Gross margin might seem like just another SaaS financial metric to keep an eye on – but it’s much more important than many other metrics. In fact, it’s one of the foundational pieces that determines whether your business model will scale or crumble under its own weight.
While entrepreneurs often focus on top-line growth and customer acquisition, understanding and optimizing gross margin can mean the difference between building a strong business and burning through capital at an unsustainable rate.
Yet, despite its importance, gross margin remains one of the most misunderstood and incorrectly calculated metrics in SaaS. What exactly counts as the cost of goods sold? Should you include customer support costs? How do third-party integrations factor in? These questions can confuse founders, often leading to misreported metrics and misguided strategic decisions.
This article aims to demystify the process of calculating your company’s gross margin. From breaking down the calculation components to exploring industry benchmarks and common pitfalls, we'll equip you with the knowledge to make informed decisions about your business's future.
SaaS Gross Margin is just one of many financial metrics that your company should be tracking. Discover other key metrics, and how to measure them, in this guide: A Comprehensive Guide to Financial Metrics for Tech Companies
Understanding Gross Margin in SaaS
Gross margin refers to the profit margin your company is left with after subtracting the cost of goods sold (COGS) from revenue, and is expressed as a percentage.
In a traditional business, calculating COGS is easy: it’s all of the components that go into making a physical product. In SaaS, it’s a little more complex, since what your company is selling to customers is software. SaaS COGS includes the direct costs of delivering the software to customers—such as cloud hosting, customer support, and third-party integrations—without factoring in expenses like sales, marketing, development, or general and administrative costs.
A healthy gross margin reflects operational efficiency, showing that the company retains enough revenue to reinvest in growth and innovation. Keeping gross margins high delivers greater profitability and sustainability, while also signaling your company’s ability to invest in growth. SaaS gross margin is also a critical signal to investors: it demonstrates that the business can scale without excessive increases in direct costs, which is essential for companies that rely on external capital to fuel their growth trajectory.
In short, the gross margin isn’t just about profitability—it’s about proving scalability and financial health to stakeholders.
Components of SaaS Gross Margin Calculation
The gross margin is calculated by subtracting the Cost of Goods Sold (COGS) from Revenue, dividing that result by Revenue, and expressing the result as a percentage. This formula reveals how much of each dollar of earned revenue remains in the business after covering the direct costs associated with selling the product.
Consider a SaaS company that generates $1 million in annual recurring revenue and has $250,000 in costs directly related to delivering their software. Their gross margin calculation would be:
($1,000,000 - $250,000) / $1,000,000 = 75%
Defining which expenses count as COGS can sometimes lead to confusion. While gross margin aims to measure operational efficiency, different companies might include—or exclude—various expenses.
Let’s break down the main components of revenue and COGS specific to SaaS businesses.
Revenue
In SaaS companies, revenue primarily comes from subscription fees, which represent the recurring income from customers who pay to access the software.
However, revenue might also include other sources, such as add-on features, integrations, implementation, or premium support packages. These sources can enhance the gross margin if their costs remain low relative to the additional revenue generated.
Cost of Goods Sold (COGS)
COGS includes the direct costs necessary to provide the software to customers, excluding indirect expenses like marketing or administrative overhead. In a SaaS context, typical COGS items include:
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- Hosting Costs: Expenses for cloud services or data centers that host the software, ensuring customers can access it reliably
- Customer Support: Salaries and expenses for support teams who handle customer inquiries or technical issues, as they’re directly tied to maintaining the service
- Third-Party Software Licenses: If the software relies on external tools, APIs, or other licensed technologies to function, those costs are considered part of COGS
- Other Direct Costs: Any additional infrastructure, security, or compliance costs needed to deliver the product
Common Pitfalls in SaaS Gross Margin Calculation
While calculating the gross margin might seem straightforward, companies often encounter pitfalls that can distort this key metric.
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- Misclassifying Expenses as COGS: One frequent mistake is misclassifying certain expenses, which can inflate or deflate the gross margin. For example, companies sometimes include marketing or administrative expenses within COGS, even though these are indirect costs and don’t directly contribute to product delivery. Only expenses tied to the actual delivery of the service, like hosting or customer support, should be included.
- Overlooking Certain Direct Costs: Some businesses fail to account for all direct costs of delivering their SaaS product. For instance, they might overlook third-party licensing fees or infrastructure costs necessary to provide the software reliably. These costs belong in COGS, and failing to include them results in an artificially high gross margin that doesn’t reflect the true cost structure. We often find that companies exclude payroll taxes and the benefits their customer support team includes from their COGS.
- Inconsistent Time Periods for Calculation: Consistency in timing is essential for an accurate gross margin calculation. Using revenue and COGS from different periods—for instance, calculating revenue annually but COGS monthly—creates a skewed view of profitability. Both revenue and COGS should cover the same period to give an accurate
Interpreting SaaS Gross Margin
In the SaaS industry, gross margin is a key indicator of financial health and operational efficiency. But what qualifies as a "good" gross margin?
While it varies, industry benchmarks suggest that most established SaaS companies aim for gross margins between 70% and 90%. Early-stage companies, however, may have lower gross margins as they build infrastructure, scale operations, and refine their product and pricing before having economies of scale in place.
As a SaaS company grows, the gross margin should ideally improve, reflecting economies of scale and a streamlined cost structure. A higher gross margin often signals a mature SaaS company with efficient processes and optimized COGS, meaning it can deliver services at relatively low incremental costs.
Tracking this metric over time can provide valuable insights, helping founders and executives gauge progress toward profitability and long-term stability.
Reimagine Your Financial Reporting with G-Squared Partners
As we’ve discussed, gross margin is a major indicator of your SaaS company's operational efficiency and scaling potential. From properly categorizing COGS to maintaining consistent calculation periods, every detail matters in painting an accurate picture of your business's health.
But, building robust financial reporting systems to track the gross margin and other critical metrics can be challenging.
This is where G-Squared Partners can transform your financial operations. Our team helps companies build the systems and processes to craft unique financial solutions tailored to your business’s operational goals.
Schedule a call with G-Squared Partners today to learn how we can help you build the strong financial foundation your SaaS company needs to thrive.
