VI

Another day another topic, or so it seems.  This time Gross Margin and SaaS.

If you’re selling a product with a one-time price, revenue is easy to determine – it’s basically the sales price.

The Gross Margin (a financial metric that is very meaningful in real products – like washing machines or routers) is defined as:

Gross Margin = ( (total revenue from product) – (total cost of product) ) / (total revenue from product)

The cost of the product is known in accounting terms as Cost of Goods Sold (COGS) and is all those expenses – both components and labor – needed to assembly the product.  Cisco, for example, has an aggregate Gross Margin of between 60% and 65%, this means that $0.35-$0.40 of every $1.00 of revenue is the cost of the product.

For software products, COGS is basically the cost of CD’s, and a CD burner and labeling equipment, the packaging and the labor costs of packing.  Obviously there is a fixed cost element of this, but in general Gross Margin for software product is in the region of 98%-99%.

For software products that are delivered via the web, i.e. downloaded, COGS is even less.  It worth noting that the cost of delivering a product, i.e. in this case the cost of a server and communications costs, are not considered as part of COGS.  So, in general Gross Margins for software products delivered digitally are in the region of 99.99%

And then there are subscription services, where a service is delivered for a monthly or annual subscription fee.

These are two interesting properties, from an accounting and financial metrics perspective.

First, revenue is accounted as the total of all subscription fees for a particular period; month, quarter or year.  This is particularly important if you have multiple price plans. 

On a side note, many it’s time interesting to calculate average revenue, for a number of reasons.

For products, it’s usually called Average Sales Price (ASP).

ASP = (total revenue from product) / (total number of sales)

I use that to get a sense of how much sales are discounted against list price.

For services, it’s usually called Average Revenue Per User (or ARPU, pronounced r-poo) and is generally regarded as a monthly average.  It’s really a vestige from telecommunications companies accounting of the monthly telephone bills they collected, but it serves well for most subscription services.

ARPU = (total subscription fees) / (total number of subscribers)

I use that to get a sense of how much upselling is being achieved.

But things get a little strange when considering the Gross Margin of a SaaS business.  At first glance, one is tempted to consider it in the same category as software products that are delivered via the web, but a very close inspection of the accounting definitions changes that.  You can’t really call it goods sold it’s more accurate to use the term Cost of Service Sold (COSS) – except the accounting world hasn’t gotten round to decide yet.   And in the case of a SaaS offering, the cost of the service includes the cost of servers and communications in order to deliver it – since the service is the product.  Whether your business buys, leases or rents servers and storage, or in-houses or out-sources the operations of those servers, its can all be consider as part of the COSS .  In my experience, and through examining P&L’s of SaaS businesses like salesforce.com, Gross Margins for software service delivered digitally are in the region of 95-97%.

 In summary:

 In conclusion.  If you are in software Gross Margin is all but meaningless, unless you are dealing with an accountant.  So just add it in with these metrics.