Gross Margin is the revenue left over after subtracting the cost of goods sold. It’s expressed as a percentage of total revenue, the amount of money you have to pay operating expenses and reinvest back into the business. Keeping an eye on your gross margin is critical for startups. Having a high gross margin means you’ll be able to grow faster because you have more money leftover to spend on growing the business.
Calculating Gross Margin
To calculate your gross margin, you need to first find your cost of goods sold (COGS). COGS includes any expenses necessary to provide your service or product to your customers (ie. hosting, support costs, third party integration fees). You can learn more about calculating COGS in this Academy article.
Once you know the monthly cost of goods sold, divide the difference between COGS and MRR by revenue to find your gross margin.
For example, if you sold $10 pens that cost $3 to make, package and ship, your gross margin on each pen is 70%.
Gross Margin = ($10-$3)/$10 = 70%
What’s a good Gross Margin for a SaaS company?
It’s basic math – if you want to make money, you need to sell your products for more than they cost to make. The more profit you make on each item, the better.
Generally, you want to increase your gross margin as you grow. A higher gross margin means each $1 of revenue is more valuable to your business.
Compare Company A with a 10% gross margin to their competitor Company B with an 80% gross margin. Company A will be able to reinvest 10 cents of every dollar of sales back into the company. Company B will have 80 cents on the dollar. That’s a huge advantage when it comes to marketing or R&D spending. It’s a big reason why a company with $10 million in revenue might be worth more than a company with $20 million in revenue.
Most VCs and SaaS experts suggest SaaS companies aim for a gross margin of around 80%.
Suggested Gross Margin targets:
- John Greathouse, GoToMeeting – over 80%
- Jason Lemkin, SaaStr – over 80%
- David Cummings, Pardot – 70-80%
- Tom Tunguz, VC Redpoint – 50 – 75% depending on lifecycle stage
Improving Gross Margin
To improve gross margin, you have two options: increase revenue or decrease COGS.
When you’re just starting out, your gross margin is likely to be lower because you’re not benefitting from economies of scale. As you acquire more customers, it becomes cheaper to support each one. As a result, your COGS decreases and your gross margin increases.
It can be tempting to continue cutting costs and increasing prices to grow your gross margin. But it’s a balancing act. Too little quality or a too expensive product might mean too few customers. A 50% gross margin on $1000 of revenue is still better than a 90% gross margin on $500 of revenue.