Gross margin and contribution margin in software as a service are important metrics that every SaaS business should know. They provide insight into the profitability of a product and the scope of growth of a company. Moreover, they aid in pricing a product based on identified product costs and helps highlights way to reduce them.
What is the gross margin in software as a service?
Wikipedia defines gross margin as the difference between a company’s revenue and the cost of goods sold (COGS) divided by the revenue. It is the money a company has after the company incurs direct costs. This metric shows gross profit over the total revenue generated.
Gross margin: (Revenue – COGS) / Revenue
This metric helps in determining the value of sales, which later helps in decision-making associated with pricing and marketing. The margin on sales is something every businessperson and manager knows, even if the values are approximate. Plus, different businesses differ in their assumptions when calculating gross margin. However, Gross margin is an excellent indicator of scalability.
There is a subtle difference between gross profit and gross margin. Gross profit refers to the total profit generated; it is indicated in numbers. Whereas, gross margin is represented in percentages or a ratio. While people use the two terms interchangeably, they are not the same.
What does gross margin mean for SaaS?
SaaS is an industry that continuously grows. And it needs to rake in tremendous profits to keep up with the expansion. Since SaaS companies focus on creating long-term relationships with their customer rather than creating a pricey initial contract. Therefore, SaaS companies build products that rely heavily on the renewal of subscriptions. Moreover, such companies need to make sure that they have high adoption rates and low churn rates. Also, SaaS companies are the perfect example of how you can improve the LTV of a customer for greater revenue.
According to onplan, the gross margin from subscriptions for SaaS is about 80%. Whereas the total gross margin in 2021 was 68% to 75% from customer services, etc. However, these stats are from medium-sized companies that have been in the market for some time. Smaller SaaS companies that have started recently have lower margins since they have a higher CAC and small customer base.
Scalability of the ability of an organization to change its computing resources to meet demand. This can mean increasing or decreasing computing resources to better fit the situation, both horizontal and vertical. Scalability is critical to the SaaS organization structure. This is because a SaaS survives on the renewal of subscriptions and provides top-notch customer services.
Moreover, gross margin provides insight into the growth prospects of a SaaS business and is an indicator of its performance. Since more profits tend to mean more expansion, a SaaS business needs to be able to limit the cost of its operation when it is experiencing a dip. Also, depending on the company, increased profit can be rerouted to sales and marketing or R&D. This, in turn, leads to better customer experience and improved products. Hence, it is no surprise that many investors use gross margins as a factor when investing.
Since, the valuation of the company is the estimate of its worth. Many investors check the ARR (annual recurring revenue) of a company before investing. However, while gross margin is an excellent metric, it is not the only metric that should be used to evaluate a company. More often than not, the scope of growth and gross margin can provide invaluable insight that ARR simply can not.
Read More: 5 SaaS Pricing Models for a Balanced Revenue
What is the contribution margin in software as a service?
The contribution margin is the difference between the selling price of a product per unit and the variable cost of that unit. This metric is used to calculate the profit made by a unit towards the total profit of the company. Moreover, it provides information on how a specific product contributes to the costs of the company.
Contribution margin: revenue – variable cost
Contribution margins are used because they do not include factors that are not directly linked to sales of a product. Such as direct labor and administration costs and other fixed costs. Moreover, it helps improve profitability by identifying places where you can reduce variable costs.
Gross margin is used to measure the profitability of the company, whereas contribution margin is the profit made by individual products.
Also, the contribution margin does not consider fixed costs (and a few others). Hence, contribution margins will always be higher than gross margins. However, gross margins use the traditional method of fixed cost allocation. And therefore, may be inaccurate. Whereas, whereas contribution margins provide a better view of money earned from sales.
The break-even analysis heavily uses the concept of contribution margin since you calculate it per unit product. It is the analysis of how many products are required to be sold (at a set price) to cover the costs of the production. Hence, the break-even point is the point at which costs and revenue are equal. Therefore, at this point, there is neither profit nor loss. It is an extremely important metric for companies since it tells them how many units they need to sell before they see a profit.
A company can use contribution margin to determine which product to pursue from a list of possible ones. Especially if they have limited resources. By calculating the contribution margin, the management can figure out which is the best use of resources and will bring in the most profit. This metric is important since it gives an insight into the profitability potential. If a product has a positive contribution margin, then that product is worth pursuing, whereas, if a product had a negative contribution margin, then management will drop that product. The calculated profit may be negative and the contribution margin is positive. In this case, the product is contributing to the costs of the company.