The market for Software-as-a-Service (SaaS) continues to grow exponentially. But more SaaS companies are reporting lower margins these days, despite historically enjoying 60-90% margins on average.
Thin margins limit a company's ability to expand in the future. They also weaken the company's market valuation and, over time, they can chip away at the company's gross margins. These scenarios are often not a result of companies failing to make enough money to reap healthy margins.
Instead, they result from a series of engineering decisions.
For example, engineering leaders who don't monitor the right cost metrics, wind up with cost overruns that erode their budgets or ROI expectations.
Many startups also assume their gross margins will improve as their business scales instead of looking at SaaS metrics that can help them improve right away. This is usually one issue that does not improve but can get worse with expansion.
Not all SaaS metrics are equal. Several metrics traditional software companies use simply do not apply to your subscription pricing model. They account for lump sum of revenue upfront, with little recurring revenue. Yet, you depend on recurring revenue, which makes a world of difference.
This guide will highlight only the key metrics necessary for a SaaS company to succeed, regardless of industry.
1. Market Size
Market sizing refers to determining the total number of potential buyers of your SaaS service or product within a specific market and the total revenue you may generate from those sales.
This is not exactly a SaaS-specific metric.
However, knowing who might eventually become your customer is essential to developing a marketing plan that targets them. With a targeted marketing plan, you can optimize your customer acquisition costs, resulting in healthy margins from each customer.
Analyzing the user journey is an important part of the market sizing process. By understanding how your target customers make their SaaS purchases, you can optimize the onboarding process for new users.
Customers should be able to find value in your offering and adopt it quickly. The shorter the activation and conversion duration, the lower the customer acquisition costs can be.
2. Lifetime Customer Value (LCV) To Customer Acquisition Cost (CAC) Ratio
Customer Acquisition Cost (CAC) is the total amount you spend to gain one additional user.
For SaaS companies, this upfront investment is repaid over time as revenue. Contrary, traditional software companies and e-commerce businesses typically collect most of their revenue upon purchase or repurchase, respectively.
As for Life Customer Value (LCV), this metric measures the value a customer provides your company from the moment they become a customer until they cancel their subscription.
CFOs use the LCV:CAC ratio to determine the return on investment a customer provides.
A common way to calculate CAC is to add up the total expenses you incurred for gaining new customers, such as sales and marketing expenses, over a specific period. Then, divide the total by the number of customers you gained during that time.
You end up with the average amount you spent on acquiring a customer, and this can be problematic for several reasons:
- The cost and effort to acquire a customer is different for each customer to bring on.
- You cannot tell which customers are your most expensive customers to acquire, to maintain, or by how much.
- This makes it challenging to decide on a SaaS pricing model for a specific client or service. If you do not have clear visibility of your cost per customer, you will have a hard time fighting out how to create healthy margins from each client or segment.
However, using cloud cost intelligence can help. Using a platform like CloudZero, you can identify, measure, and monitor the cost to serve each of your customers.
CloudZero aligns cloud spend to specific customers, features, and products so you can identify cost per customer, see your most expensive customers, or even track changes to your unit cost baseline.
With this data in hand, you can make informed decisions regarding your pricing, how to price different segments, and which segments to focus more of your attention on (i.e., determine which segments are most profitable).
3. Monthly Active Customers Vs. Users
It is common for teams to use the terms monthly users and monthly active users interchangeably. Although monthly users describe all your SaaS users per month, active customers are people who pay monthly to use your service.
Those on free trials or free plans do not count as active customers unless you use a freemium business model.
The difference is significant, as it gives you insight into how many people are using versus paying for your SaaS product. Thus, you can understand your cash flow in terms of your costs to support all customers versus the revenue you earn from them.
This metric also allows you to see if the resources you use to support all users versus paying subscribers is sustainable.
You can introduce different pricing tiers that free users can upgrade to after a specific period (limited-time trial) if you figure that you might run into cash flow trouble in the future. By doing so, these users can start generating recurring revenue to ensure profitability.
