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Tracking a business’s revenue sounds straightforward, but there are often plenty of moving pieces and it’s important to understand how all the puzzle pieces fit together so you can better understand your profit, costs, and cash flow.
If you want to have a firm grasp on how much your business is actually making— and your scalability potential after the costs involved— then you’ll want to understand those metrics.
An important one to track is your gross margin.
Understanding Gross Margin
Gross Margin is expressed as a percentage, and it tells you how much revenue you retain after considering your other costs. The higher a company’s gross margin is, the more capital they retain after costs. This means more profit, and it can allow for brands to scale more aggressively.
“Good” gross margins vary significantly by industry.
The average gross profit margin for auto manufacturers, for example, is only 11.1%, while it’s closer to 44.6% for non-alcoholic beverages.
Why Gross Margin Matters
Your gross margin matters because it directly impacts how much profit you walk away with at the end of the day.
It’s great to make $500,000 in sales… but if you’re looking at $495,000 in costs, there’s not exactly much left over for scalability.
The higher your gross margin percentage is, the more room you have in your budget. Cash flow improves, profit increases significantly, and there’s plenty of room in the budget to invest in growing the company.
Whether you want to grow your team, invest in new training, develop new products, or build your customer base, it’s always good to have room in the budget to do that. Plus, when there’s extra left over, there’s more opportunity for bonuses and pay raises for the team and executives that worked hard to build your product to begin with.
A low gross margin percentage can spell trouble for a SaaS business, so it’s best to avoid when possible.
How to Calculate Gross Margin
Calculating your gross margin does involve several different steps and formulas, but the good news is they’re all relatively straightforward, and having that gross margin information is well worth the effort.
Let’s walk step by step through the entire process of calculating gross margin.
1. Calculate Cost of Goods Sold (COGS)
First, you need to calculate your COGS.
Your COGS includes any direct costs of producing and delivering the products you sell.
For SaaS businesses, common costs included in this metric may be:
- Software developing and engineering
- Q&A testing
- Marketing and sales teams
- App development
- Payment processing fees
- Online servers
You can calculate COGS by adding up all of your expenses within a set time period.
2. Understand Monthly Recurring Revenue vs. Revenue
One thing that trips up some SaaS businesses is understanding the difference between monthly recurring revenue (MRR) and plain old revenue.
Monthly recurring revenue tells you how much revenue your business generates monthly. For subscription-based businesses, this number will be calculated by the number of active, paying subscriptions and the value of those subscriptions.
Your revenue, on the other hand, is any income generated by the business. It does not necessarily have to be recurring revenue. You may, for example, want to compare revenue (which includes all purchases in that time period) to monthly recurring revenue, which features active subscriptions with predictable income.
(As a note: Make sure that your subscription analytics platform is only calculating MRR when using active customers whose subscriptions aren’t paused or delinquent— not all platforms do this, but here at Baremetrics, it’s a priority.)
3. Calculate Gross Margin
Once you’re familiar with the monthly cost of goods sold, you can calculate your gross margin by using this formula:
(MRR - COGS) / MRR = Gross margin %
What is the difference between gross margin and net margin?
Gross margin measures the percentage of revenue that remains after deducting the cost of goods sold (COGS), while net margin measures the percentage of revenue that remains after all expenses, including operating expenses and taxes, have been deducted.
Net margin, on the other hand is a more comprehensive measure of profitability, as it takes into account all expenses, while gross margin only considers COGS.
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.
SaaS Gross Margin Benchmarks
Industry research indicates that the median gross margin for SaaS companies is around 73%, although this figure can vary significantly depending on the nature of the business. As an example, enterprise SaaS companies tend to have higher gross margins compared to non-enterprise companies.
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
How to Improve Gross Margin
Most businesses want to improve (read: raise) their gross margin percentage. The higher it is, the more revenue you keep.
While the “how” can vary from business to business, these tips are a good bet regardless of company size or SaaS industry:
- Look at scaling. In many cases, scaling can lead to “bulk” discounts that can actually lower your COGS.
- Consider your current pricing structure. Is your pricing currently high enough for you to make the profit that you need to? And does your pricing model itself work for you, or would you be better off with add-on products instead of an all-in-one suite to maximize profit?
- Find variable costs impacting your COGS. You may realize that making a few quick changes (like outsourcing some work to third-party vendors or switching server companies) can drastically lower costs and increase your gross margin.
- Ensure you’re accounting for all costs in COGS. It’s easy for SaaS brands to leave out costs they forget are lumped into the COGS, including app development or customer support systems. In order to improve your gross margin, you need to have an accurate understanding of what you’re currently working with, first.
Strong analytics are essential for understanding everything about your revenue— including gross margin. See how Baremetrics can help you track your revenue to maximize your gross margin and your profit.
