SaaS gross margin is the revenue a software-as-a-service (SaaS) business retains after subtracting the direct costs associated with developing, delivering, and maintaining its software services. It’s usually expressed as a percentage of total revenue and serves as a key indicator of a business’s financial health and growth potential.

The global SaaS market was valued at nearly $274 billion in 2023 and has been projected to exceed $317 billion in 2024; gross margin helps these businesses understand whether they can cover their direct costs and remain profitable. Below, we’ll cover how to calculate gross margin, benchmarks you should know, and how SaaS businesses can improve their gross margin.

What’s in this article?

• How important is the gross margin for SaaS businesses?
  
• How to calculate gross margin for SaaS businesses
  
• Benchmarks for SaaS gross margins
  
• Why recurring revenue and service margins are important
  
• How to improve SaaS gross margins
  

How important is the gross margin for SaaS businesses?

Gross margin is an important metric for SaaS businesses, providing insights on performance in these areas:

• Profitability: Gross margin reveals how much a business retains from each unit of revenue after paying the direct costs associated with producing its services. High gross margins indicate the business can cover its direct costs, leaving more resources available for research and development, marketing, administration, and other operating expenses. This is especially important in the SaaS sector, where maintaining and updating software is continual and resource-intensive.

• Scalability: A high gross margin suggests a business can potentially scale up its operations without proportionately increasing its direct costs. This is particularly relevant for SaaS businesses, which often incur substantial upfront costs in developing software but have relatively low incremental costs for each additional customer.

• Attractiveness to investors: Investors often look at gross margins when evaluating SaaS businesses. A high gross margin is typically viewed as an indicator of a sound business model and strong potential for profit. It also suggests the business has pricing power and cost control, which are attractive qualities for equity investors and lenders.

• Market position: By tracking the gross margin, businesses can compare themselves with their peers and competitors. Using these benchmarks, a SaaS business can gauge its operational efficiency and effectiveness in the marketplace.

• Resource allocation: Gross margins help management make informed decisions about where to allocate resources. A low gross margin might prompt a review of pricing, service delivery costs, or target customer segments.

• Pricing: Gross margin analysis can influence pricing strategies. Businesses with higher gross margins might have more leeway to compete on price if necessary or invest in better service features to justify premium pricing.

How to calculate gross margin for SaaS businesses

Here’s a breakdown of how gross margin is typically calculated for SaaS businesses:

Define revenue

• Subscription revenue: This is the primary revenue source for most SaaS businesses, and it comes from recurring monthly or annual fees paid by customers for accessing the software.

• Other revenue: Some SaaS businesses might have additional revenue streams such as professional services, consulting, or one-off fees. These should be tracked separately to accurately calculate the gross margin. If a SaaS business has multiple revenue streams or product lines, it’s useful to calculate gross margins for each segment to identify areas of strength and weakness.

Identify COGS

The cost of goods sold (COGS) in SaaS businesses typically will include:

• Hosting and infrastructure: Costs associated with servers, data centres, cloud services, and other infrastructure needed to deliver the software

• Customer support: Salaries and expenses for customer support teams, including software licences for support tools

• Development and maintenance: Salaries for developers and engineers, software licences for development tools, and ongoing maintenance costs

• Direct cloud costs: Expenses related to cloud services, such as data storage, bandwidth, and computing power, which directly scale with usage

• Professional services costs: If applicable, the direct costs of providing professional services, including salaries, travel expenses, and software licences

It’s important to exclude operating expenses from COGS because these are not directly related to the production and delivery of the software. Operating expenses include:

• Sales and marketing: Marketing and sales salaries, advertising expenses, and other marketing costs

• General and administrative: Salaries for executives and administrative staff, office rent, and other overhead costs

• Research and development: Costs associated with developing new features or products, unless they are directly related to maintaining the existing software

Some SaaS businesses report a non-generally accepted accounting principles (non-GAAP) gross margin, which also excludes expenses such as stock-based compensation. Understand which metric is being used when comparing gross margins.

Calculate gross margin

Use this formula to calculate gross margin:

(Total Revenue - COGS) / Total Revenue x 100 = Gross Margin

A sample calculation

A SaaS business has these financials:

• Subscription revenue: £1,000,000

• Professional services revenue: £100,000

• Hosting and infrastructure costs: £150,000

• Customer support costs: £100,000

• Development and maintenance costs: £200,000

Here’s how this business would calculate gross margin:

• Total revenue: £1,000,000 + £100,000 = £1,100,000

• COGS: £150,000 + £100,000 + £200,000 = £450,000

• Gross margin: (£1,100,000 - £450,000) / £1,100,000 x 100 = 59.1%

Benchmarks for SaaS gross margins

SaaS gross margin benchmarks are important for understanding the financial health and potential of a business, internally and for external stakeholders such as investors. But what qualifies as a “good” gross margin can vary. Here’s what you need to know about gross margin benchmarks:

General benchmarks

• A gross margin above 75% is typically considered good for a SaaS business. This indicates a healthy business model with fine-tuned operations and pricing.

