SaaS Gross Margin

What is SaaS Gross Margin?

SaaS gross margin measures the profitability of a Software-as-a-Service (SaaS) company relative to its development, maintenance, and support costs. It represents the percentage of revenue left over after deducting the cost of goods sold (COGS), but not operating expenses (e.g., sales, marketing, office space, R&D).

To calculate your SaaS gross margin, you’ll need to look at two numbers:

• Revenue — The total amount of top-line earnings from your product or service.
• Cost of Goods Sold (COGS) — The direct costs associated with producing and delivering your product or service, including hosting fees, software licensing, cloud storage, customer support, and third-party services.

Your SaaS gross margin measures your business model’s efficiency and growth potential and indicates how well your company is managing its costs. It shows you how much money you have available to cover operating expenses and invest in growth.

A high gross margin percentage means your company generates more profit from each dollar of revenue, while a low percentage indicates that your costs are eating into your profits. It does not, however, factor in operating expense. That’s why it’s essential also to track your SaaS operating margin and SaaS net profit margin.

Synonyms

• SaaS margin
• SaaS profit margin

Importance of Measuring SaaS Gross Margin

Understanding your gross margin is the first stepping stone towards building a successful SaaS business. It helps you identify inefficiencies in your cost structure that may hurt your bottom line and gives you insights into optimizing for better profitability. If you’re barely breaking even at the gross level, you’re definitely losing money at the operating level. Potentially tons.

Evaluate Profitability

To evaluate profitability using the SaaS gross margin, start by benchmarking against industry averages. Most SaaS companies have a gross margin between 70% and 85% (if they’re where they should be, efficiency-wise), but this can vary depending on the product type, growth stage, target market, and pricing strategy.

A lower-than-average gross margin could indicate that your product is too expensive or that your COGS are too high. On the other hand, an above-average margin could suggest that you’re not investing enough in growth, which may hurt your long-term profitability.

Identify Growth Potential

SaaS gross margin also reflects your business’s potential for future growth. A high percentage means you have more money to reinvest in your company and expand your customer base, develop new features, or enter new markets. Increased revenue and a larger market share typically follow alongside or right behind SaaS businesses with a solid gross margin.

Conversely, a low gross margin means you have less money to invest in growth and may be limited in your ability to scale. Since scalability is practically built into the recurring revenue model, a low gross margin for your SaaS company is a huge indicator that something is wrong with your internal processes or the product itself.

SaaS Valuation

Because of how accurately you can use SaaS growth margin to evaluate your growth potential and overall financial health, investors will do the same. They’ll eventually look at other metrics (like operating margins and net revenue retention). But the only way you’ll get investors, partners, and buyers to look at your company long enough to see those is if your gross margin is high enough.

• Salesforce — A pioneer in the SaaS industry, Salesforce has a consistently high gross margin of 75.44%. It invests heavily in sales and marketing to drive growth but maintains a healthy profit due to its efficient cost structure.
• Dropbox — As of 2023, Dropbox reported a gross margin of 80.7%. This exceptional margin is thanks to its simple and scalable software delivery model, which results in low cost of revenue. In the past, it’s achieved EV/EBITDA multiples as high as 17.7x.
• Zoom — In July 2023, Zoom reported a gross margin of 76.59%. Although fantastic, this margin is slightly lower than its 2020 highs (80%+).

It’s worth noting a software company doesn’t necessarily have to be profitable to be valuable. On June 30, 2023, Uber reported a gross margin of 40.25%, which is considerably below the threshold. The company has also famously never had a profitable year.

That said, Uber is the exception, not the rule. Long-term investors are betting on Uber’s ability to capitalize on EVs, which would make the rideshare service profitable. However, most SaaS companies (especially B2B ones, which aren’t offering a crazy, unique product like Uber) have a specific structure and cost model that makes profitability more likely. So, potential investors look at that first.

