Gross Profit Margin: Why You Should Care and How You Can Improve It

As the founder or CEO of a SaaS company, one of the metrics your investors and buyers will likely scrutinize most closely is gross profit.

Gross profit, or GP, is simply defined as revenue minus cost of products sold. For example, a company that generates revenue of $100 and has a cost of products sold (COGS) of $15 for delivering the product to customers has a GP of $85. Gross profit margin is 85% – calculated as $100 minus $15 divided by $100.

Gross profit matters because the higher it is, the more capital you could invest in other operational areas of your organization, resembling sales and marketing, research and development, and general administrative purposes. Higher gross profit also reduces your dependence on external equity or debt capital.

Below is a easy example comparing two similar corporations with one key difference: gross profit margin.

While Company A and B have similar revenues and operating costs, Company A is 2.5 times more profitable than Company B because of its higher gross profit margin.

Company A generates $85 in profit in comparison with Company B’s $65 in profit. This allows Company A to take a position much more in other areas of the business, which can help it compete and win with Company B.

In our evaluation of 146 public SaaS corporations, the median spend on sales and marketing is 21%. Research and development is 16% and general and administrative costs are 12%, which implies that SaaS corporations will generally spend a total of 49% of their revenue on operational costs.

If your gross margin is lower than 51%, you run the risk of never turning a profit and growing in a capital-efficient manner.

What you may do to enhance your gross profit margin

Basically, there are two knobs you may turn to enhance your gross profit: increase your revenue and lower your cost of sales.

In terms of revenue, do you price your products in a disciplined manner, consistent with the value you deliver to customers? Are you properly comparing your prices with your competitors, which might assist you improve and increase your revenue? Simple policies like having automatic price increases built in every 12 months may help ensure your gross profit margin improves over time.

For COGS, one of the biggest aspects affecting most SaaS corporations is cloud hosting costs. Have you negotiated the best prices for your cloud spend and compared pricing options across providers? Cloud providers often offer significant discounts on multi-year contracts – have you taken advantage of this? Are your infrastructure engineering practices optimized to scale back cloud spend, and are you monitoring and eliminating underutilized cloud resources using various cloud cost monitoring tools?

Another vital component of COGS is typically the costs of product implementation, DevOps, and customer success teams. Much of this work may be done remotely, so have you considered using resources in cheaper locations?

Have you explored a product-led development strategy appropriate to the complexity of your product? Have you considered designing your products so that your customers can implement and integrate your software themselves, relatively than implementing significant skilled services that may reduce gross profit margins? Do you have digital resources available in case they need support?

We have found that product-led growth strategies, or PLG, typically result in lower COGS and higher gross margins. We also saw situations in the Nineteen Sixties where a company had lower gross margins because of the costs of third-party software embedded in its product, but its entire go-to-market was PLG-driven versus expensive sales-driven growth, still enabling profitability.

We also see that founders calculate COGS incorrectly. It should only include direct costs of revenue, resembling cloud costs, customer support, customer retention costs, engineers’ fees directly supporting the delivery of the product, skilled services (only if a part of the product offering), costs of third-party software used in the product, royalties, and commissions and transaction fees.

Indirect costs resembling research and development, overhead and other expenses shouldn’t be included in COGS costs. A professional CFO may help discover appropriate costs and make sure that only those attributable to COGS are included.

Higher valuations correlate with higher gross margins

Below is a chart of 146 SaaS corporations. As you may see, corporations with higher gross margins trade at higher multiples.

It’s value noting that this correlation holds true during bull markets like 2020 and 2021, in addition to during periods like 2022 and 2023 when valuations are muted.

Higher gross margins are attractive to investors and buyers

High-quality SaaS corporations have gross margins ranging from 75% to 90%. Ideally they needs to be above 80%.

If a software company’s gross margin is lower than 70%, it might be a cause for concern. The company could also be ignored by an investor who desires to support a more capital-efficient company, or by a strategic buyer who desires to make sure acquisitions work by buying corporations whose gross margins are equal to or higher than their very own gross margins.

Overall, having a high gross profit margin is a proven strategy to successfully grow and build a significant business.