SaaS gross margin: Learn how to calculate and improve it

SaaS gross margin

The first point on the income statement provides an indication of profitability is gross margin, also known as the gross profit margin, has been one of the most popular measures for evaluating the health of a business. Hence, it acts both as the starting point towards a healthy business outcome and an early indicator of challenges in profitability, should that turn out to be the outcome. 

Gross margin and SaaS companies

But what about a SaaS company? Surely, SaaS businesses are different, are they not?

As we know, SaaS, or Software as a Service, refers to a business model in which software applications are served through the cloud instead of the traditional on-premise deployment, with users generally paying for their access to the application in the form of a subscription which constitutes their primary source of revenue. In many cases, it becomes recurring revenue for the provider.

Does the relevance of SaaS gross margin change in any way for such companies?

How important is it for SaaS businesses to evaluate their financial performance using gross margin as a parameter?

While the model may be new, the importance of profitability for a business is not. Hence, the ability to know the profit potential early does not change. In fact, one could argue that with increasing competition in the SaaS industry, gross margin is acquiring greater relevance. The better the performance at the SaaS gross margin level, the brighter the prospects of outperforming competitors. 

The importance of SaaS gross margin

SaaS companies continue to rely on gross margin as a key performance indicator. Some of the key questions it helps them answer are:

• When I produce and sell the next unit of the product, am I making or losing money in doing so?
• What is the contribution towards the recovery of the other business expenses?
• What is the prospect of the business delivering a profit after everything has been accounted for?

The higher the gross margin, the better the prospects of the SaaS entity to pay for its other costs and earn a profit. It is a good indicator of the profit potential of a company.

The importance of SaaS gross margin also stems from the fact that interested third parties, such as banks and credit institutions, will often look at this metric as a way of establishing its capacity to repay debt. Hence, a healthy gross margin is in the long-term interest of a SaaS company. 

What is SaaS gross margin?

In simple terms, gross margin is the amount that is left over for the business after having accounted for the direct costs incurred on the production and distribution of the product or product set for which the calculation is being done, also known as cost of goods sold (COGS), from the money realized as revenue.

Gross margin can be calculated in two ways:

1. In gross value (or dollar) terms
2. In percentage (or ratio) terms

While gross margin in value terms holds relevance for the SaaS company, on account of differences in scale, comparisons and benchmarking become possible only when used in percentage terms. Hence, gross margin as a percentage has come to be relied upon as a key measure of financial performance. 

How is the SaaS gross margin different?

Even though conceptually, it serves the same purpose for SaaS industries as it does for others, the way a SaaS company does business often results in SaaS gross margin benchmarks being different from other industries.

For one, SaaS companies have a cost structure that is loaded up-front. What it means is that a significant investment in infrastructure is required by the provider to enable the delivery of their product, which, in most cases, is access to software through a subscription model. While it often results in a recurring revenue stream, it also results in a cost structure skewed towards higher operating expenses compared to the COGS.

However, it does not reduce the relevance of the measure. If anything, it makes it even more relevant. The SaaS business needs to evaluate the gross margin to know how it will pay for its operating expenses.

It also indicates the potential of the SaaS business. The higher the gross margin, the greater the bottom line potential of the business with an increase in scale.

Though there are no hard rules as to what constitutes COGS and could vary from one SaaS company to another, the following are some standard inclusions:

• Web hosting services, including any additional cost of cloud computing
• Merchant fees for processing
• Direct software licensing cost
• Cost of staff involved in client support
• Travel related to support and implementation 
  

SaaS gross margin benchmarks

Gross margin provides valuable inputs for an industry where it is not unusual for startups to accumulate negative operating profits in the early years. Leaders watching only the company's operating profits could be tempted to take a pessimistic view of the future.

If, however, the gross margin is taken into account, significantly positive values will indicate to the management that there is potential in the business. They would do well to carefully evaluate the position to understand what they need to do to ensure that the bright future is realized.

While there is no perfect number, the performance of industry leaders often results in establishing some benchmarks that can act as goals for followers. It is a bit like targets in sales, to which this number is closely linked. It often provides greater clarity regarding what to strive for, as opposed to a moving target that is only defined as 'better.' Successful sales professionals often discuss a defined target as a better motivator than simply a target of 'more' or 'most.'

SaaS gross margin benchmarks often differ from other, more traditional industries. Gross margins below 70% are generally considered to be unviable in a SaaS business. 

What is the 'Rule of 40' in SaaS?

The Rule of 40 has established itself as a reliable and popular benchmark in the SaaS business and is tracked by analysts and industry watchers. Even leadership teams of SaaS companies often make it a part of their dashboards.

Sacrificing profitability for growth is an established strategy of SaaS companies. With the creation of shareholder value being the final goal of a business, the 'Rule of 40' provides a thumb rule for evaluating SaaS companies that may not be generating a healthy profit margin at present but hold the potential for creating significant value in the future.