Optimize Pricing Strategy

Companies can improve their gross margin by achieving price optimization. SaaS businesses usually use a combination of:

• Tiered pricing — offering different packages at various price points (e.g., Basic, Pro, Enterprise)
• Flat-rate pricing — your base-level cost of each product tier
• Usage-based pricing — price per user, storage space, etc.
• Value-based pricing — aligning price with the perceived value of the product.

Since SaaS business models are already quite efficient, profitability (e.g., via a cost-plus model) isn’t normally part of the plan.

But, because there are so many layers to SaaS pricing strategies, small differences in even one element of the model can significantly impact gross margin. For instance, your base-level pricing might work just fine. But customers won’t continue to invest in your product if adding additional seats is more financially feasible with a different product.

SaaS Gross Margin Calculation

For SaaS businesses, calculating gross margin is fairly straightforward. There are, however, some variables to consider when doing so.

Variables

Revenue

Revenue simply refers to all your revenue streams. Most SaaS companies use the subscription model, so revenue is mostly sourced from recurring subscription fees. The metric presumes you have already received payment for the work done in a particular period.

You can either look at top-line revenue from your invoices (excluding any discounts or rebates). Alternatively, you can take a more granular approach by accounting for MRR churn and upsells.

Cost of Goods Sold (COGS)

Cost of goods sold — abbreviated to COGS, and sometimes referred to as cost of revenue — is the cost of producing your product. In other words, it’s the direct costs of creating and delivering your product to customers.

For companies selling physical products, these expenses would include manufacturing, assembly, and shipping costs. For SaaS companies, however, COGS is more variable.

Examples of COGS for software companies include:

• Web hosting (AWS, Azure, or GCP)
• Third-party APIs
• Hosting and infrastructure costs (e.g., Heroku, Digital Ocean)
• Customer support services, software, and salaries
• Credit card processing fees
• Software licenses for internal tools used to develop and maintain the product
• Development costs (including engineering/developer salaries)
• Professional services and travel costs related to implementation and support

These are all considered variable costs because they depend on your product and user base. A larger user base will put more strain on the server. And more advanced technologies will require more infrastructure and development/maintenance resources. These, of course, cost more.

SaaS Gross Margin Formula

The SaaS gross margin calculation is as follows:

SaaS Gross Margin = (Total Revenue – COGS) / Total Revenue

If your gross margin is 80%, that means for every $100,000 in revenue, $80,000 is available to cover indirect costs and provide profits.

Ways SaaS Companies Can Improve Gross Margin

Gross margin is just a percentage of revenue before operational expenses. So, improving that number is all about finding ways to make that percentage closer to 100%.

Here are a few ways to approach that:

Expand Accounts and Markets

The best way to become more profitable is to sell more to your existing customers. This approach allows you to increase revenue without incurring additional costs (i.e., COGS).

It’s also a lot more efficient. Existing customers are 50% likelier to try your new products/features. And they spend 31% more on average.

You can expand accounts by:

• Upselling — offering additional products or upgrades
• Cross-selling — suggesting related products to existing customers (e.g., “Customers who bought X also bought Y”)
• Freemium to paid — offering a free version of your product and then converting those users to paid accounts
• Microservices — A lot of SaaS companies offer microservices (e.g., Dealhub CPQ + DealRoom + Billing) to meet the additional needs of their current customers.
• Feature add-ons — Whether it’s an upper-tier feature everyone can access or a new paid feature, offering use-case-specific features will certainly get some of your customers to buy more.

These approaches are often referred to as land-and-expand account management strategies. They’re highly effective for B2B companies with a subscription model because they convert at around 60% to 70%.

Another way to increase revenue is by expanding into new markets. If your product resonates with a particular group of customers, try to expand your target market to reach more potential customers.

You can use some of the same product-led strategies mentioned above (microservices and feature add-ons work well for attracting new market segments). You can also adjust your sales and marketing strategies or run campaigns to reach different audiences.

