When you sell products you generate revenues. Subtracting the cost of goods sold (COGS) from that revenue will give you a numerical value called Gross Margin. For simplicity, the revenue you have after excluding COGS is called gross margin. It is a percentage or portion of total revenue that you have for operational expenditures and investments.
Keeping an eye on gross margin is important for every SaaS business, especially startups. If you estimated a nice gross margin at the start of your SaaS business, you have more chances of growing your business quickly. This is because you have more money than other startups to spend on growing your business and reinvesting in it. Some other factors also impact the growth of your business.
So, gross margin is an important metric for your SaaS company. In this article, we will cover details about this SaaS metric including the formula to calculate it, estimate its fair value, effective ways to enhance your gross margin, and some FAQs.
Formula to Estimate Gross Margin Accurately
The cost of goods sold or simply COGS is the first thing that you need to know to find out the gross margin of your company. COGS doesn’t include the cost only, all other maintenance and storage charges and 3rd party support expenses are also included in COGS.
Once you have the COGS value, you can use it to estimate the gross margin. To do so, you simply have to subtract it from the monthly recurring revenue or MRR and then divide it by the total revenue. The formula for gross margin will be:
Gross Margin Formula
Gross Margin % = Revenue-COGS ÷ Revenue = Gross Profit÷Revenue×100
The numerical value you will get by putting values in this formula will be a percentage representation of the gross margin.
Suppose you own a SaaS company selling pens across the globe. The cost and all additional charges for your top-selling product are $22. You managed to sell it for a good price of $100. Your gross margin for this product will be:
Gross Margin = ( $100 – $22) ÷ $100 = 78%
So, your gross margin percentage is 78% for that specific product. You can use the same formula to estimate the gross margin for every product.
How Gross Margin is Different From Net Margin?
Some people mistakenly considered gross margin and net margin as the same metrics. However, these two metrics greatly vary from each other.
Gross margin is the amount you have after excluding COGS only. While the net margin is the percentage of the total revenue you have after excluding COGS, operational charges, taxes, and all other expenses. Net margin gives you a more detailed insight into your profitability as all types of charges are excluded from it. The gross margin is not that comprehensive as only COGS is excluded from it.
“Acceptable” Gross Margin for SaaS Companies
Knowing a good gross margin value is not a complex thing, it’s basic mathematics. You all know to earn profit you have to sell your products at a price higher than their actual cost. The more profit you manage to make, the better it will be for your company.
As your business grows, you want your gross margin to improve as well. This is quite general as every single dollar matters a lot when we count it in terms of gross margin. Let’s understand this with the help of an example:
Suppose two SaaS companies, A and B, have a gross margin of 10% and 80% respectively. It means that company A has only 10 cents per dollar to manage operational expenses and reinvest. While company B has 80 cents per dollar for operational expenditures and investment.
Gross margin is a big reason a company worth $20 Million has more value than a company worth $50 Million.
Benchmarks for Gross Margin
You can achieve a good gross margin by practicing different methods. However, you first need to know what you can consider a good gross margin. According to business and industrial research, the average gross margin for SaaS companies is 73% and it’s an acceptable value.
However, 73% is not fixed for each company. Gross margin value may vary based on different factors. For example, enterprise companies have higher gross margins than non-enterprise SaaS companies.
Many experts believe that a gross margin of less than 80% is not acceptable for SaaS companies.
Effective Ways to Enhance Gross Margin
In general, there are two most effective ways to boost gross margin percentage for your SaaS company. These are:
- Reducing COGS
- Generating more revenues
When you start your SaaS company, your gross margin is usually low as you have fewer customers and not getting any benefits from the economies of scale. As you grow your business, your gross margin also improves because you manage to get more customers and can support them together which can reduce COGS.
Continuously lowering the quality of your products and selling them at higher prices is not going to help you improve your gross margin. In fact, it can result in losing your customers. You need to manage both these things together to improve gross margin. A 50% gross margin on a $20000 revenue is far better than an 80% revenue on a $10000 revenue.
How do you calculate gross margin?
To calculate gross margin, you need to find COGS. Then you can subtract it from MRR and provide it by the total revenue. You will get a numerical value that will be the gross margin. The formula for gross margin will be:
Gross Margin = (Total Revenue – COGS) / Total Revenue
What are some benchmarks for SaaS gross margins?
According to research reports, 73% is the average gross margin for SaaS companies. However, it may vary from. company to company. Business type and strategies hugely impact gross margin. For example, enterprise SaaS companies have higher gross margins than non-enterprise ones.
How can a SaaS company improve its gross margin?
To improve gross margin, you can reduce COFS and generate more revenues. COGS can be reduced to a certain limit only as you have to maintain quality as well. Therefore focus on engaging more customers, improving product quality, and introducing advanced features to generate more revenues and improve gross margin.
What is the difference between gross margin and net margin?
- Gross margin is the percentage profit you get by excluding COGS from MRR. On the other hand, net margin is the amount you have after excluding COGS, taxes, and all other charges. Net margin gives a more comprehensive view of the profit than gross margin.