Before we get up-close and personal with Gross Margin, how it’s calculated, and why you should care about it, we need to come clean about Saa's dirty little accounting secret: it's not uncommon for SaaS companies to miscalculate Gross Margin (also known as Gross Profit Margin or GPM) and their Cost of Goods Sold (COGS).
These numbers are key metrics investors use to evaluate a company for funding and to determine valuation. Even more importantly, Gross Margin is like a grade for business leaders, showing the company's profitability. So, it’s important to get the calculation right!
It's an honest mistake, really. Accounting software isn’t typically designed to do proper cost accounting for SaaS companies – many programs are still tailored to traditional manufacturing companies (think raw materials, shipping charges, etc.)
In fact, there are two common scenarios we see as investors where SaaS companies are actually incorrectly booking their COGS and miscalculating gross margin. Let's explore both:
Scenario 1 – Company A
Company A’s gross margin is only 25%, which is far below our investment criteria of 50%. After further analysis, we found that Company A books all salaries and wage expenses, commissions, and bonuses as COGS, resulting in the low gross margin.
Company A is a pure SaaS company offering a B2B turnkey solution through monthly/annual subscriptions. For these types of companies, we typically consider hosting and server expenses (AWS Reserves, Microsoft Azure, etc.) as the main component of COGS. A typical Gross Profit Margin for a true SaaS business ranges from 70% to 95%, depending on the type of product, and it includes technology ecosystems. For example, you should think about the revenue share component of ecosystem partnerships as COGS if you are listed Salesforce’s AppExchange or similar platforms.
Scenario 2 – Company B
Company B’s gross margin, according to their accounting software, is 100%, which is, of course, impossible. For some reason, Company B doesn’t book any Cost of Goods Sold and allocates everything into operating expenses.
Company B offers professional services to help customers build tailored applications using their tech-enabled platform. This requires Company B to hire contractors or full-time developers to perform services. After looking further into their financials, we found that Company B should have allocated 70% of their total payroll expenses to Cost of Goods Sold because 70% of their developers’ time is spent helping customers build their apps. This reallocation drives down their gross margin from 100% to 55%.
Take a look at the SaaS industry standards for Gross Profit Margin below to see if you're in the right ball-park:
Pure SaaS companies, GPM is usually between 75% to 95%
Professional service SaaS companies are about 40% to 60%
Ready to learn how SaaS businesses should calculate Gross Margin?
Accurately Calculating Gross Margin for a SaaS Business
Gross Margin is a concept that can be tough to wrap your arms around in the SaaS and cloud technology world, so let's start with the basics:
What is Gross Margin?
At its core, Gross Margin is the percentage of revenue left after the cost of servicing that revenue.
Why is Gross Margin important?
Gross margin is representative of the amount of cash your business is generating to cover all of your operating expenses. Sales and Marketing, your office (if you have one), your big management salary — that’s all covered by Gross Margin.
Additionally, the higher your margin is, the more money you can reinvest back into your business to accelerate your overall growth trajectory. The more you can make and reinvest, the faster you’ll grow.
Before we get into the Gross Margin calculation, we need to clearly define the following components in our formula:
Revenue: The amount of money a company received or recognized by selling its products and services during a specific period, including discounts and deductions for returned merchandise.
Cost of Goods Sold (COGS) The direct costs attributable to the production of the goods sold by a company or the services provided. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good or service.
Gross Profit: a company’s revenue minus its Cost of Goods Sold. This number represents the profit a company makes after paying for the costs of making and selling their products or providing their services.
Gross Margin: a company’s Gross Margin is its Gross Profit described as a percentage of sales (revenue).