Gross margin is a critical metric for SaaS startups to measure and improve. Low margins aren’t healthy or sustainable for most SaaS companies, and gross margin is one of the first metrics VCs and other investors often look at when evaluating a SaaS company. This article examines how SaaS companies should calculate gross margin and offers tips to help you improve your SaaS gross margin.
What is SaaS Gross Margin?
SaaS gross margin $ is simply the difference between revenue and cost of goods sold (CoGS). The % is Gross margin $ / Revenue.
If this sounds a lot like the standard “profit margin” metric from any other industry, it is, with one key difference. In SaaS companies, CoGS only includes the direct cost of goods sold. Indirect costs of doing business such as product development, office space, administrative salaries, and marketing expenses aren’t included in CoGS.
By looking at the gross margin and only factoring revenue and expenses directly tied to subscriptions, SaaS startups can effectively understand their unit economics. Product delivery costs like R&D are often front-loaded at SaaS startups, so just looking at net profit margin can show an inaccurate and diluted picture of the company’s real value and potential moving forward.
SaaS gross margin $ is simply the difference between revenue and cost of goods sold (CoGS).
What’s a Good Gross Margin for a SaaS Startup?
Successful SaaS companies typically see large profit margins, with averages in the mid-70s and anything above 75 is generally regarded as very good or excellent. High future margins help make the heavy upfront R&D investments worth it in the end.
For a more detailed view, see KeyBanc Capital Markets’ 2022 SaaS Survey Results.
High future margins help make the heavy upfront R&D investments worth it in the end.
Tips to Improve Your SaaS Gross Margin
Now that we have a basic definition and benchmark, I’ll share some tips that can help improve your SaaS gross margin.
1. Scrutinize Your CoGS
First, ensure you’re including only direct costs of goods sold in the CoGS section of your income statement. This might sound obvious, but I frequently meet SaaS startups that are including indirect operating expenses in their CoGS.
Are you including the correct things under CoGS in your income statement? Or are you including indirect costs too?
Cost of Goods (CoGS) should usually include:
- Cloud costs and other third-party expenses directly related to product delivery
- Customer support and other retention-oriented customer success costs
- Internal engineering salaries that directly support product delivery
- Professional services that directly support product delivery
- Royalties and commissions
- Transaction fees
For a detailed view of what should typically be included under CoGS vs. Operating Expenses, see The SaaS Income Statement from SaaSOptics and SaaS Capital.
If you’re including indirect operating expenses in your CoGS, you’re diluting your gross margins on paper. Simply itemizing, scrutinizing, and correctly organizing your expenses could lead to an instant improvement in your gross margin.
2. Renegotiate Your Largest Expenses
As you itemize and evaluate your CoGS, keep an eye out for opportunities to lower the cost of your most significant expenses. For example, if hosting is one of your largest expenses related to product delivery, can you negotiate a better rate? What about your credit card fees? A good SaaS CFO can help you scrutinize your CoGS line-by-line and identify intelligent ways to lower costs and improve your gross margin.
3. Analyze Your LTV:CAC by Segment
LTV:CAC Ratio is a crucial KPI for SaaS startups. This metric helps measure and achieve the right balance between growth and profitability by comparing Lifetime Customer Value with Customer Acquisition Cost.
SaaS startups should aim for an overall LTV:CAC of at least 3:1. However, it’s also important to segment your LTV:CAC by customer type and marketing channel to spot opportunities to improve your profitability.
For example, what are the most profitable customer segments? How can you grow them? Are there similar segments you could attract? Are there unprofitable segments you should let go of?
Similarly, what are your most effective and cost-efficient sales and marketing channels? Can you redirect budget to focus your marketing spend more efficiently?
Understanding which customers are the most financially valuable and directing your product development, sales, and marketing dollars towards gaining more of these customers can be a powerful way to improve your SaaS gross margin.
4. Evaluate Your Pricing Model
SaaS startups have a number of different pricing models available, from flat-rate pricing to tiered pricing, per user pricing, per feature pricing, and more. It’s worth exploring your pricing model to see what is most effective for your particular business. Determining the best pricing model can take some time, as you’ll need to measure revenue over time, not simply conversion rate between different pricing models.
Consult with your CFO and investors on the best pricing model for your software. They’ve probably worked with numerous SaaS companies and have insights into the best pricing model based on the myriad factors that come into play and can help you get to the best answer faster.
5. Restructure Payment Contracts
In addition to your pricing model, also evaluate your payment contract terms. Most SaaS companies have annual or monthly payment contracts, and many offer both options, with a price incentive for customers to choose the annual option. It’s generally understood that monthly SaaS contracts are less valuable than annual contracts, but the degree of difference is often not reflected in the pricing spread we see between the two options.
Consider the more customer-friendly payment terms of monthly contracts, the cost of capital, and churn. All suggest SaaS companies should charge a much higher price on monthly contracts to have the same economics. In fact, according to our research, monthly SaaS contracts should incorporate a premium greater than 22% to achieve the same economics as an annual SaaS contract.
As you work through the above, another important consideration for investors, and for running the business is to adopt an approach and be consistent. Changing what goes into CoGS from quarter to quarter or even year to year will not give you an apples to apples view on whether your margins are improving. Develop an approach, review it and get approval from your Board and then stick with it. If you do find a valid reason to change your approach then go back 1-2 years so there is a consistent historical basis for your calculations.
I hope this article gave you some ideas you can use to improve your SaaS gross margin. Each SaaS business is unique, and there is no single right answer to any question. By experimenting, analyzing, and consulting with experts, you’ll find the solutions that work best for your business. Burkland’s SaaS experts have helped hundreds of successful SaaS startups. Contact us to request more information.