Return to site

How to Use Gross Margin to Create Value for a SaaS Business

If you’re a SaaS company, knowing your gross margin metric is essential. There’s no way around that. Investors and buyers will look at your gross margin when deciding whether to invest, because it shows the scalability of the company. They want to know, for every dollar of revenue you make on a product, how much did it cost to actually produce and sell that item? That cost around your product is fundamental to your business and its scalability.

Why gross margin?

In general, the best business metrics are those that have a dual purpose, including gross margin. Gross margin gives you the insight to know how to create more value in your business, whether that’s for yourself or for an investor or buyer. You want to look at gross margin when you’re looking to sell or raise money, because that’s what an investor will look at.

But you also want to use it to help you make decisions about the scalability of your business. Dig deeper by splitting gross margin into different types of products. If you happen to have a subscription business and you have a separate product that offers customization, you can use gross margin to understand the scalability of each of those differently and make informed decisions. You could decide you need to up your price for the implementation work you do for your product to become viable, or the metric might indicate that you really want to grow your subscription business. Gross margin will tell you all those things.

How do you determine your gross margin?

Gross margin is what’s left of your revenue once you’ve deducted your cost of sales as a percentage of that revenue. For your overall gross margin, be clear about is what goes into cost of sales. In determining the cost of sales in a SaaS business, start with development operations (the cost for hosting your software or your cloud computing costs or, in some cases, amortization of capitalized R&D and royalties — the underlying operations to run your software). Then look at payroll for the portion of your customer success team that deals with retaining customers and servicing those customers as they’re using the software. If you have a customer success team that’s doing some sales, make sure you don’t include that sales work into cost of sales. That’s a common mistake.

Once you’ve got those components, you have your overall cost of sales, which you then deduct from revenue to determine your overall gross margin. Please keep in mind that you still want to split out gross margin by product, as the overall metric can hide a lot of differences. When you think about what it costs to provide customization services vs. software, you’ll find very different cost structures and, likely, different revenue streams — and different gross margins.

What’s a good target gross margin?

A good target for gross margin, especially for a SaaS business, is 70% or more. When you are starting a SaaS business, that can feel daunting. Even so, it would be a mistake not to find a way to get there, because you need to show scalability to create value. Gross margin is a key indicator of how scalable and how valuable a business will be in one year, two years, five years …

If you’re a SaaS business having trouble calculating or understanding your gross margin, please reach out to me. I’m happy to help.