Software Growth

Gross margin

Gross margin is the share of revenue left after the direct costs of delivering your software, such as hosting and support. Most SaaS targets 70 to 80 percent.

Gross margin tells you how much of each revenue dollar is left after paying to deliver the product. It is the reason software is attractive: once built, serving one more customer costs little, so most of each dollar can go to growth, salaries and profit. If your gross margin is weak, everything downstream is harder, from CAC payback to hitting profitability.

How to calculate gross margin

Example: your product brings in $20,000 in MRR. Direct costs this month were $2,000 for hosting, $1,500 for support staff, $900 for third-party APIs and $600 in card processing fees, a total of $5,000.

What goes into COGS

The a16z guide says all costs of manufacturing, delivering and supporting the product belong in gross margin, and that companies should be clear about what they include. For SaaS that usually means:

  • Cloud hosting, storage, CDN and bandwidth.
  • Third-party software and APIs used inside the product (email delivery, AI model calls, maps).
  • Customer support and onboarding staff.
  • Payment processing fees.
  • Professional services delivery costs.

Sales, marketing, product development and general admin sit below the line in operating expenses. See COGS for the boundary cases.

What good looks like

  • David Sacks says SaaS companies should target at least 75% over the long run, and warns that persistently low margins can mean humans are doing the product's work behind the scenes.
  • Bessemer's benchmarks for cloud companies show about 70% at $1 to $10 million ARR and 65% to 70% at larger scales, with most companies in a 60% to 80% range.

AI features change the picture. If every action calls a paid model, usage costs can pull margin below 60% unless pricing tracks usage.

Why it matters beyond the percentage

Gross margin feeds every efficiency metric. Lifetime value and CAC payback are computed on gross profit, not revenue. At the same CAC of $300 and ARPA of $50, an 80% margin pays back in 7.5 months, while a 50% margin takes 12 months.

Gross margin versus contribution margin

Contribution margin subtracts every variable cost, including things like sales commissions, not just delivery costs. It is a stricter view, useful for break-even work.

Mistakes

  • Leaving support salaries out of COGS to look better.
  • Counting the founder's whole salary in COGS, or none of it, rather than the share spent on support.
  • Ignoring that free users also cost hosting money.

Ways to improve it

  • Review hosting each quarter. Unused instances and oversized databases are common leaks.
  • Reduce support load with better onboarding and documentation, so support cost grows slower than customers.
  • Price usage-heavy features by usage, so a few heavy accounts do not eat the margin.
  • Negotiate or switch payment processing and third-party APIs once volume justifies it.

A five-point margin gain on $20,000 of MRR is $1,000 a month, with no new customers required.

Sources

Back to the SaaS glossary