According to the 'Rule of 40,' the operating profit of a SaaS company, along with its growth rate, should be 40 percent or higher.

According to research done by McKinsey between 2011 and 2021, less than a third of SaaS companies are able to meet this benchmark, and even fewer are able to do so consistently.

Experts opine that this measure should only be applied to mature companies that are able to generate a million dollars or more in recurring revenue every month.  

Calculating SaaS gross margin

The formula for calculating gross margin is straightforward and no different from the gross margin calculation used universally.

The gross margin (in dollar terms) is determined by deducting the Cost of Goods Sold (COGS) from the revenue generated.

This Gross margin is divided by the revenue (in dollar terms), and the resultant is multiplied by 100 to arrive at the SaaS gross margin as a percentage.

In summary, the two formulae to calculate gross margin for a SaaS company are:

1. gross margin (Number) = {Revenue (in dollars) – COGS (in dollars)}
2. gross margin (Percentage) = [{Revenue (in dollars) – COGS (in dollars)}/Revenue (in dollars)] x 100.

Like any other measure, SaaS gross margin can be tweaked to suit the requirements of the business. However, for best results, it is suggested that the same version be used consistently so that a trendline can build up across measurement periods, whether monthly, quarterly or annual. If the measure keeps changing every period, cross-period comparisons, often a great source of insights for a SaaS organization, will not be possible. 

Positive and negative SaaS gross margin

As you can probably guess, the resultant figure can be negative or positive based on the value of the underlying variables.

SaaS gross margin will be negative if the COGS value exceeds the revenue. That is not a place any business wants to be. It means the business has no money to pay for its operating expenses, and there is no way it can hope to earn a profit.

However, forewarned is forearmed, they say. Having an accurate picture of performance is an aid to decision-making. A negative gross margin should serve as a wake-up call for the management to take a hard look at the viability of the business.

If the situation is reversed and revenue exceeds COGS, the SaaS business gets a positive gross margin. Though this does not provide any certainty about the business's ability to meet all its other costs and return a profit, it is a good starting point.

The greater the positive value of the resultant, the better the prospects of the business turning in a handsome profit.

Improving SaaS gross margin

"If you can't measure it, you can't manage it," management guru Peter Drucker is believed to have said.

Now that we know how to measure SaaS gross margin let us understand how we can improve it for our business. Continuous improvement and striving to move towards goals are what every decision in every SaaS company seeks to do.  

A holistic performance improvement is the goal of any company, at all times, including a SaaS company. Of course, as there is an effort and cost involved in each improvement exercise, each company needs to determine the priority order for various measures.

SaaS gross margin benchmarks can help a company establish which side of the financial performance it lies, on the acceptable side or the unacceptable one., and can often determine the urgency with which gross margin improvement measures are to be undertaken and implemented. 

How to improve SaaS gross margin

Though performance and improvement measures are often determined by various factors such as scale, target market, and industry sector, some actions apply to all SaaS companies, regardless of their differences.

SaaS gross margin is the difference between Revenue and COGS, with a positive difference being the desirable goal. As all SaaS gross margin benchmarks also specify, the effort, as we all know, has to be towards increasing revenue and reducing the cost of goods sold SaaS companies measure. A high gross margin will ultimately translate to a higher net profit margin.

Identify the main contributors to the cost of goods sold SaaS companies consider

This is an application of the traditional 80:20 model that all senior leaders are familiar with. In most cases, 20% of the cost items will contribute 80% of the costs. Hence, paying closer attention to this 20% could result in large savings.

The cost of goods sold by SaaS companies considers usually has a large component of cost that pertains to the cloud. Though an integral part of the business, and a necessary cost, closer attention by senior management can, surprisingly, result in savings.

Use signals from a combination of financial measures

There are many financial measures designed to provide insights into a SaaS business. A judicious use of a combination of financial measures can highlight leakages and gaps, which, if fixed, will raise the company's performance and positively impact many other measures, such as the SaaS gross margin.

Rely on modern marketing and outreach techniques

While the digital marketing discussion has been done to death in boardrooms, it continues to yield results for many a SaaS company when deployed correctly. Introducing marketing techniques such as broadening the social media presence, creating omnichannel access for customers, and introducing referral programs, can have positive revenue outcomes without any increase in the cost of goods sold SaaS companies need to bear.

Market expansion

A SaaS company could sometimes feel part of a challenged SaaS industry with limited upsell opportunities since the client is already using their primary offering, the software subscription.

What they have going for them is their ability to serve clients almost anywhere in the world. This makes them free to explore new markets, which, in any case, subject to plans and budgets, should be the goal of all self-respecting marketing teams.

Keep your eye on the ball

Though this might sound generic and even didactic, senior leadership paying close attention to the nuts and bolts of each mechanism has beneficial outcomes. It could be to review and restructure the accounts receivables, change the discount structure, or engage an outsourced partner for a difficult and expensive part of the processing. Such actions are likely to have a beneficial impact on your company's gross margin and improve the long-term prospects of the business.

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