Gross margin is the percentage of revenue left after paying the direct costs of delivering your product or service. It is the single most important indicator of whether a business model is economically viable at scale — and one of the metrics investors scrutinise most closely at every stage from seed through to IPO.
Most founders know their gross margin number. Far fewer understand what it actually includes, what an appropriate benchmark looks like for their business model, or what the levers are to improve it. This guide covers all three.
What gross margin is and how to calculate it correctly
Gross margin is calculated as:
Gross Profit = Revenue − Cost of Goods Sold (COGS)
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Gross Margin % = Gross Profit ÷ Revenue × 100
The formula is simple. The complexity — and where most mistakes happen — is in defining COGS correctly.
COGS should include all costs directly attributable to delivering your product or service to the customer. For different business models, this means different things. Costs shared across products need allocating first; see cost allocation and overhead analysis.
For a SaaS business:
- Hosting and infrastructure (AWS, GCP, Azure) — the compute cost to run the product
- Third-party software costs directly embedded in the product (APIs, data providers)
- Customer success and implementation headcount — the people directly involved in onboarding and retaining customers
- Support headcount (if support is a core delivery function, not a general cost)
What SaaS COGS does NOT include:
- R&D / engineering headcount (these build the product; they don't deliver it per customer)
- Sales and marketing (these acquire customers; they don't deliver the product)
- G&A (finance, HR, legal — not attributable to delivery)
For a services business (consulting, agency):
- The directly billable labour cost of the people doing the work
- Subcontractors
- Direct project costs (travel, software, data)
For a marketplace:
- Payment processing fees
- Logistics or fulfilment costs (if the marketplace takes responsibility for delivery)
- Direct customer support for transaction-related issues
The most common COGS error is including costs in COGS that should be in operating expenses — or excluding costs from COGS that should be included. Both distort the gross margin figure in ways that mislead investors and internal decision-making.
Gross margin benchmarks by business model
Benchmarks matter because gross margin is only meaningful in context. A 45% gross margin is excellent for a hardware business and alarming for a SaaS company. Here are the ranges investors typically use to benchmark performance:
| Business model | Expected gross margin range | What top quartile looks like |
|---|---|---|
| Pure SaaS (software only) | 65–85% | 80%+ |
| SaaS with professional services | 55–75% | 70%+ |
| Marketplace / platform | 50–70% | 65%+ |
| Services / consulting | 30–55% | 50%+ |
| Hardware + software | 30–50% | 45%+ |
| E-commerce | 20–45% | 40%+ |
| Fintech (payments) | 40–65% | 60%+ |
Why gross margin matters so much to investors: Gross margin determines how much money you have left to invest in growth after covering the cost of delivery. A SaaS business with 75% gross margins can invest 75 cents of every revenue dollar in sales, marketing, and R&D. A services business with 35% gross margins has 35 cents. At scale, this difference in unit economics determines the capital efficiency of growth and the long-term profitability ceiling of the business.
The three dimensions of gross margin analysis
Looking at a single gross margin number is a starting point, not an analysis. Useful gross margin analysis has three dimensions.
Dimension 1: Trend over time Is gross margin improving, stable, or declining as the business scales? For SaaS businesses, the expectation is that gross margin should improve over time as fixed infrastructure costs are spread over a larger revenue base. If gross margin is declining as revenue grows, it typically signals that either COGS is growing faster than revenue (a unit economics problem) or that the product delivery cost structure is not scaling efficiently.
A monthly view of gross margin over 18–24 months is more informative than a single current-period figure.
Dimension 2: By customer segment or product line Blended gross margin can mask significant variation within the business. A SaaS company might have 80% gross margin on its core product and 25% gross margin on a recently launched professional services offering. The blended figure of 65% looks reasonable until you realise the services business is dragging overall margins down and growing as a percentage of revenue.
Segment-level gross margin analysis is essential for: understanding which parts of the business to invest in, pricing decisions, and investor conversations where the blended margin might be misinterpreted.
Dimension 3: Versus plan Gross margin should appear in your monthly variance analysis. If gross margin is 68% when the budget assumed 72%, the 4 percentage point gap needs explanation. Common causes: higher-than-expected cloud infrastructure costs, customer success headcount hired ahead of schedule, or a product mix shift toward lower-margin segments.
Five levers to improve gross margin
1. Renegotiate infrastructure costs. For SaaS businesses, cloud infrastructure is often the largest COGS item. As you grow, you have increasing negotiating leverage with AWS, GCP, and Azure — committed use discounts (CUDs) and enterprise agreements can reduce infrastructure costs by 20–40% compared to on-demand pricing. Most early-stage companies don't do this systematically. It is almost always worth a conversation.
2. Automate customer success activities. If your customer success model requires significant manual effort per customer, gross margin will be structurally constrained. Investing in onboarding automation, in-product guidance, and self-serve help centres reduces the CS headcount required per €1M of ARR. The payback period on these investments is typically very short.
3. Move implementation from a cost centre to a revenue line. Many SaaS businesses absorb implementation and onboarding costs in COGS. If those costs are material, there is a strong argument for charging for implementation — transforming a cost that reduces gross margin into a revenue line that contributes to it. This requires pricing and packaging changes, but it is one of the most direct gross margin improvement levers available.
4. Optimise the product mix. Not all products and customer segments have equal margin profiles. Understanding which customer segments generate the highest gross margin — and actively shifting the mix toward them — can improve blended margins without changing the cost structure at all. This is a pricing and go-to-market decision as much as a finance one.
5. Review third-party data and API costs. Many SaaS businesses embed third-party data sources, APIs, or services in their product that are charged on a usage basis. As the customer base grows, these costs can scale unexpectedly and erode gross margin. A regular review of usage-based COGS items — and negotiation of volume pricing with key providers — is a recurring gross margin management activity, not a one-time exercise.
Gross margin and the fundraising conversation
Investors will calculate your gross margin from your financial model and compare it to their benchmarks. If your gross margin is below sector norms, be ready to explain why — and what the trajectory looks like as the business scales.
The most credible answers are:
- "We're currently investing heavily in customer success to drive retention. As the cohorts mature and NRR demonstrates the payback, we'll optimise the CS model. We project gross margin to reach X% by [date]."
- "We offer a professional services component that carries lower margins, but it drives enterprise customer acquisition. Longer term, the services business will shrink as a percentage of revenue as the software scales."
- "Our current infrastructure cost base is oversized for our current ARR. As revenue scales, the infrastructure cost per unit will decline. Gross margin should reach X% at €5M ARR."
What destroys credibility in this conversation: not knowing why your gross margin is where it is, or being unable to articulate a credible path to improvement.
FAQs
Is gross margin the same as gross profit? No. Gross profit is an absolute number (revenue minus COGS, expressed in currency). Gross margin is the percentage (gross profit divided by revenue). Both are useful; the percentage is more useful for comparisons across time and against benchmarks.
Should I include sales commissions in COGS? No. Sales commissions are a cost of acquiring customers, not a cost of delivering the product. They belong in Sales & Marketing operating expenses. Including commissions in COGS would artificially suppress gross margin and misrepresent the economics of delivery.
My gross margin improved because I changed how I categorise some costs. Is that OK? Only if the change reflects a genuinely more accurate categorisation — and only if you disclose the change and restate prior periods for comparability. Reclassifying costs to improve the gross margin metric without disclosing the change is a credibility risk if discovered during investor due diligence.
BB Financial Services Kft helps startups build the financial models and reporting frameworks that give investors confidence in the numbers. Get in touch if gross margin analysis is something you want to get right.