As the Software as a Service (SaaS) industry continues to grow, finding ways to win on gross margin becomes increasingly important. By finding sustainable strategies that either increase revenue or limit the cost of goods sold (COGS), SaaS companies can gain a competitive advantage and continue pursuing their broader growth objectives.
While all SaaS brands want to be “profitable”, broadly speaking, there are many different ways to define what profitability actually means. Gross margin is an effective metric for determining how the revenue generated from a product (the software) compares to the costs accrued in producing and delivering the product.
Gross margin offers a focused way to evaluate the current and future profit potential of the product at hand. Below, we’ll discuss the most important things to know about SaaS gross margin and a few of the ways your SaaS company can potentially improve in response.
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SaaS Gross Margin represents the difference between revenue and the cost of goods sold (COGS). For SaaS companies, revenue — which is defined as positive income from the sales of goods or services — is usually generated from the sale of software or software subscriptions.
COGS is a term used to describe the direct costs associated with producing and distributing the corresponding product(s).
Usually, the term “gross margin” will refer to all revenues and direct production and distribution expenses accrued by a company over a specific period of all time. However, gross margin can also be itemized by different sectors, different products, and other variables, thus allowing for direct comparisons.
SaaS Gross Margin is different from the commonly used “profit margin” because while profit margin simply compares revenues and expenses, gross margin only accounts for the expenses accrued from selling an additional unit of goods or services. Fixed costs, such as office space and (some) salaries, are excluded from the gross margin calculation.
Essentially, looking at the gross margin can help answer the question, “If we were to produce and sell one additional unit, how much revenue would we generate and how much more money would we need to spend?”
Gross margin can be calculated in two different ways. Unit margin measures how much can be made from the sale of an additional unit in terms of raw dollars, whereas the margin percentage measures the margin as a ratio.
In a survey administered by the Marketing Accountability Standards Board (MASB), managers exhibited a slight preference to using the gross margin percentage, but the unit margin is also widely utilized.
Paying close attention to gross margins is especially important in the SaaS industry, where many businesses have a lifecycle and profit structure that are notably different from their more-traditional counterparts.
For example, in the SaaS industry, the costs of delivering a product from conception to the end-user are usually heavily concentrated up-front (particularly, Research and Development). Only looking at the net profit margin might not accurately illustrate the company’s true earning potential.
The digital, pseudo-physical nature of the “product” (software subscription) also yields a situation in which it makes more sense to separate fixed costs and costs categorized in the actual selling of goods (COGS).
Furthermore, many SaaS companies begin operating with deep losses, hoping to overcome these losses in the future. The question that leadership needs to ask themselves is, “if we were to keep expanding and selling more of our product, could our business model be sustained?”
This is not a question that can always be answered by the net profit margin, especially in a SaaS company’s earlier years. But the SaaS Gross Margin, on the other hand, helps illustrate the organization’s sustainability potential. If gross margins are low (or even negative), this means that even in the “best-case scenario”, the business will continue facing financial challenges.
The more a business can do to widen the gap between marginal revenue and marginal COGS, the better positioned that business will be.
Additionally, Gross Margin is one of the first metrics that banks, venture capitalists, angel investors, and other individuals will look at when they are making important funding decisions. On the margin, excelling in this component of your income statement can help your company distinguish itself from possible alternatives or competitors.
Calculating the SaaS Gross Margin (Gross Margin Percentage) is relatively simple:
Gross Margin Percentage = (Revenue – COGS)/(Revenue) x 100 percent
If you are familiar with accounting, you will realize that the formula is structured very similarly to many other common ratios, including net profit margin.
SaaS gross margin can be either positive or negative (though it will usually be positive). If the margin is negative, this indicates that the money being spent to create and deliver a product is greater than the revenue being generated from the sale.
As suggested, some managers also like to look at the unit margin in addition to the gross margin. The formula for calculating the unit margin is:
Unit Margin = Selling Price – Cost Per Unit
Once again, this a metric that could yield a negative number; likewise, a negative value indicates there is probably something wrong with the company.
Knowing how to calculate and interpret the gross margin makes it easier for leadership to make informed, profit-motivated decisions.
When the difference between revenue and COGS is high, this suggests that the company’s current operating produces a high markup. Higher markups, combined with higher sales volume will combine to maximize profit.
Now that you know how to calculate gross margin, you can have a better understanding of your company’s current financial and operational situation. However, understanding how to calculate gross margin is one thing, knowing how to improve gross margins is another.
The best ways to improve gross margins will depend on your company’s stage in the business cycle, its size and structure, its target market, and numerous other factors. However, even keeping these nuances in mind, there are still a few things that virtually all SaaS organizations can do to increase gross margins:
As a SaaS enterprise, your access to and implementation of cloud technology and data can help you establish a competitive edge.
In addition to gross margin, there are many other broader metrics that will need to be monitored including cost per transaction, lifetime customer value, and many others.
Using platforms like CloudZero makes it easier to take a deep dive into your cloud usage, map costs to products and features, and develop a sustainable, high-yielding business model.
When all else is equal, your business would obviously much rather be paid today than a year from now. Finding ways to encourage upfront payment (such as discounts or “bonus” features), rather than defaulting to monthly payment will accelerate your cash flow cycles and give you the capital you need to advance gross margins.
Additionally, decreasing the “trial period” will also help your margins. The difference between a 15-day and 30-day trial may not affect subscription rates, but it can affect your cash flow cycle.
The term “cost of goods sold” includes many different expenses. On any given income statement, there are potentially many different expenses that can be bundled, decreased, or outright eliminated.
Itemizing the broader categories makes it easier to spot potential opportunities. If you have not taken a deep dive into your financials this year, it might be time to take a look.
Because your company relies on a subscription model, it can be difficult to sell already existing clients. Rather than working your current network, it might be helpful to look outward in search of new opportunities.
Implementing an international, digital, and multifaceted marketing campaign can help increase exposure and lead to more conversions. Offering specialized versions of your already existing product (enterprise, platinum, office, student, etc.) can also help increase your reach.
The more your business can do to increase revenue without significantly increasing COGS, the better your gross margin will be. There are many short-term marketing techniques that have proven to be effective.
Creating a referral program, expanding your social media presence, implementing a content marketing campaign, and investing in better branding can all deliver real results.
While there is no way to “automatically” improve your SaaS gross margins, there are certainly many things that can be done to put your enterprise in a much better position.
Your gross margin calculation, after all, is simply a derivative of revenues and the costs of goods sold. Anything that can be done to drive revenues up or drive your costs of goods sold down will cause an improvement.
For SaaS companies, cloud costs are a large component of COGS. Having a solid understanding of how much you spend on specific AWS services and how those costs translate to your business (e.g., how much your features or products drive specific AWS service costs or how much specific customers cost your business) will be vital to finding ways to design architecture that maximizes profitability.
CloudZero enables SaaS companies to gain true cost visibility into their cloud spend and measure the costs that drive their features and products. Schedule a demo today to see how CloudZero can put your team in control of your costs and enable you to make informed technical decisions that improve profitability.