4. Monthly Recurring Revenue (MRR)
MRR is a fundamental SaaS metric because it tells you how much revenue your customers generate each month. You can calculate MRR manually, just as you can with total users and active clients. Alternatively, you can use a tool like ProfitWell to calculate it in real-time.
You can calculate your annual run rate or annual recurring revenue (ARR) by multiplying your monthly revenue by 12.
It is also possible to use MRR to determine if you are charging enough per month to break even, become profitable, or sustain growth.
SaaS companies with a healthy MRR are self-sustaining. The rule of thumb is to ensure your revenue growth rate and profitability margin are both at least 40%. If your range is less than 40%, you may experience liquidity problems soon.
You can use ARR to plan your investment in additional features, hiring, and subscriptions such as CloudZero and ProfitWell.
5. Customer Retention Rate
In SaaS business models, retention is a vital metric. Essentially, Customer Retention Rate (CRR) measures the total number of customers you have at the beginning of a period minus the number you keep at the end.
Remember, SaaS is built on the concept of recurring revenue. The only way to earn recurring revenue is to retain your customers over a specific period. So, your recurring revenue depends on how many customers you keep each month.
6. Churn Rate
Churn is the rate at which customers leave a company over a specific period, expressed as a percentage of your total number of customers.
SaaS companies with a freemium model pay attention to customer churn (loss of customers). The companies that offer paid plans keep track of the revenue they lose when paid users (active subscribers) cancel their subscriptions.
Having a high churn rate shows that something is wrong (either with your software, customer service, or some other aspect of your business). Maybe a critical feature doesn’t work as well as it should. Maybe adding features would make customers stay longer.
Sometimes, churn spikes can show that a competitor has just introduced a highly sought-after feature, or lowered prices significantly, which you may consider to match to retain customers.
Low churn rates can show that your software provides excellent value and fits your market well. It may also indicate that you are undervaluing your offering by charging a low subscription fee. If you have a low churn rate but a struggling cash flow, this might be the case.
You can calculate your monthly customer churn rate manually by dividing the number of canceled subscribers by the number of active subscribers 30 days ago. You can convert this result to a percentage by multiplying it by 100.
Monthly customer churn rate = (Unsubscribed customers in the month/Active subscribers 30 days ago) X 100%
Add the MRR of canceled subscriptions to the MRR lost to downgrades to get the monthly revenue churn rate. You can then divide that number by the MRR you had 30 days ago. Then multiply the result by 100 to get your churn rate in percentage.
Monthly revenue churn rate = ((MRR of canceled subscriptions + MRR lost to downgrades)/MRR 30 days ago) X 100%
Or you can use a tool like Baremetrics to calculate churn actively for your company, including trials and cancellation insights.
Make sure you monitor your churn rate continuously, looking for ways to keep it under 8% per month. If not, it could erode your revenue and, ultimately, margins.
7. Contraction MRR
If you offer pricing tiers, then you know customers may sometimes downgrade to cheaper options. The contraction MRR metric helps measure this kind of scenario.
Contraction happens every time you lose MRR from an existing customer — not when they cancel their subscription. So anything that leads a customer to pay less for their monthly subscription than they usually do.
A customer may downgrade if they feel they are getting enough value while paying less. It may also be because teams that use multiple user accounts and pay on a per-user-per-month basis have reduced team members. Downgrading customers may feel that your higher-priced plans do not provide enough value.
In any case, a high contraction rate hurts your MRR.
The Net Promoter Score (NPS) and customer feedback will be essential for helping you figure out why people are downgrading — just like if you had a high churn rate. Only when you have this insight can you revise your SaaS pricing strategy effectively. You can, for instance, add extra features to higher-paid plans to justify upgrading.
If that is the case, you'll need first to determine how much it costs to run a feature. If you don't this type of cost intelligence, it will be hard for you and your team to decide how much to charge for additional features or whether it makes sense to add them.
8. Expansion MRR
As the opposite of a contraction MRR, an expansion MRR shows an increase in MRR gained from existing customers. Upgrades to higher-paid plans and subscriptions can create this scenario.