• A gross margin below 70% might raise concerns for investors and analysts, suggesting potential issues with pricing, cost management, or competitive positioning.

• Top-performing SaaS businesses often achieve gross margins of 80% or higher, demonstrating exceptional efficiency and profitability.

Factors that influence benchmarks

• Business stage: Early-stage startups might have lower gross margins because of higher initial costs of product development and customer acquisition. A gross margin of 50% or above is acceptable for early-stage SaaS businesses. As businesses mature and achieve economies of scale, their gross margins tend to increase.

• Industry: Certain industries, such as those that require extensive infrastructure or specialised expertise, might inherently have lower gross margins as a result of higher COGS.

• Target market: Businesses targeting enterprise customers might have higher gross margins than those focused on small businesses, because enterprise solutions often command premium pricing.

• Business model: Businesses with a pure SaaS model, in which all revenue comes from subscriptions, typically have higher gross margins than those with hybrid models that include professional services or other revenue streams.

• Product complexity: Complex products that require substantial ongoing development and support might have lower gross margins than simpler products with lower maintenance costs.

Why recurring revenue and service margins are important

Recurring revenue provides a firm foundation for SaaS businesses, while service margins derived from professional services such as consulting, implementation, or training improve profitability and customer relationships. This creates a virtuous cycle that promotes predictable and sustainable growth, attracts investors and secures funding, and improves customer satisfaction and retention in the competitive SaaS landscape.

Here’s more information on why each of these figures matters:

Recurring revenue

• Predictability and stability: Recurring revenue, typically generated through subscriptions, provides a predictable, steady income stream that makes financial forecasting, planning, and budgeting easier. It also has a lower risk of revenue fluctuations than businesses that rely on one-time sales.

• Customer lifetime value (LTV): Recurring revenue models encourage focusing on customer retention and satisfaction. A happy customer is more likely to continue their subscription, increasing their lifetime value and generating more revenue over time.

• Business valuation: Investors highly prize businesses with recurring revenue streams. This predictability lowers the perceived risk, leading to higher valuations and easier access to funding.

• Scalability: Recurring revenue models are inherently scalable. Once the product is developed, the marginal cost of serving additional customers is relatively low, allowing for swift growth without substantially increasing costs.

Service margins

• Profitability: Service margins can substantially affect a SaaS business’s overall profitability. High service margins contribute to the bottom line.

• Customer success: Professional services can improve customer satisfaction and adoption, leading to increased retention and higher LTV.

• Upselling and cross-selling opportunities: Service engagement provides opportunities to identify and address customers’ needs and opens the door for upselling additional features or cross-selling complementary products.

• Differentiation: Offering high-quality professional services can differentiate a SaaS business from competitors and attract customers who value comprehensive solutions.

How to improve SaaS gross margins

Here are tactics to improve your SaaS business’s gross margin:

Maximise revenue

• Value-based pricing: Shift from cost-plus pricing to value-based pricing by assessing the value your product delivers to customers and pricing accordingly. This could involve tiering your offerings for different customer segments with varied budgets.

• Usage-based pricing: Consider implementing usage-based pricing, in which customers pay based on their consumption. This keeps costs in line with revenue and encourages efficient usage.

• Expansion: Focus on upselling and cross-selling to existing customers. This is often more cost-effective than acquiring new customers and can substantially boost revenue without proportionally increasing costs.

• Churn reduction: Prioritise customer retention. Reducing churn rates increases the LTV of existing customers and can have a major impact on revenue and profitability.

• Premium support: Offer premium support packages as an additional revenue stream. Customers who value high-touch support are often willing to pay more for it.

Reduce costs

• Cloud infrastructure: Fine-tune your cloud infrastructure by analysing usage patterns, right-sizing instances, and using spot instances or reserved instances. Consider using cloud cost management tools to gain insights and automate optimisation.

• Vendors: Regularly review contracts with vendors for hosting, software licences, and other services. Negotiate better terms or explore alternative vendors to reduce costs.

• Customer support: Implement self-service resources such as knowledge bases, frequently asked questions (FAQs), and online forums to reduce the burden on customer support teams. Use chatbots or artificial intelligence (AI)-powered support to automate routine enquiries, and consider offshoring or outsourcing to lower-cost locations.

• Development: Improve development to reduce time to market (TTM) and minimise maintenance costs. Adopt agile methodologies, automate testing, and invest in developer tools that boost productivity. Consider offshoring or outsourcing.