Updated May 17, 2018 by Jie Ji, Underwriting Manager
Back in 2016, we wrote the original post below about gross margin, how it’s calculated, and why it’s important to your business. Since then, we’ve come across two common scenarios where SaaS companies miscalculate Gross Margin (also known as Gross Profit Margin or GPM) and Cost of Goods Sold (COGS). These numbers are key metrics investors use to evaluate a company for funding, so it’s important to calculate them correctly. Here’s what we’ve learned.
Some accounting software isn’t really designed to do solid cost accounting for SaaS companies because the programs are still tailored to traditional manufacturing companies (think raw materials, shipping charges, etc.) Here are two common scenarios we’ve seen with SaaS companies incorrectly booking their COGS.
Example 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. Typical Gross Profit Margin for a true SaaS business ranges from 70% to 95%, depending on the type of product, and it includes 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.
Example 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%.
I hope these two examples give you some insight into how we look at Cost of Goods Sold and Gross Margin here at Lighter Capital. As a rule, for pure SaaS companies, GPM is usually between 75% to 95% and about 40% to 60% for professional service companies. Check out the original post below for more info on how to calculate Gross Margin.
Originally published Feb. 18, 2016
Accurately calculating gross margin for your SaaS business
Gross Margin is a concept that can be tough to wrap your arms around if you’re running a SaaS business. At its core, gross margin is the percentage of revenue left after the cost of servicing that revenue.
Why should you care about gross margin? Easy. 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, 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.
Let’s break it down, starting with a few definitions:
Revenues: 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.
NOTE: Gross Profit is a derivative of the above Revenues and COGS, it is vital that these two numbers are calculated properly and the appropriate costs are recognized in COGS to determine the correct gross profit.
Gross Profit: a company’s revenues 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 (Revenues).Gross Margin (%)=
Revenue – Cost of Goods Sold
Calculating Gross Margin: An example
ABC Company buys Widgets for $1, and can sell each Widget for $10. On each sale, they make $9. The gross margin for this company is 90%. On the other hand, XYZ Company buys Thingies for $5, and sells each Thingy for $10 making $5 in profit on each sale.ABC CompanyXYZ CompanySale (One Unit)$10$10Cost of Goods Sold$1$5Gross Profit$9$5Gross Margin90%50%
Assuming all else is equal, ABC Company has a higher margin on their sale (90% vs 50%), we can see they retain an additional $4 per unit sold. Although the above example is very simplistic, it makes understanding Gross Margin very easy.
However, when it comes to working with SaaS and other software companies, getting the accurate gross margin number can be a little more difficult because you need to properly account for the Cost of Goods Sold. When working with a software company, personally I think it is easier to not think of them as COGS, but cost of revenue. Think about it this way: what are the unavoidable expenses you’ll incur to create revenue? For a SaaS company this will include expenses such as hosting and customer support, but also third-party license agreements, data fees and other costs. This is a great way to determine whether or not something is a COGs for a software company.
Let’s look at an example for the same two companies, but as if they were software companies. Both companies are currently at $100,000 MRR. ABC Company has five Customer Support representatives which cost $4,000 each per month. Each employee has licenses to numerous software products they need to offer effective support to their customers. This costs ABC company $1,000 per month per employee. Lastly, ABC Company has hosting expenses of approximately $1,000 per month.
XYZ Company does not need any Customer Support representatives for their product. As they do not need any support representatives, they also do not need any licensing for the employees which they do not have. XYZ company generally sees their hosting expense around $5,000 per month.ABC CompanyXYZ CompanySale (One Unit)$100,000$100,000Cost of Goods SoldSupport and Maintenance$20,000$-Hosting$1,000$5,000Licensing$5,000$-Gross Profit$74,000$95,000Gross Margin74%95%
In this scenario, we can see that XYZ Company had better margins and is able to retain more dollars of each sale compared to ABC Company. The largest factor driving this variance is the cost of the Customer Support Representatives. This is very accurate of what we frequently see at other companies — staffing is often the top expense.
Learn from the big guys: How other SaaS & cloud companies manage their accounting
If you aren’t sure how to account for a certain expense or recognize revenue, it can be helpful to look at public tech companies (especially cloud businesses) to see how they report their financials. Some great examples are Salesforce.com, Box, and Zendesk. It’s particularly worthwhile to explore financial statements, earnings releases and Management Discussion and Analysis (MD&A) statements to see how tech companies account for various aspects of their business and clarify information for investors. These companies spend a lot of money having their financials prepared by some of the best accounting firms in the world, so we can all learn a lot from them.
Download our free 8 SaaS Metrics That Matter Guide to learn about the core metrics used to measure SaaS company success. Using simple examples, we’ll show you how to calculate each metric, and describe why specific indicators are important to investors.