How to Calculate Your SaaS Gross Margin : Free Cash Flow (2024)

If you are a SaaS business, then you must read this article for the following reasons:

• Understand why determining Gross Margin is important for your business
• How to calculate SaaS Gross Margin?
• How can your SaaS business improve this financial metric?

Gross margin is a traditional financial metric that many sectors track, including traditional software, to understand their business performance. SaaS businesses also keep a track of this financial metric to know their current business performance, longer-term profitability, and cash flow.

Note that the primary difference between a traditional software business and a SaaS business is that the SaaS Business provides a service to its customers. To deliver such services, a SaaS business needs to invest in hosting servers, IT security, data management, software licenses, and round-the-clock operations.

Besides this, a SaaS business bears the risk of data getting lost or servers going down as they are responsible for IT and data security.

On the other hand, a traditional software business sells software licenses to its customers. In return, the customers install these licenses on their local servers. In other words, once a traditional software license business sells a software license to the customer, such a business also transfers the operational IT responsibilities to the customer’s in-house IT department.

Thus, it becomes essential for SaaS businesses to calculate their Gross Margins. This is because such a financial metric will help SaaS businesses to understand whether they have the ability to serve their customers at a nominal cost.

So, let’s understand what is SaaS Gross Margin is, how to calculate this SaaS financial metric, and why is it important for SaaS businesses to track Gross Margins?

What is SaaS Gross Margin?

SaaS gross margin is one of the key SaaS metrics that refers to the percentage of revenue left after taking into account the cost of servicing such revenue. The cost of servicing the revenue generated as a result of delivering SaaS services to customers may include costs like costs for hosting, onboarding customers, customer service costs, and third-party costs.

Thus, the above components demonstrate that different businesses may have different gross margin profiles. These gross margin profiles may be driven by infrastructure costs, customer support costs, services vs software split, and many other factors.

For instance, a company with 85% gross margins has enhanced gross profit or bottom line numbers than a business with 60% gross margins. Gross Margins when combined with other metrics like magic numbers can help a SaaS business in determining the efficiency of its sales.

SaaS Gross Margin Formula

Gross margins are calculated as the difference between subscription revenue and costs (including application hosting costs, etc.) over the subscription revenue.

The following is the SaaS Gross Margin Formula:

Gross Margin = (Subscription revenue – subscription COGS) / Subscription revenue

I. Subscription Revenue

The subscription revenue refers to the income that a SaaS business generates from customers in the form of recurring fees paid at regular intervals. These can be weekly, monthly, or annual payments.

Thus, customers either subscribe to a product, content, or service, with an expectation that they will continue their subscription. This puts the responsibility on the company to continue providing services, products, or content to satisfy the customer’s expectations.

Subscription billing and revenue business models enable customers to pay for products or services based on what they consume (pay-as-you-go). Further, such business models help customers scale their service usage up or down based on business needs, and automatically renew their subscriptions.

Thus, we can say that a business is all set to generate subscription revenue if it is able to develop an offering that meets this ongoing expectation of its customers. Let’s consider amazon’s example to have a better understanding of the concept.

Amazon Inc generates subscription revenue in the form of fees associated with Amazon Prime memberships. Prime memberships provide customers access to a suite of benefits that represent a single stand-ready obligation. In return, the customers or subscribers pay the subscription fee either at the time of or in advance of delivering the services. Revenue from such arrangements is recognized over the subscription period.

Further, it also generates subscription revenue by giving its customers access to content. The content may include audiobooks, digital video, digital music, e-books, and other non-AWS subscription services.

These revenues can be determined using a few of the revenue-based key SaaS metrics like MRR, ARR, and ARPU.

II. Subscription COGS

The Cost of Goods Sold in the case of a SaaS business may include the following costs.

i. Application Hosting Costs

The application hosting costs may include costs for the cloud infrastructure, application migration, proactive monitoring, automation, and management of the cloud server.

ii. Customer Onboarding Costs

There is a need on the part of SaaS businesses to ensure customer success with the SaaS product. Such success begins from the customer’s initial onboarding experience and continues until the contract renewal by the customer.

