How to Correctly Calculate your SaaS Gross Margin

How to Correctly Calculate your SaaS Gross Margin

There are a couple financial metrics that I calculate and review each month and this includes my SaaS gross margin. Of course, it’s not just your overall gross margin, but it’s also your recurring revenue margin and services margin. You may also have hardware margins, but that’s not as common these days.

In this post, I’ll explain how to calculate your SaaS gross margin, recurring revenue margin, and services margin. And I’ll also explain what financial data you need in order to do this.

SaaS Gross Margin Definition

Let’s start with your overall SaaS gross margin. Your SaaS gross margin is simply total revenue minus cost of goods sold (COGS). COGS, it’s such an old school term, but this is your bucket of expense that directly supports ALL of your revenue streams.

So, what should be included in COGS? I include Support, Services, Customer Success (CSM), and Cost of Operations (COO). What is COO exactly? I use COO to house my hosting costs, R&D amortization from capitalized software (if any), and resold product expense. Of course, there could be other expenses in COO, but these are the major expenses.

What about the CSM Department?

Shouldn’t the CSM department be under sales and marketing in operating expense (OpEx)? That’s a great question and very debatable. I view it this way. If your CSM team is purely focused on retention, then keep it in COGS. If your CSM team also transacts some business such as seat add-ons, then I’d put them below the gross margin line in OpEx.

Service Margins

Calculating your specific revenue stream margins is simply a matter of bucketing the correct revenue and expense. If your SaaS P&L is not set up like the picture below, then please read my post about the SaaS chart of accounts.

On my SaaS P&L, I have services revenue GL accounts tied to the Services Revenue line. I also have a department called Services (no surprise!). I simply take Services Revenue minus Services expense to calculate my services margin, or sometimes called contribution margin.

Your services department should include wages, benefits, payroll taxes, non-billable travel, training, and so on. This set up is under the assumption that you charge for professional services. This could be for training, configuration, and onboarding.

Even if your services are “light touch” and you don’t charge, I’d still bucket these expenses into its own department if they are material. I’d rather not skew another department’s expenses.

Recurring Revenue Margins

Recurring revenue margins follow the same logic as services. You take your recurring revenue minus the departments that directly support that revenue. In this case, you have Support, CSM (depending on how you classify them), and COO directly supporting your recurring revenue stream.

To be comparable with other companies, you might want to calculate your recurring gross margin with and without R&D amortization. Some companies capitalize their software development and some do not and it can have a large impact on your margin.

Why are Gross Margins Important?

It’s important for founders and SaaS teams to understand how and which revenue streams are contributing to their overall SaaS gross margin. The blend between services, recurring, and any other revenue streams is important.

For example, you could have a great 85% SaaS gross margin, but your service margin is at 50% and masking lower than ideal margins from recurring revenue. Or vice versa, you undercharge for onboarding and configuration which drags down your overall margin, but you don’t get credit for great recurring margins.

It also helps in your planning sessions to balance resource requests against forecasted margins. It’s hard to make decisions without knowing revenue stream margins and impact of investments in your business.

Do you review your margins monthly? What other margins do you review? To read the original post, please click here.