SaaS Gross Margin: How to Calculate New and Recurring Profit Margins in SaaS

Why is gross margin important in SaaS?

SaaS gross margin tells you what percentage of revenue you will retain as gross profit when you sell a single unit (depending on your pricing strategy) of your product or service. While gross margin is expressed as a percentage. 

Revenue isn't the only measure of a company's success. The higher the gross margin, the more profitable and sustainable its business model becomes. SaaS companies are characterized by high gross margins in comparison to traditional businesses. The higher gross margins of SaaS businesses are made possible by their typically low cost of delivering services and are what makes them extremely attractive to investors.

David Cummings, CEO of Atlanta Ventures, puts it best: “Gross margin is a reflection of how valuable a dollar of revenue is to the business… Margin is one of the main reasons a $10 million revenue company can be more valuable than a $100 million revenue company.”

The gross margin of a SaaS business is composed of two separate components: The subscription margin and the service margin. The subscription margin is determined by the recurring revenue generated from product subscriptions, whereas the service margin is associated with the one-time revenue generated from offering professional services.

Both aspects of your SaaS gross margin play an important role in painting a valuation picture to investors. The overall gross margin level (that includes subscription and services margin) indicates whether your business is a SaaS (typically high gross margin) or a tech-enabled services company (lower gross margin and a different business model). 

With tech-enabled companies, services are a core business offering and integral in fueling the subscription side of the company. However, for true SaaS companies, services are not core to generating or maintaining subscriptions. Therefore, the subscription gross margin is more important in this case, with the services gross margin offering additional context to the overall picture, while remaining important nonetheless.

How to calculate gross margin for SaaS?

Here is the standard formula for gross margin:

While this formula works well enough for most industries, it doesn’t provide enough context for a SaaS company.

SaaS companies should break this formula down by categorizing their gross margins into services and subscription-based revenue streams. Note that in the SaaS context, employee salaries associated with product development and core services (such as DevOps, customer support, customer success, etc.) should also be filed under cost of goods sold (COGS) and not selling, general, and administrative expenses, since they’re part of the recurring expenses associated with the production process.

Calculating your subscription gross margin

The subscription gross margin is the most important metric for determining profitability for a SaaS business. It’s calculated by subtracting all recurring COGS associated with your SaaS subscriptions from your annual recurring revenue (ARR).

Knowing all the different expenses that should be categorized as COGS for a SaaS company can be a bit challenging compared to companies that sell physical products. For a SaaS company, COGS might include items like:

• Servers and hosting space for the software platform
• Licensing for third-party integrations
• Expenses related to onboarding new customers
• Customer support and account management
• Fees and commissions to various partners
• Employee salaries related to operating expenses, broken out by core function such as DevOps, customer support, and customer success

Note: 

• Expenses include salaries, wages, payroll taxes, employee benefits, contract labor, travel costs, training costs, software and tool costs.
• Any expenses that are billed back to the customer should be excluded (for e.g, travel) under COGS. 
• Any implementation costs (or services costs or professional services costs) for the software and tools used by these teams are excluded from COGS.
• Tool costs need to be amortized depending on if they're paid up-front, or in periodic installments, or ad-hoc based on usage.

Here is the formula for calculating subscription gross margin:

Here’s an example calculation of subscription gross margin for a company that has an ARR of $1,000,000 and COGS of $250,000:

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Calculating your services gross margin

The services gross margin is calculated by deducting the costs associated with providing one-time services from the additional revenue generated from those services in a given year.

Here is the formula you would use to calculate the services gross margin:

Here’s an example calculation for a SaaS company generates $50,000 in total revenue from providing one-time services while spending $40,000 in providing those services:

Accounting for customer success

There’s an ongoing debate about how you should account for customer success when calculating your SaaS gross margin. But there’s a simple way to look at it, according to Ben Murray, the SaaS CFO.

He recommends that if your customer success team is focused solely on retention, you should file any costs associated with it under COGS when calculating your subscription margin. However, if a considerable part of your customer success efforts is to generate referrals for new business, he says customer success should be filed under sales and marketing expenses. 

When looking at customer success costs, we recommend dividing costs based on objective (salaries of employees focused on retention versus expansion). Include retention costs to COGS and expansion to sales and marketing expenses.

What is a good gross margin for SaaS? 

According to the operations team at Software Equity Group, a good gross margin benchmark for SaaS is anything higher than 75 percent. If a SaaS company’s gross margin is lower than 70 percent, that is a red flag for potential investors.

Let's look at what Cummings has to say about how companies should think about their gross margin: “Early on, a startup shouldn’t worry too much about gross margin. It’s most important to find product-market fit and build a repeatable customer acquisition process.”

Further, he states that, “Over time, economies of scale will start to kick in and most SaaS companies will be able to achieve gross margins in the 70-80% range, if not higher. Gross margin, subscription revenue, and great growth opportunities all come together to drive high valuations for SaaS companies.”

When evaluating the profitability of a mature SaaS business, however, gross margin plays a vital role that trumps even revenue. 

‍Tomasz Tunguz, Managing Director at Redpoint Ventures, says, “Investors prize SaaS companies because providing SaaS service costs very little, and consequently these startups record very high gross margins.” However, he adds that, “The median gross margin for publicly traded SaaS companies expands from 50% in year four to just under 75% in year five… Hosting costs and customer success costs comprise the majority of SaaS Costs of Goods Sold (COGS).”

In summary, SaaS businesses shouldn’t worry too much about their gross margin early on, but most should reach a gross margin of at least 70% as the company matures. A gross margin of lower than 70% could be a concern for investors because it results in poor returns.

How to improve your gross margin

Unlike most other SaaS metrics, there’s no easy way to improve a low gross margin without radically altering your business model. This is because your gross margin is tied to the core economics of your business model, making it difficult to control. On top of that, recurring customers expect stability in their contracts, which can make it difficult to tweak your pricing model as needed.

Despite these challenges, given its impact on your company’s profitability, you should always be looking for ways to improve your gross margin. Here are a few things that might help you do that:

• Examine hosting costs: Optimize your cloud usage by examining your codebase and simplifying components that consume the highest resources. Negotiate with your service provider to reduce costs or spread them out over several years.
• Revise your implementation model: Outsource, charge more, or switch to hourly billing when implementing your product. This will boost your services gross margin.
• Examine your customer success motions: Compare your CSM headcount to established benchmarks. Automate more workflows to reduce workload.
• Create tiered customer service: Consider offering standard support for free and charging more for round-the-clock support, if your customers are open to the idea.
• Track profitability per customer: Change low margin customers’ pricing or upsell them to boost profitability.