You can assess your company’s financial health using a number of SaaS metrics, depending on the type of business you are in. Among the most useful is the SaaS Magic Number. So, why is it called the SaaS Magic Number and how do you calculate it? And why is it so important to track your SaaS Magic Number regularly?
This jargon-free post will answer these questions and more, including:
Table Of Contents
What Is The SaaS Magic Number?
The SaaS Magic Number measures the sales efficiency of a SaaS business. It does that by evaluating the return on investment on sales and marketing spend versus annualized revenue growth.
Essentially, the SaaS Magic Number seeks to answer the crucial question: “How much revenue does our company generate for every dollar we spend on acquiring new customers? ”
The SaaS Magic Number helps measure the ratio between the current quarter’s recurring revenue and the last quarter’s marketing costs. It is calculated quarterly because accounting reports sales and marketing expenses quarterly.
Why Is The SaaS Magic Number Important?
By comparing your annual recurring revenue with sales and marketing spend, the SaaS Magic Number determines if you are making enough money (profit margin) to continue investing in sales and marketing.
If your company’s magic number is 1, it indicates your ratio of dollars spent to dollars earned is 1 to 1, meaning your sales and marketing processes are efficient.
A SaaS Magic Numbers below 1 indicates that you should evaluate your SaaS business and see what needs to be improved, including your:
- Product-market fit
- Customer retention strategy
- Conversion rate optimization, and
- SaaS pricing (or setting more ideal pricing tiers, plans, etc)
Other benefits of the SaaS Magic Number include:
- Tracks sales and marketing ROI – Helps tell if you are earning a healthy ROI on your sales and marketing dollars
- Measuring scaling efficiency – Shows whether your company is ready to boost sales and marketing to accelerate growth
- Sales and marketing redesign – It helps you see what sales and marketing techniques are working and which ones you’ll want to improve or replace
- Cloud cost optimization – By analyzing your Cost of Goods Sold (COGS), you can determine where to invest more to maximize ROI and where to reduce costs without hurting revenue, to increase gross margins
Here’s something else.
How To Calculate Your SaaS Magic Number
To determine your SaaS Magic Number, take the current quarter’s recurring revenue and subtract the previous quarter’s recurring revenue, then multiply the result by four (to annualize it) then divide it by your sales and marketing costs in the previous quarter.
Here’s the formula for calculating the SaaS Magic Number:
SaaS Magic Number = [(Current Quarter’s GAAP Revenue – Previous Quarter’s GAAP Revenue) X 4] / Previous Quarter’s Cost of Sales and Marketing
Other formulas for calculating your SaaS Magic Number include:
SaaS Magic Number example:
Company A’s recurring revenue in Q3 is $700,500. Its recurring revenue in Q2 was $550,700. It spent $600,200 on Sales & Marketing in Q2.
Using the SaaS Magic Number formula, Q3’s Magic Number is:
SaaS Magic Number = [($700,500 – $550,700) X 4] / $600,200
SaaS Magic Number = 599,200 / 600,200
Company A Q3 Magic Number is 0.998 or just about 1
You can calculate this number manually. Or, you can use one of several SaaS Magic Number calculators available today, including Ramp and Klipfolio.
So, is Company A’s Magic Number healthy or should it work on making its sales and marketing efforts more efficient? And what is a good SaaS Magic Number anyway?
How To Interpret Your SaaS Magic Number
If your SaaS Magic Number is below 0.75, you should evaluate your sales and marketing strategy as it currently isn’t working in your favor.
A SaaS Magic Number between 0.75 and 1 indicates that the company is on track to streamline its sales and marketing to improve profitability.
If your SaaS Magic Number is greater than 1, it means the strategies you are using are efficient and sustainable – and you can use more similar ones to further increase your margins.
What Metrics Relate To The SaaS Magic Number?
You can better understand your Magic Number with the help of several SaaS metrics. These include:
Customer Acquisition Cost (CAC)
Customer Acquisition Cost (CAC) is the total amount you spend to gain one additional user. Over time, SaaS companies recover this upfront investment through subscription revenues.
CAC Payback Period
The Customer Acquisition Cost (CAC) payback period is the time it takes a SaaS company to recoup all the sales and marketing costs it used to gain one customer.
Investors are also interested in this metric because it lets them know when to expect a return on their investment.
Monthly Recurring Revenue (MRR)
MRR measures how much revenue your existing customers generate on a monthly basis, regardless of the number of pricing tiers you have.
