What is SaaS Gross Margin & How to Calculate It?

SaaS gross margin is the revenue remaining after deducting the cost of goods sold (COGS), which includes expenses related to delivering and maintaining your software product. Typically expressed as a percentage of total revenue, it strongly indicates your company’s growth potential.

 Why Does Saas Gross Margin Matter?

The Gross Margin for your SaaS company measures how healthy your company is financially. It depicts how much revenue is left after costs. This residue (leaving) amount is used to pay wages and taxes and to repay debt. One of the most important things to understand with this metric is its formula. If you know how to Calculate Gross Margin, you can make wise business financial decisions.

A Good Indicator Of Profitability

Evaluating your profitability with SaaS Gross Margin is a must. It tells you how much gross profit you make from your revenue. In this metric, what percentage of profit is left when you factor in the production and delivery costs?

If you’re tracking that gross margin, it means you’re making more revenue than expenses. A read from Software Equity Group found that brands with a gross margin of 75% or more are strong SaaS gross margin companies.

Monitoring this metric is critical to understanding your profitability journey. It can help you develop your financial strategy and provide accurate revenue forecasts. Calculating the Gross Margin is easier when you use the Gross Margin formula.

It Helps Investors Assess Your Company’s Valuation

Building a SaaS product involves significant costs, including technology and personnel expenses. Many companies seek additional funding to cover these upfront costs.

Investors use SaaS Gross Margin to evaluate your company and determine funding levels. They can gauge your company's financial health by comparing your gross margin to industry benchmarks. Companies with higher gross margins typically enjoy a greater enterprise value relative to their trailing twelve months (EV/TTM) revenue.

During economic downturns, investors prefer to invest in companies demonstrating strong profitability. However, they don’t focus solely on gross profit margins. They also apply the “Rule of 40,” which states that a company’s combined revenue growth rate and profit margin should exceed 40%.

SaaS gross margin is a crucial metric for monitoring financial health and measuring growth potential.

How Should SaaS Businesses Calculate Gross Margin?

To calculate SaaS Gross Margin, use the following formula:

Gross Margin = [(Revenue - Cost of Goods Sold) / Revenue] x 100

Let’s break this down. Revenue includes all income from your SaaS company, such as:

Recurring subscriptions

• Add-ons and extras
• Premium support
• Custom development work
• Integration services

Cost of Goods Sold (COGS) consists of direct costs related to delivering your software. Unlike product-based companies, SaaS firms lack traditional production costs. However, essential costs still apply, including:

• Application hosting fees
• Website maintenance
• Software licenses
• Employee costs for customer success and DevOps
• Subscription costs
• Customer onboarding

To determine if a cost belongs in COGS, ask if it impacts customer access. If it does, include it.

Remember to exclude non-direct costs, such as product development and advertising, from COGS.

For example, with monthly ƒ revenue of $500,000 and COGS of $150,000, your gross margin is 70%. This means you earn $0.70 for each revenue dollar.

Calculating gross margin for different revenue streams helps assess profitability.

What’s a Good Gross Margin for SaaS Companies?

The gross margin varies widely across industries. Product-based companies often face lower gross margins due to high overhead costs. For instance, auto parts average 14.25%, construction supplies 22.73%, and general electronics 28.40%.

In contrast, the SaaS industry typically enjoys higher gross margins because there are no raw material or freight costs. A survey found that 350 private SaaS companies had an average gross margin of 73%. This included customer support in COGS and excluded those with less than $5 million in GAAP revenue.

A survey of over 1,200 SaaS companies revealed that 70% had gross margins exceeding 70%. Best-in-class firms reported margins of at least 80%.

Generally, a good SaaS gross margin falls between 70% and 85%. It’s important to note that early-stage companies usually have lower margins than more established ones. Smaller SaaS firms with less than $1 million in revenue have an average gross margin of 67%, while larger companies often exceed 75%. Regardless of your current gross margin, there is always room for improvement.

How to Improve SaaS Gross Margin

If your gross margin is below industry benchmarks, don’t worry—there are ways to enhance it. By implementing targeted strategies, you can boost your SaaS Gross Margin effectively. Follow these strategies to improve your SaaS gross margin.

• Reduce Your Cost of Goods Sold

Reducing your COGS can significantly improve your SaaS Gross Margin. Start by re-evaluating your software tools. For instance, if your customer success team uses separate tools for onboarding and support, consider switching to a single platform that combines both functions. Additionally, negotiate software license costs to lower your expenses further.

• Evaluate Your Pricing Strategy

Setting the right pricing strategy can be challenging. If your price is too low, you risk harming your profit margins. If you price too high, attracting customers becomes easier. It’s essential to experiment with pricing to maximize revenue.

•  Offer a Free Trial

Free trial is good and bad for any SaaS business. Although implementing this strategy may enhance overhead costs and prolong the bicycle’s selling cycle, it enables people interested in the bike to use it before considering purchase. Moreover, collecting more information about users’ behavior to improve the onboarding process is possible. If you have not implemented this, try a free trial and monitor your SaaS Gross Margin about conversion rates.

• Remove or Otherwise Improve Poor Services

This exposes you to the reality that offering services that compose opportunities to generate other revenues may not meet your expectations. Subtracting all the cost of sales from the total net sales of each service and arriving at the gross margins of each service helps you decide which services to retain and which to drop. It gives a more precise understanding and efficiently eliminates incongruous products that enhance your SaaS Gross Margin.

• Reduce Customer Churn

Customer churn refers to the percentage of customers your company loses over a specific time frame. While some churn is typical, a high rate can harm your SaaS Gross Margin.

To reduce churn, enhance your onboarding process, and provide exceptional customer support. Implement dunning workflows and continually develop new features.

• Upsell or Cross-Sell to Existing Customers

Upselling encourages customers to purchase higher-end products, while cross-selling promotes additional products or add-ons. Consider offering premium plans and training your sales team to identify opportunities for extras, like new features or support packages. Both strategies can effectively boost your SaaS Gross Margin.

• Expand Into New Markets

Increasing revenue is essential for boosting profitability. One effective way to achieve this is by expanding your SaaS product into new markets. However, it’s crucial to have the proper payment infrastructure in place.

 Final Words

Maintaining a healthy SaaS Gross Margin is vital to financial growth and scalability. By understanding and optimizing this metric, you’re equipping your business with the tools to boost profitability and attract potential investors. Regularly monitor and refine your strategies to ensure your SaaS company’s success in an increasingly competitive market. For further updates, visit https://www.aquifercfo.com/

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