Either way, growth in this area likely means you are doing something right. Therefore, you can use expansion MRR to evaluate whether a recent marketing campaign or conversion optimization strategy has been successful.
If you have strong expansion MRR, you can counter churn when upsells and value from upgrades and upsells exceed the value you lose through cancellations. Expansion is also the best way to maintain a high retention rate, MRR, and customer lifetime value. In fact, upselling costs up to 70% less than signing up a new customer.
An important SaaS growth metric to monitor here is the Month-over-Month Monthly Recurring Revenue (MoM MRR). The MoM MRR growth is a business expansion metric that shows market traction. You can calculate it manually using Net MRR, or you can use a metrics automation tool such as Klipfolio to do it for you.
9. CAC Payback Period (Months To Recover CAC)
Your CAC payback period defines how long you need a customer to stay subscribed in order to break even. Some call this metric positive cash flow.
Months to recover CAC describes the number of months a customer needs to renew their subscription before you can recover a revenue amount equal to the amount you used to gain them.
Eventually, you start to collect returns on that investment from the month you break even. This is assuming the customer renews their monthly or annual subscription consistently.
Divide your CAC by the product of MRR and Gross Margin (GM) to calculate your Months to Recover CAC.
Months to Recover CAC = CAC/MRR X GM
Note: Calculate GM by subtracting your SaaS cost of goods sold from gross revenue.
10. SaaS Cost Of Goods Sold (COGS)
COGS is a measure of how much your SaaS company spends on serving its customers. The following are examples of SaaS COGS:
- The cost of hosting customers' workloads on AWS
- Software delivery costs
- Cost increases related to extra features or an increase in computing power
- Expenses associated with engineering experiments, including quality assurance
- Updates and patches for security issues
You can boost your profit margins by reducing the costs of goods sold on different product lines. This can also enable you to lower prices or increase your discount rate, a move that can help you attract more customers.
Keeping SaaS COGS low is not always a good thing. How come?
This is because reducing inputs might require tradeoffs.
Suppose your company reduces its AWS EC2 budget. The decision may limit your application's scaling capabilities, further deteriorating its performance, availability, and overall customer experience. It may also result in user security threats.
Depending on what finance and engineering recommend, you must first decide on what tradeoffs to make or which risks to mitigate.
11. Net Profit Margin
This is the ultimate metric you want to increase even if you won't break even in the next couple of years. Net profit heavily depends on several variables, some of which are outlined in the metrics presented here. These are all part of cloud economics for SaaS companies.
There is another metric many SaaS businesses find difficult to measure, but one that is crucial to find out if you are on track to making a profit.
12. Unit Cost
Unit cost can refer to cost per customer, per feature, per message, and even per team in the SaaS industry. This metric should help you visualize the relationship between cloud computing costs and various aspects of your business. Here are some examples:
- What specific features of your application are the most expensive to run?
- What features do customers actually use?
- Are there features you can decommission without losing significant revenue?
- Which customer is the least profitable for you?
- How much does each transaction cost?
You can also monitor unit costs to see how changes in inputs impact outputs. What happens, for example, when you add extra features to your application?
Unit costs inform you how one area of your business, such as an engineering team or specific developers’ actions, affects your entire company’s finances.
One big problem remains. In most SaaS monitoring tools, you cannot see costs in this way or map them to the way you work. An AWS bill, for example, doesn't provide details about what, who, or how your EC2 instances were used.
Gain SaaS Cost Visibility With CloudZero
With CloudZero, SaaS teams can measure COGS, identify unit costs (like cost per customer or feature), and optimize their cloud spend.
Our cloud cost intelligence platform also enables teams to drill into cost data from a high level down to the individual components that drive their spend — as well as alerts teams of any important cost anomalies to prevent cost overruns.
CloudZero can help your engineering and finance teams make smarter cost decisions when improving features, implementing pricing changes, and optimizing gross margins. To see how you can improve your margins, 
.
Resources
Blog
Case Studies
Events
Free Cloud Cost Assessment
