Margin metrics are obviously important in any business, not just a SaaS business, and hold significant importance for several reasons.
Firstly, margin metrics, such as Gross margin and Operating Margin, provide insights into the financial profitability of a SaaS business. They help assess the efficiency of cost management, pricing strategies, and revenue generation. Monitoring margin metrics allows companies to understand their financial health, identify areas for improvement, and make informed decisions to enhance profitability.
Furthermore, margin metrics are critical for determining the long-term viability and sustainability of a SaaS business. By analysing margins, companies can assess whether their pricing structure and cost management practices are generating sufficient profits to cover expenses, invest in growth initiatives, and ensure business continuity. Sustainable margins are essential for the overall health and resilience of the company.
What’s more, investors and stakeholders closely scrutinize margin metrics to evaluate the financial performance and potential of a SaaS business. Healthy margin levels indicate that the company can generate consistent profits and efficiently manage costs. Positive margin trends instil confidence in investors and stakeholders, increasing their trust in the business and its ability to deliver long-term value.
And also, margin metrics help SaaS businesses evaluate their pricing strategies and overall monetization approach. By understanding their gross margin and cost structure, companies can assess whether their pricing adequately covers expenses and generates sufficient profit margins. Margin analysis allows businesses to optimize their pricing models, explore upselling or cross-selling opportunities, and adjust pricing tiers to maximize revenue while maintaining profitability.
Last but not least, margin metrics enable companies to identify inefficiencies and optimize costs. Analysing margins helps businesses evaluate the cost of goods sold (COGS), infrastructure expenses, customer acquisition costs (CAC), and other operational expenses. By identifying areas of high costs or low margins, businesses can implement strategies to streamline operations, negotiate better vendor contracts, and identify opportunities for cost optimization.
Margin metrics allow SaaS businesses to compare their financial performance with industry benchmarks and competitors. Analysing gross margin, operating margin, and net margin provides insights into the company’s relative profitability and cost efficiency. This information helps businesses evaluate their competitive positioning, identify areas of improvement, and benchmark their financial performance against industry peers.
Let’s now explore the key margin metrics of a SaaS business.
Gross margin tells us what the “top half” of its income statement is. Or put different, gross margin is the variable profit contributed by one or many revenue streams after covering the direct operating expenses of those revenue streams. It tells us if our revenue streams are profitable and if that profit is being “dropped” to the bottom line. It tells a business if it has revenue or cost structure issues and is key to understand the current and the expected financial profile of a SaaS business. It tells us what is working and what is not working in a business, and thus what to focus on.
As a financial metric, gross margin measures the profitability of a SaaS business by evaluating the relationship between revenue and the direct costs associated with delivering the product or service. It represents the percentage of revenue remaining after subtracting the cost of goods sold (COGS). Gross margin provides insights into the company’s ability to cover its direct costs and generate profit from its core operations.
The key to calculating gross margin is having a proper SaaS income statement. To remind the reader, a proper SaaS income statement shows a clear picture of performance, includes bookings information, is organized by departments (functions, cost centres), revenue stream, expense category, shows gross margin as well as EBITDA and operating margin, allows for easy period comparisons and trend analysis and can serve as a starting point for forecasting and budgeting.
Cost in individual departments should be fully burdened, which is to say they should also include allocations of shared cost such as the use of business’ facilities or depreciation of shared assets. In addition, it is important that each department (or function) has its unique departmental leader (or functional head) who oversees the activities of the department and has the responsibility for its financial performance.
What is essential in calculating gross margin is having a proper break-down of each major revenue stream, showing subscriptions, services, hardware sales, etc. In the overall revenue mix, it is also of utmost importance to identify which portion of revenue is recurring (or contracted MRR/ARR), and which is non-recurring (or variable, such as transaction, usage, processing, services).
If your business has several products that generate revenue you want to have detailed of revenue by product which could look as this. As was explained in the opening chapter of this book, it is possible and indeed advisable to use profit centres to organize business’ revenues and one way of organizing it could be around products. If you provide discounts to customers these should not show as a deduction to your overall revenue streams but should be incorporated into your core revenue numbers showing pocketed (or net) revenues.
Cost of goods sold (or “COGS”) in a SaaS business of obviously essential if one wants to correctly calculate the gross margin. And the “good” COGS come from having a proper structure of cost centres that show SaaS variable expenses.
The typical cost elements of COGS include:
CS belongs in COGS
CS belongs in Sales
To calculate the gross margin in a SaaS business, follow these steps:
The formula for gross margin is as follows:
Here’s why gross margin is important in a SaaS business:
It is significant to note that while in a properly organized SaaS P&L it is easy to establish recurring revenue it is a bit more complicated to establish the portion of COGS that supports recurring revenue. This is because variable expenses of a SaaS business typically support both recurring and non-recurring revenue streams. For this reason, it is important to normalize COGS, and identify the portion of COGS that supports recurring revenue. This can be done by analysing the direct costs associated with delivering the service to customers. Here’s a step-by-step approach to help you identify those costs:
For example, costs related to hosting infrastructure, technical operations, and customer support are typically directly attributable to recurring revenue, as they are necessary for maintaining the service and supporting active customers.
Only with such normalization can the recurring gross margin calculation produce a reliable number.
Here is how the margins of Hubspot, a very popular CRM software provider, have evolved:
An alternative way of benchmarking margins is to look at them depending on where the SaaS business is in terms of recent funding:
Not all SaaS businesses are equal, particularly as they may be in a different stage of growth and life. This is why it is essential to benchmark margins depending on the size of the top line.
An alternative way of benchmarking margins is to look at them depending on where the SaaS business is in terms of recent funding:
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