Reduce Costs

Aside from selling more without increasing your customer acquisition cost, you can achieve higher gross margins by reducing costs internally. Since this calculation doesn’t include sales, marketing, or administrative expenses, you can’t just cut your Google Ads budget and call it a day. You have to look at the direct costs associated with your product.

Some SaaS companies choose to outsource some of their services, such as customer support or development. The main issue you’ll run into with this is you’ll have less control over the product/customer service outcome.

Outsourcing is generally OK for SaaS startups that are still refining their MVP and working on a tight budget. But won’t can’t support a growing customer base’s demands in the long run.

For larger companies, then, the only ways to reduce costs are to:

• take a close look at internal processes for efficiency
• automate tasks that can be
• adopt an agile approach to development, like continuous integration or continuous delivery
• implement a DevOps mindset focusing on collaboration between software developers and IT teams

Every company can also invest in making its product more efficient. The fewer development resources it takes to run and maintain, the fewer costs you’ll incur on that front. This also allows you to focus more on product development and less on maintenance.

Optimize Pricing

As mentioned earlier, price optimization is a solid way to improve your gross margin because it improves profitability. An often-overlooked benefit of having the right offer is increased sales efficiency. It’s a lot easier to sell products when customers think they’re getting the value they’re paying for.

Although sales costs aren’t factored into gross margin, efficiency doesn’t just reduce the cost. By increasing lead velocity, sales volume and average deal size also increase. So does your top line, and thus gross margin.

Pricing can be a tricky game to play. You don’t want to scare anyone away by asking for too much (e.g., charging more than the perceived value). But you also don’t want to lose money on customers who are willing to pay more.

The best way to optimize pricing is by performing market research. Look at your competitors to see what they charge for similar products (and how that’s working out for them). And survey your customers to gauge their willingness to pay.

If you can, use differential pricing (but do not vary prices on the wrong parameters). Also, don’t A/B test your pricing levels. You’ll end up frustrating customers who could have paid less.

Examine Payment Structure

Without making any pricing changes, you can improve your margins simply by changing how you structure payments. The best example of this is SaaS companies that offer discounts for annual prepayment instead of the usual monthly billing.

Although they might receive a month free when they pay for the year upfront (the most common discount), it rewards loyalty. It’s better to guarantee your customer retention for a year than it is to watch it fluctuate.

Explore Marketing Channels

Although a marketing expense won’t fall under the ‘gross margin’ metric, they still impact your overall profitability. Over time, they also impact the success of new products/updates (and the data that informs them). So, solid marketing collateral and useful data will make your development process more efficient and increase your overall product revenue.

Another way to increase your gross margin is by exploring different marketing channels. While this may not directly impact the calculation of gross margin, it can accelerate revenue growth.

Some popular marketing channels for SaaS companies include:

• Social media marketing
• Content marketing
• Influencer marketing
• Email marketing
• Referral programs

Each marketing channel has its own unique advantages and target audience. By implementing a multi-channel sales approach, you can reach a wider customer base and potentially increase sales.

Analyze and Reduce Customer Acquisition Costs

The activities linked to a lower customer acquisition cost (CAC) will vary depending on your business. However, there are some effective universal strategies for reducing this cost:

• Word-of-mouth marketing
• Search engine optimization (SEO)
• Channel sales
• Partnerships

By reducing your customer acquisition cost, you can improve the overall profitability of your SaaS company. This can in turn positively impact your gross margin by lowering direct costs associated with each sale.

Leverage a Revenue Tech Stack

(Decrease costs and increase efficiency and profitability by using CPQ, billing, revenue analytics, etc.)

Your RevOps tech stack should include:

• CPQ (Configure, Price, Quote)
• Billing
• Contract management
• Revenue analytics and insights tools

The more you can automate the sales process and improve efficiencies, the lower your costs will be. This will eventually lead to a higher gross margin for your SaaS company.

People Also Ask