross margins for each of these to determine which are successful and profitable.
For example, a company could see gross margins of:
- 70% for professional services revenue.
- 90% for monthly recurring revenue (subscription revenue).
- 80% overall.
In this case, their recurring revenue is performing well, but the service revenue stream drags down the overall gross margin and needs special attention.
3. Helps You Reinvest Profits into Scaling the Business
If your gross margin is low, it’ll be harder to scale your business. This is because you’ll have less profit to reinvest in other areas.
A high gross margin frees up more profit to put back into your growth areas. For instance, if your SaaS offering delivers a higher gross margin, you can reinvest it in improving R&D efforts or infrastructure.
4. Enables Investors to Perform Valuation for Funding
With the relatively high up-front costs of starting a SaaS company, you may require SaaS capital funding. Your gross margin is a key part of your SaaS income statement that investors look at when performing a SaaS valuation.
Investors are more likely to grant you SaaS capital to grow your business if you have a high gross margin.
So, clearly, boosting your gross margin should be a priority for any SaaS company.
How?
8 Effective Ways to Improve Your SaaS Gross Margin
Below are eight strategies you can leverage to boost your gross margin — from rethinking buyer personas to expanding to new markets:
1. Reassess Your Customer Segmentation
Ineffective customer segmentation can cause you to waste resources marketing the wrong product, pricing, or features to the wrong personas. This can also lead to lower conversion, retention, and customer satisfaction.
You should analyze customer data to gain insights into customer needs and preferences. This can help you segment your customers better and tailor your product and marketing accordingly.
2. Evaluate Your Pricing and Payment Structure
Your pricing plans should cater to your ideal customer segments. You can offer a range of pricing tiers with varying features and services to appeal to different segments.
Another option is to encourage more upfront payments with incentives (e.g., discounts, exclusive features) for customers who pay for a year (or more) in advance.
There may be some trial and error to identify the most effective and appealing pricing strategies. However, it’ll help you gain high-value customers, improve cash flow, and reduce churn.
3. Assess your COGS
An obvious way to improve your gross margin is to address your expenses.
There are three steps you should take:
- Include the right expenses in your gross margin calculations. Not every SaaS operating expense and fixed cost falls under cost of goods sold. For your gross margin calculations, only include costs directly involved in delivering the SaaS product.
- Itemize your COGS. Track your expenses on your SaaS income statement in categories such as hosting infrastructure, customer support, and transaction fees. This way, you know exactly where you’re spending the most money, making it easier to spot cost-cutting opportunities.
- Identify areas to reduce COGS. To do this, you may need to negotiate with suppliers of your hosting and cloud solutions, third-party software, or payment gateways.
Alternatively, shop around for cheaper or consolidated solutions. For example, your customer success team may use two different tools for customer onboarding and customer support. You can try to find one tool that does both at a lower cost.
You can also outsource some business processes to minimize costs.
In the end, you want your costs and revenue to go like this:
4. Restrategize Marketing
Once you’ve redefined your customer segments, you should adapt your marketing approach. Doing so can help you better target your ideal customers and increase conversions.
Consider marketing approaches like:
- Targeted marketing / retargeting: Use customer data (e.g., website visitors) to send prospects personalized advertising on other platforms.
- Content marketing and SEO: Create high-quality content that increases organic traffic and educates your audience about your product. (Psst, Startup Voyager can assist! Startup Voyager can help you turbo charge your organic monthly traffic and conversions.)
- Referral marketing: Offer incentives like discounts or premium features when your existing customers invite others to the platform.
5. Optimize your LTV:CAC Ratio
The LTV:CAC (lifetime value to customer acquisition cost) ratio is a measure of your customer acquisition cost versus average revenue per customer lifecycle. The minimum benchmark for this SaaS metric is 3:1, meaning you should gain at least three times more revenue than you spend acquiring customers.
Here’s an example:
Company A earns a $1,000 LTV, but spends $500 per customer acquisition. Their LTV:CAC ratio is 2:1.
Company B has a $600 LTV but a $200 CAC, meaning they have a 3:1 LTV:CAC ratio.
Company B earns less revenue per customer. However, their customer profit margin is higher than company A.
You can also calculate the LTV:CAC ratio for different acquisition channels and customer segments. Based on their relative profitability, you can decide which customers to target and which channels to prioritize. The result should be more value at a lesser expense, which is great for your valuation and profit margin.
To your investors, the LTV:CAC ratio would indicate marketing effectiveness and customer profitability.
6. Pare Down Your Underperforming Services
Offering different services can create new revenue streams, but some may not generate the results you had hoped for.
By calculating the gross margin for each service, you can identify which is a profitable revenue stream and which isn’t.
You can then make informed decisions about which services to discontinue or prioritize. This can help you streamline your offerings, reduce costs, and achieve a higher gross profit margin.
7. Upselling and Cross-selling
One way to achieve revenue growth from your existing customer base is by upselling and cross-selling.
- Upselling entails encouraging customers to upgrade to a pricing plan with more comprehensive features.
- Cross-selling refers to offering related products and add-ons alongside your primary product.
8. Expand to New Opportunities
Expanding into new markets can help SaaS companies increase revenue and improve gross margins. This involves identifying potential customers in different regions and new customer segments.
You may need to adapt your product or pricing to suit these new markets. For instance, you may need to add more language and currency support and streamline international payments.
But, remember to take steps to lower costs as well.
Now, while gross margin is a vital SaaS metric, there are others you need to monitor to get a complete picture of your growth rate and profitability.
Let’s look at some of these.
5 Related SaaS Metrics to Track
Here are five revenue and expense metrics that can provide more insight into your profit margin:
- Monthly recurring revenue (MRR) and Annual Recurring Revenue (ARR): The predictable recurring revenue (subscription revenue) a SaaS company expects to receive every month or year.
- Customer acquisition cost (CAC): The total amount of money a SaaS company spends on acquiring new customers, including marketing and sales expenses.
- Churn rate: The percentage of customers who cancel their subscription over a given period.
- Burn rate: The rate at which a SaaS company is spending its cash reserves to finance its operations and growth, typically measured monthly.
- ARPU: The average revenue a SaaS company generates per customer over a specific period.
Improve Gross Margins for Sustainable SaaS Business Growth
Having a healthy SaaS gross margin helps you reinvest in the business and sustain your growth rate. It’s also a crucial SaaS valuation metric for investors.
You can do this by optimizing pricing and marketing strategies, reducing infrastructure costs, balancing customer acquisition costs versus revenue, and more.
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