Thus, a SaaS business while undertaking customer onboarding primarily focuses on coordinating activities between a host of teams to ensure that customers adopt the SaaS product smoothly. These teams include deployment, migration, and training teams.

This means that customer onboarding is primarily concerned with coordinating onboarding activities between the customers and SaaS providers. The onboarding staff needed in a SaaS business varies widely.

It depends on the degree of self-service inherent to the product, the need for data import, and the need for integration with other systems. The onboarding staff needed also depends on the sales growth rates, customer training needs, rollout schedules, and overall SaaS product complexity.

Note that such costs help a SaaS business to make customer onboarding much faster. Furthermore, such costs make the onboarding process quite simple relative to the one in the case of the on-premise software product.

As a result, the time to onboard a customer in the case of a SaaS product is just a few days or weeks relative to a few months in the case of an on-premise software product.

iii. Customer Service Costs

SaaS businesses have to onboard operations teams in order to provide customer support services. This team is responsible for technical assistance related to cloud infrastructure, policies, procedures, and post-sales support.

Thus, a SaaS business needs to invest money in establishing a separate cloud operations team for cloud infrastructure issues. Customer support managers focus on ensuring customers were deriving as much value as possible from the SaaS offering.

Furthermore, the customer support team also ensures that they are consistently exploring opportunities to sell more licenses to customers and managing the overall customer relationship.

iv. R&D Amortized Costs vs Capitalized Costs

This is the expense needed to develop the first launch-ready product and for ongoing development of new features, new products, and bug fixing. Thus, it includes the cost of hiring developers to work on building the SaaS product.

Again, the development expense varies as it depends on a host of factors that originate from the product itself. These factors include product complexity, the completeness of features built into the initial product, the amount of money available to fund the initial development, etc.

In addition to investing funds to develop the first launch-ready product, a SaaS business also has to invest funds for incremental product development.

The ongoing product development together with a regular product update release cycle is the foundation of SaaS businesses. Such a cost helps them in bringing new innovations, features, and bug fixes easily and rapidly, with minimal disruption or expense to their customers.

Typically, the incremental product expense of a SaaS business ranges between 5% to 55% of the total expense. This means that the average incremental product development expense ranges from 5% to 40% of total costs.

v. Third-Party Fees Such As Software License and Data Fee

This is an expense that SaaS providers have to incur in case they are using the technologies of any other providers to deliver the SaaS solution.

SaaS Gross Margin Example

The following table showcases the Income Statement of Salesforce Inc. for 3 years. Let’s calculate SaaS Gross Margin using Salesforce’s financials.

Using the above SaaS Gross Margin Formula:

Gross Margin = (Subscription revenue – subscription COGS) / Subscription revenue

Accordingly the Gross Margins for Salesforce Inc for the years 2021, 2020, and 2019 are as follows:

Gross Margin for 2021 = ($21,252 – $5,438 )/$19,976 = 74.41%

Gross Margin for 2020 = ($17,098 – $4,235 )/$17,098 = 75.23%

Gross Margin for 2019 = ($13,282 – $3,451)/$13,282 = 74.01%

Thus, the Gross Margin of a SaaS business indicates its ability to service its current customers at a nominal cost. It also indicates how valuable a dollar of revenue is to the business.

The gross margin of a SaaS business indicates how valuable a dollar of revenue is to the business. Say, for instance, e-commerce business has a 20% Gross Margin whereas a SaaS business like Salesforce has a Gross margin of 75% in the year 2021.

This means that every additional dollar of revenue for the SaaS business is equivalent to 3.75 dollars in the eCommerce business due to the much higher contribution margin.

What is a Good Gross Margin in SaaS?

As per a survey, SaaS Gross Margin Benchmarks typically ranged from 40% to 70%. It was observed that simpler products like cloud security or secure cloud storage and multitenant environments had higher gross margins. Note that the top-performing SaaS products had average SaaS gross margins of 76%.