Also, MRR is extremely helpful in calculating other SaaS metrics for reporting, such as Gross Margin, Net Monthly Growth Rate, and SaaS Profit and Loss.
Annual Recurring Revenue (ARR)
ARR is the annualized MRR; your MRR X 12.
An organization’s customer churn rate is the percentage of its total customers who do not renew their subscription during a particular period. Defection, attrition, and turnover rates are all terms used to describe customer churn.
Likewise, revenue churn rate refers to how much revenue you lose over time compared to the previous period. Revenue retention rate refers to the percentage of income you keep from recurring subscriptions.
Gross profit margin
SaaS Gross Margin refers to the difference between revenue and cost of goods sold (COGS). For SaaS companies, revenue is positive income from sales of goods or services — usually software sales or subscriptions. COGS describes the direct costs associated with producing and distributing the software.
Net profit margin
Net Profit Margin (also called Profit Margin or Profit Margin Ratio) indicates how much profit a company generates from its total revenue. Specifically, it measures how much profit you make for each dollar of revenue.
The net profit margin is expressed as a percentage of total revenue divided by net profit (often referred to as net income).
The Rule of 40
According to the rule of 40, a SaaS business is healthy and profitable when the sum of its growth rate and profit margin is greater than 40%. Here’s a quick guide to the Rule of 40 for SaaS companies.
Check out our snackable guide on SaaS metrics you need to know. You’ll learn how metrics like growth rate, expansion revenue rate, customer retention rate, and cost of goods sold (COGS) compare to each other and why they matter so much.
How To Improve Your SaaS Magic Number?
The following are some common tips for improving your Magic Number:
- Shortening your sales cycle
- Encourage upsells
- Facilitate more cross-selling
- Focus on customer retention/subscription renewals
- Make conversion optimization a priority
- Experiment with different marketing channels to discover the ones with the best price-returns ratio
- Do more of what returns the highest sales and marketing ROI
Here’s the thing. SaaS is a highly dynamic market where change is the only constant, so regardless of your score, you’ll want to continuously improve your SaaS Magic Number.
In fact, when your Magic Number is exceeding 1, it is also an ideal time to experiment with different sales and marketing techniques alongside the ones that are already producing a good ROI. You can afford it.
Here are several advanced yet relatively simple ways to improve your SaaS business Magic Number:
Optimally manage your COGS
When you know exactly what’s driving your cost of goods sold, you can cut unnecessary costs and pass the savings on to your customers to encourage renewals. Or, you can keep the increased margins to boost your bottom line and fund further growth.
Maximize ROI by evaluating your unit costs
By understanding where your money is going, such as the people, products, and processes driving your cloud costs, you can pinpoint where to cut costs and where to increase investment to improve margins.
Set profitable SaaS pricing
When you know how much you are spending to support each cost center, a specific customer, or project, you can tell how much you need to charge for each to protect your margin.
Encourage renewals with timely, personalized discounts
Knowing how much you spend to support a specific customer helps you determine how much discount you can give them without hurting your margins or losing them.
Understand your gross margins
Total gross margin does not tell the whole story. Knowing how much gross margin you earn per customer, project, team, software feature, product, etc., is more effective. Taking this approach helps you build a business that is profitable from day one.
If you are wondering where and how to collect, analyze, and act on this level of SaaS intelligence, CloudZero can help you automate it.
With CloudZero’s Cloud Cost Intelligence approach for SaaS organizations, you can:
- Accurately track and collect the costs of tagged, untagged, and untaggable cloud resources, along with those in shared environments – even if you have imperfect cost allocation tags.
- Simplify your total cloud costs using granular, immediately actionable cost insights, such as your cost per individual customer, project, environment, product, team, product feature, etc.
- Help finance understand your cost per customer to ensure your margins aren’t eroded during pricing negotiations.
- Empower your engineers to track the impact of their activities on costs to make your product more competitive in your market and cost-effective to you.
- Ensure your FinOps team can better budget, forecast, and allocate costs (showbacks and chargebacks), among other things
- Take advanatage of real-time cost anomaly detection, and prevent overspending with timely alerts via Slack, email, etc.
Yet, reading about CloudZero’s capabilities is nothing like seeing it in action for yourself. to increase your SaaS Magic Number in days — not years. Companies like Drift, Remitly, and Malwarebytes, are already saving up to $2.4 million annually with CloudZero.