November 22, 2019

Metric Deep Dive: Gross Margin

What is Gross Margin

Gross Margin is how much money is left over from revenue after deducting the Cost of Goods Sold (COGS). Expressed as a % of total revenue, it’s the revenue left for you to pay operating expenses to keep your doors open and money to reinvest back into the business. It’s used to determine the financial health of a company.

Formula: Gross Margin (%) = (Revenue - COGS) ÷ Revenue

Items Needed to Calculate Gross Margin

Revenue: Total sales

COGS: COGS is the group of expenses that support all of your revenue streams

Gross Margin copy.png

Why is Gross Margin Important

Gross Margin can be confusing for people, but in simple terms it represents the revenue leftover after the cost of earning that revenue is subtracted.

The better your gross margin is the more you have to put back into your business to accelerate growth (e.g. Sales & Marketing spend, new product hires, etc.).

Gross Margin Benchmarks for SaaS:

Now that you've calculated your Gross Margin, what % should you be shooting for?

Depends on who you ask:

So, maybe it doesn’t depend on who you ask - shoot for 80%

How to Improve Gross Margin

Sell more for less and keep people longer. What that means is the ways to improve gross margin are to increase revenue and decrease COGS.

Revenue:

  • Decrease length of trial if you have one. There is no standard trial length, but it should be enough time for your software to become a part of a customer’s routine and business. Not so long however, that you're letting someone who would be a paying customer coast on free. Start trying shorter trials and watch for when conversion decreases, that’s your ideal trial length.
  • Make understanding your pricing structure easier. Pricing pages are usually the most visited page of any SaaS company. Make sure your pricing page includes all costs and exactly what the customer will get. Confusion on packages and pricing tiers can be a reason someone hesitates to do a trial. Be easy to buy from.
  • Offer an annual payment option - with this, you keep customers for 1 year and get cash to invest back in the business. Proof below from Tom Tunguz. The only difference is when payment is collected. All hold the same revenue, have same growth and burn.
Tomasz - annual payment .png
  • Increase conversion rates - Review your content marketing efforts and drip campaigns. Create content that is right for your users and remember that the effort to provide relevant content isn't only a lead strategy, it’s a retention play as well.
  • Case studies / testimonials - Build social proof, make sure your glowing reviews and business impacts are plastered everywhere.
  • Referral Program - Ask and you shall receive. Make it worth it for your clients to want to send their friends to you. Offer a bonus (which would fall under COGS) and make it simple for someone to refer. Whether it be a form or referral link, don't make your clients work too hard to do you a favor.

COGS:

The other areas have a lot more wiggle room for improvement. The ways to improve COGS are to operate lean. Review all fees and see where you can negotiate, cut costs that aren't 100% necessary, and ensure your CS team is as efficient as possible.

If you don’t have a CS team, be conscious about how you’re calculating your sales and marketing costs as some of those expenses should be in your COGS and it will affect your gross margin.

Investor Perspective on COGS Sales and Marketing Expenses:

“Ask anyone in the software industry and you’ll get the same response: software companies have approximately 80% gross margins. What if we told you software costs of goods sold (COGS) aren’t always as they appear?

The answer lies in sales & marketing expense. Similar to CapEx, Growth Street breaks down S&M expense into two categories: (1) Maintenance S&M (i.e., the cost to replace churned customers) and (2) Growth S&M (i.e., the cost to grow your customer base). Call us crazy, but we put Maintenance S&M in COGS.

If you want to command a premium valuation, get churn under control and reduce your Maintenance S&M. Build your growth budget today!”

- Steve Wolfe, Co-Founder of Growth Street Partners

Full article here.

Final Thoughts

  • There is a slight difference:

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 delivering 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 can be calculated for different areas. You should be tracking revenue streams separately, i.e. subscription revenue separately from services revenue.
  • Growth is not as representative of the health of your company as your gross margin is.


“Growth solves many problems at startups, unit economics is not one of them.”

- David Sacks of Craft Ventures

Full article here, it’s worth the read!

TL;DR: Gross Margin is how much money your business makes once direct costs are deducted. 80% is the number to shoot for, if you’re not there the ways to improve are to increase revenue while reducing Cost of Goods Sold (COGS), but then again, if you’re not at 80%, it might be helpful to scroll back up and read about how to improve your margin.

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