Also, in terms of developing the SaaS product, the costs to develop the first minimally viable SaaS product exceeded the planned budget of the business. This demonstrated that complex SaaS products have to incur higher development costs because more architecting may be needed.

Also, SaaS products generate lower-than-expected revenues, specifically in the early years for all the firms. The reasons behind generating lower top-line numbers in the case of SaaS products depend upon how long a business has been selling SaaS solutions.

In addition to this, limited geographic availability and feature gaps in SaaS products are among the other important factors responsible for lower SaaS sales. Even competition from other SaaS vendors is one of the other important reasons for lower-than-expected revenues.

This means that SaaS providers must ensure that they have sufficient development resources so that their initial SaaS products have enough features. This would satisfy their customer needs as well as help them in bringing their products to the market in a timely manner.

Note that SaaS businesses should not focus too much on improvising the Gross Margin numbers during the initial days of its startup. At such a time, it is important for business owners to look for product/market fit and build a recurring customer acquisition process.

Over time, economies of scale will start to kick in. Hence, 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.

Over the same period, the average market capitalization of these firms surged nearly 300%.

Gross Margin SaaS Calculation

Forrester Research created a composite Independent Software Vendor (ISV) to demonstrate the quantifiable revenues and costs of pursuing a SaaS strategy. The composite ISV on-premises software products. But now it wants to pursue a SaaS strategy in order to respond to competition.

Shifting to a SaaS strategy would mean a larger upfront investment but would result in lower operating costs over time.

The following section showcases the Gross Margin calculation and calculation of various other components if the composite ISV adopts a SaaS-based model.

How To Improve Gross Margin?

Note that low gross margins can indicate a host of issues. These may include

• A poorly architected product requiring significant effort to run;
• Expensive reliance on third-party components;
• A complex environment requiring large numbers of support staff

This means efficiency in SaaS business operations can result in very high profitability from new customer wins. That’s because the incremental gross margins contribute almost 100% to the bottom line. Furthermore, an efficient set of operations gives a growing SaaS business more options on where to invest and develop its business.

Here are some of the key strategies that can help a SaaS business in improving or optimizing its Gross Margins.

1. Focus On Retaining Customers

The biggest asset for a SaaS business is its customers. Therefore, it is extremely important for a SaaS business to focus on retaining its existing customer base. Further, it should also make efforts to expand the value delivered to the existing customers and make it their top priority.

This means it is extremely important for a SaaS business to ensure customer success in order to enhance its Gross Margins. It must invest in customer-centric innovation, develop broader and deeper solutions strategies, and implement pricing strategies as well as discipline.

Note that SaaS businesses can take leverage of the customer data. Such data can help them to know insights on the best ways to deliver to the existing customers. Besides this, SaaS businesses also need to develop more efficient ways of selling SaaS products and services to existing customers.

For instance, a SaaS business can have an in-house sales team instead of the expensive field forces. Besides this, they can even pay their channel partners quite well based on the value they create.

2. Technology Team Productivity

The technology team of a SaaS business faces new challenges as a SaaS business matures. Such teams have to balance the demands of delivering new features with those of product maintenance. In addition to this, they also have to make smart choices when it comes to determining the SaaS portfolio for the business.

On top of that, the technology teams also have to deal with technical debt that often slows them down. Thus, it is important for a SaaS business to clearly chart out the priorities of the technology teams. In addition to this, a SaaS business must also get clarity on how much time the technology team is spending to align its priorities.

Note that streamlining roles, supporting critical developers, and clarifying website strategy can refocus the best resources on building what is important in the most cost-effective way.

3. Operational Efficiency

Complexity in processes and systems is a major factor that hinders the functioning, or the operational efficiency of a mature SaaS business. Note that the processes and systems within a SaaS business reflect the choices it has made in the past as new products, customers, and countries are added to the business mix, along with new acquisitions.

Continuous streamlining and process automation can help raise efficiency. This can include reducing the number of SKUs and price meters, streamlining the number of legal entities and channel types, clarifying the roles of operational teams and removing duplication, and eliminating layers of management.