Are you running a SaaS business and wondering how to improve your gross margin? Or do you want to learn the basics of this figure?
Either way, it's all in this article.
Find out how to calculate the gross margin, discover what affects it, and meet a partner who will help you make the most of it. Sit back and learn all the answers!
What is Gross Margin and Why it's Important in SaaS?
Let's start from the beginning and answer what is gross margin.
Gross margin is a financial metric used by businesses to understand how profitable they are at selling their products or services. It tells you how much money is left over from sales after covering direct costs.
It's a really important number because it says how effectively a company turns sales into profit.
Now, why is gross margin especially important in SaaS?
Well, in the SaaS area, companies usually spend a lot upfront to develop their software. Once it's made, they need to sell it at a fair price, which would cover all costs and make some money.
So, a healthy gross margin means the company is really efficient at turning its main product, the software, into gain.
Gross Margin Formula and Components
The gross margin is calculated by subtracting the Cost of Goods Sold (COGS) from the revenue and then dividing that result by the revenue.
Gross margin calculation: Gross margin = (Revenue - COGS) / Revenue
Here are the components:
Revenue - the total amount of money earned from sales before any expenses are deducted.
Cost of Goods Sold (COGS) - in the context of a SaaS company, this includes all the direct costs associated with producing and delivering the service, like servers, software license fees, ongoing maintenance, etc.
Factors Affecting Gross Margin in SaaS
To better understand the gross margin metric in the SaaS industry, we need to understand what can affect it.
There are many areas, but we focus on 7 of them:
1️⃣ Subscriptions - they are often the primary source of income for SaaS companies. They come from the fees customers pay, usually on a monthly or annual basis, to use the software. Revenue from them is the starting point for calculating gross margin. It's important because the more subscription revenue a company generates, the higher the potential gross margin - assuming costs are managed well.
2️⃣ Costs - here, we are talking about indirect costs (not related to sales, like material, employee salary, rental costs, Customer Acquisition Costs (CAC), etc.) as well as direct costs, which may refer to expenses related to the delivery of software, for example:
- server and hosting costs (expenses related to the infrastructure required to host and deliver the software service)
- third-party service fees (payments for any third-party services integral to the software)
- support (expenses related to customer support who help customers use the software effectively)
3️⃣ Customer behavior - the market is evolving rapidly, so customer behavior is also. You may have a month where you have more customers, but there may also be times when your services are not in high demand. This translates into revenue - if it's low and costs are high, the gross margin will be low too.
4️⃣ Business scale - as a SaaS company grows, its subscription revenue typically increases. However, the direct costs and variable expenses may increase at different scopes - faster or slower - so they can potentially lead to a higher or lower gross margin.
5️⃣ Pricing - pricing should reflect the perceived value of the product or service. If your price is too low, it might result in high sales volumes but lower revenue (and hence, lower gross margin). In contrast, if priced too high, it may deter potential customers, especially in a competitive market.
6️⃣ Savings - larger companies often have more negotiating power with suppliers, which can help lower costs for raw materials or services. This reduction in costs can significantly improve this margin.
7️⃣ Technology and automation - investments in technology and automation can also yield many benefits, like more efficient operations, reduced labor costs, and minimized other expenses. Thus they can really improve this metric.
💡Remember: The accuracy of data in each of these components is crucial for a meaningful gross margin calculation. Overestimating or underestimating can create an inaccurate picture of a company's financial health and drive inappropriate decisions.