Understanding Gross Margin and Cost of Sales

Your overall gross margin gives you a general idea of the production costs in relation to your revenue. But is that all? The answer is no.

Niko Laine

October 4, 2022


What is Cost of Sales (COS)?

Cost of Sales (COS) refers to the direct costs associated with selling and delivering your product. 

What goes into your COS depends on your business model. Typically, the COS for SaaS businesses includes the following cost centers: 

  • Wages of Support staff 
  • Services
  • Wages of Customer Success staff
  • DevOps
  • Payment processing expenses
  • Hosting expenses

Once you have your COS, you can then calculate your gross margin using the formula below. 

It’s normal for your COS to scale alongside your revenue. It means the more revenue you generate, the more COS you have. The trick to making your business more profitable is: Grow your revenue faster than your COS.  

While it may be relatively slow for that to happen, it doesn’t mean there aren’t ways to speed up your revenue growth.

What is gross margin?

Gross margin is the amount left after deducting the Cost of Sales from the total revenue. 

Total revenue - COS = Gross margin

Your overall gross margin gives you an idea of your production costs in relation to your revenue. Use your gross margin rate to help you figure out how to grow your revenue faster than your COS. 

How do I calculate my gross margin rate? 

The formula to calculate your gross margin rate is pretty straightforward: 

[(Total revenue - COS)/Total revenue] x 100 = Gross margin rate

Let’s say the total revenue for your product is $120,000. We’ll assume that your COS includes the following cost centers–Support ($7,500), Services ($9,000), Customer Success ($12,500), Dev Ops ($1,500). Your variables are: 

Total revenue = $120,000
COS = $7,500 + $9,000 + $12,500 + $1,500 = $30,500

Therefore, your gross margin is $89,500. 

To calculate your gross margin rate: 

[($120,000 - $30,500)/$120,000]*100 = 74.58%

Your gross margin rate is 74.58%. 

That looks healthy, right? 

Yes. No. Maybe–all three answers are valid depending on who you talk to. 

According to Tom Tunguz, 50-75% is a good target to aim for depending on which lifecycle your SaaS business is in. A more common consensus is that a profitable SaaS business model should have a gross margin rate of 80-90%. It means that your COS should only take up 10-20% of your total revenue. 

Your gross margin is likely to be smaller at the beginning of your SaaS business. The goal is to increase as you scale. We’ll go with the common consensus of aiming for an 80-90% gross margin rate. Based on the example above, you have a few options to improve your gross margin rate:

  1. Increase revenue by acquiring more customers.
  2. Decrease COS by making internal adjustments, such as reshuffling your resource allocation.
  3. Invest in self-serve onboarding.
  4. Create excellent knowledge base articles and guide customers to read them.
  5. Revise your pricing strategy.
  6. Integrate new products or services to expand your Net Revenue Retention (NRR)
  7. Alter your customer segment focus.

How does your gross margin rate affect other metrics?

Your gross margin rate affects your Customer Lifetime Value (LTV) metric that is crucial to your company’s valuation. To calculate your LTV based on your gross margin rate, you need to know your:

The formula is: 

(A x B) / C = LTV.

Assuming your variables are: 

ARPA = $500
Gross margin rate = 80%
MRR churn rate = 4%

($500 x 0.8) / 0.04 = $10,000

Your LTV is $10,000.

Here’s what happens if you have a gross margin rate of 50%. We’ll keep the rest of the variables as they are: 

ARPA = $500
Gross margin rate = 50%
MRR churn rate = 4%

($500 x 0.5) / 0.04 = $6,250

Your LTV decreases to $6,250.

Go deeper: What is Customer Lifetime Value?

Key takeaway:

Your gross margin is one of the key indicators of how profitable and scalable your business is. It gives you a general idea of your production costs in relation to your total revenue. The goal is to increase your gross margin rate as much as you can. Apart from that, knowing the gross margin of ALL your revenue streams and how they contribute to the overall gross margin will help you with budget and resource allocation. 

Author Avatar

Niko Laine

Founder, CEO and CFO

Niko is a CFO and a financial advisor who is passionate about solving problems, data analysis, mentoring smart entrepreneurs and bringing clarity and focus in difficult situations.