Expose the Truth About Your Business With This Brutally Honest Metric: Gross Margin
- gandhinath0
- Apr 23
- 4 min read
Revenue numbers can be misleading. What truly reveals your business health is gross margin—the actual money you keep from each sale. It’s typically shown as a percentage of total revenue and serves as a key indicator of growth potential and reveals if your business model is working, as intended to be.
What is Gross Margin and, how to calculate
Definition:
Gross margin measures the percentage of revenue remaining after deducting direct costs of delivering services (COGS). For SaaS companies, this metric reflects operational efficiency in converting revenue to gross profit before accounting for fixed costs like R&D and marketing.Formula:
Gross Margin % = ( (Revenue - COGS)
÷
Revenue) X 100Example Calculation
Component | Formula | Example Calculation |
Revenue | Monthly Recurring Revenue | $500,000 |
COGS | Hosting + Support + Licenses | $100,000 |
Gross Profit | Revenue – COGS | $500,000 – $100,000 = $400,000 |
Gross Margin Percentage | (Gross Profit ÷ Revenue) × 100 | (400,000 ÷ 500,000) × 100 = 80% |
Why It Matters
Gross margin isn't just another finance metric—it's your business model speaking to you revealing four critical insights:
Your pricing power: Low margins mean you're not charging enough to deliver your product profitably.
Your operational efficiency: Strong margins signal you've built smart systems—your infrastructure scales well, your support runs lean, and your costs stay in check.
Your growth potential: Every dollar you keep is a dollar you can pour back into product development, sales expansion, or hiring. This is why investors care so much about margins.
Your CAC recovery speed: Higher margins mean faster payback on customer acquisition costs. Better margins today mean more efficient growth tomorrow.
A strong gross margin makes every other metric work harder. A weak one makes growth expensive and unsustainable.
In theory, Gross margin seems simple: revenue minus COGS. But in SaaS, defining COGS trips up even experienced founders. Unlike traditional businesses, we're not counting physical inventory or manufacturing costs.
Your COGS includes every direct cost of delivering your SaaS product: cloud hosting, support team salaries, infrastructure costs, and third-party services that your product needs to function. If removing the cost would stop your product from working, it's probably COGS.
What Counts as COGS (Cost of Goods Sold)?
Your cost of goods sold should only include expenses that scale directly with customer usage. Here's what belongs:
Cloud Infrastructure: Your AWS, GCP, or Azure spending on servers, databases, and content delivery
API and Software Licensing: Usage-based fees to critical partners like OpenAI, Stripe, or Twilio
Customer Support Operations: Direct costs of people handling tickets and managing accounts
Essential Onboarding: If you can't activate customers without live setup help, include those costs
Payment Processing: Customer-driven fees like Stripe or Shopify charges (especially relevant for B2C)
Clean COGS calculations give you honest margins. Mixing in operating expenses like R&D, marketing, sales commissions, or executive compensation only obscures reality and undermines investor confidence.
Here's my own experience: At our computer vision startup I worked with, gross margins kept declining despite steady revenue. The culprit? Per-use fees for a third-party AI model. While this made sense during testing, as customer usage grew, these fees ate our margins. The solution was straightforward: we built in-house. This cut costs and gave us better control.
This pattern repeats across the startup landscape. Young companies naturally gravitate toward ready-made solutions to reach the market quickly. While this works for MVPs, unchecked reliance on third-party tools can silently erode your gross margins. The key is recognizing when to make the switch from convenience to ownership as these dependencies quietly eat your gross margin.
Benchmarks SaaS Founders Should Aim For
As your startup scales, gross margin should improve. This reflects your ability to serve more customers without proportionally increasing delivery costs.
Growth Stage | Benchmark | Strategies to Improve Gross Margin |
Validation Seekers ($1M-$2M ARR) | 50%–65% | Test pricing, cut infrastructure costs, reduce tool spend |
Traction Builders ($2M-$4M ARR) | 65%–75% | Add automation, streamline delivery, focus on high-margin products |
Scale Preparers ($4M-$7M ARR) | 75%–80% | Get better cloud rates, add pricing tiers, optimize tech |
Growth Accelerators ($7M-$10M ARR) | 80%+ | Use AI for support, upsell enterprise tiers, experiment pricing models |
Your Path to Better Gross Margins
Smart margin improvement isn't about cutting corners. It's about building operational leverage through better decisions in product, engineering, support, and infrastructure. This works at any stage - from early startup to growth.
Goal: Lower COGS while keeping customers happy.
Quick Action Plan:
Clean up cloud costs - Kill idle resources, use reserved instances
Review vendor costs - Evaluate expensive APIs, consider building in-house
Layer your support - Self-serve for basic, high-touch for premium
Know your numbers - Track margins by product and feature
Get better deals - Negotiate high-usage tool contracts
Go Open source - Use PostgreSQL, Redis to slash license fees
Bundle smart - Package premium features to boost ARPU
These approaches aren't theoretical. Operators have grown margins up to 80% by tightening infrastructure (rationalization), granular cost attribution, and delivery models innonvation like bundled pricing. (Sources: Wall Street Prep, Faster Capital, Cello)
Key Takeaways
Gross margin shows what you really earn
Rich margins = Investors Competition
Segment revenue. Classify costs right. Avoid markup traps
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