Gross margin

Gross margin measures the percentage of revenue remaining after subtracting the cost of goods sold (COGS) and reflects a company’s operational efficiency.

What is gross margin?

Gross margin—also known as gross profit ratio—is the percentage of revenue a company retains after subtracting the cost of goods sold (COGS) or cost of revenue. These are the direct costs tied to producing and delivering your product or service.

Unlike net profit margin, which accounts for all operating expenses, gross margin focuses solely on production-related costs. It shows how much you keep for every dollar earned. For instance, a gross margin of 75 percent means you retain 75 cents from every dollar of revenue, while 25 cents goes toward production costs.

This metric is especially important for assessing operational efficiency and understanding the financial health of your business when reviewing your income statement.

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While gross profit ratio may seem like a straightforward metric for comparing revenue and profit, the key variable—cost of revenue—can vary significantly depending on your industry and business model.

For manufacturing businesses, cost of revenue typically includes production expenses like raw materials. But in SaaS, it looks quite different. Common cost of revenue items for SaaS companies include:

• Web hosting services (e.g., AWS, Microsoft Azure)
• Cloud computing and performance monitoring tools
• Payment processing fees
• Software licenses directly tied to product development or delivery
• Payroll for support teams and other customer-facing roles
• Professional services and related travel for onboarding or implementation
• Product development costs, including engineering salaries

These are direct costs tied to delivering your product or service—not overhead. That means operational expenses like sales commissions, marketing spend, and administrative salaries should not be included in your gross profit ratio.

Because there’s no strict industry standard for what to include in cost of revenue, it can be challenging to get this calculation exactly right. Still, accuracy matters—since your gross margin is a key indicator of financial health, especially when analyzing your income statement.

How is gross profit ratio calculated?

You can calculate gross margin by subtracting the cost of goods sold (COGS) from your total revenue, dividing that result by total revenue, and then multiplying by 100 to express it as a percentage:

• (Total Revenue – COGS) ÷ Total Revenue × 100 = Gross Margin (percent)

This gives you your gross profit ratio, which focuses solely on direct costs tied to delivering your product or service. It’s different from net margin, which accounts for all expenses, and operating profit margin, which includes operational costs like salaries, rent, and marketing.

For example, if you’re an SaaS company with revenue of $1.5 million and your COGS is $360,000, your gross profit margin is 76 percent.

• 1,500,000 – $360,000 / $1,500,000 = 0.76 x 100 = 76 percent

Why does gross profit margin matter?

Gross profit ratio is one of the most essential metrics for evaluating profitability. It reflects how efficiently your company operates and supports key business decisions.

A low gross profit margin may signal the need to reduce production costs or revisit pricing strategy. On the other hand, a high margin can indicate room to expand, reinvest in the product, or scale go-to-market efforts.

Beyond internal use, gross profit margin is a critical metric for investors, VCs, analysts, and potential acquirers—especially in SaaS. It plays a key role in company valuation and helps assess scalability. Higher gross margins typically mean more flexibility to reinvest in product development and marketing—two core levers for sustainable, long-term growth.

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What is considered a good gross profit margin?

Understanding why gross profit margin is important and how it’s calculated is good, but it means little without context. It’s a significant benchmark for measuring the financial health of a company. SaaS companies should achieve a gross profit margin of 75 percent, and anything below 70 percent may raise concerns for financial advisors, investors, VCs, and analysts.

Companies that went public between January and September of 2020 had an average gross profit margin of 76.6 percent, while companies surveyed for KeyBanc’s 2021 SaaS survey had a median gross profit margin of 73 percent. SaaS companies that are best-in-class typically have gross profit margins that range from 80 percent to 90 percent or even higher.

Gross profit margin varies widely by industry and is much higher for SaaS companies than for companies in other industries because the cost of goods sold is much lower than it is for other industries. For example, the average gross profit margin for the auto and truck industry is 9.04 percent, for restaurants and dining it’s 27.60 percent, and for household products, it’s 50.87 percent.

What challenges do companies face tracking gross profit margin?

Getting your gross profit margin wrong can lead to costly missteps—both internally and externally. For company leaders, inaccurate margins can distort strategic decisions. For investors, VCs, and analysts, incorrect data can impact valuations and overall confidence in your business.

One of the most common pitfalls is misunderstanding what belongs in your cost of goods sold (COGS), which can be particularly complex in SaaS. If your COGS aren’t clearly defined and documented, your gross margin calculation can be skewed—either undervaluing or overvaluing your company’s financial health.

For example, including expenses in COGS that actually belong in operating costs will deflate your gross margin, making performance appear weaker than it is. On the flip side, misclassifying operating expenses as COGS can artificially inflate your gross margin, giving the impression of higher profitability.

Getting this right depends on a clear understanding of where each expense belongs. Take customer service, for instance: if a support team is solely focused on helping existing customers, their costs belong in COGS. But if they also assist with sales or lead conversion, those costs fall under sales and marketing.

Manual processes introduce even more room for error—whether it’s a miscalculation, a copy-paste mistake, or overlooking a cell in a spreadsheet. Automating your financial reporting can significantly reduce those risks. With the right tools in place, you can ensure accuracy and easily visualize how your gross profit margin evolves over time—so you and your stakeholders always have a reliable view of your company’s performance.

Key takeaways

• Gross profit ratio, often called gross margin, measures the percentage of revenue remaining after subtracting the cost of goods sold (COGS) and reflects a company’s operational efficiency
• For SaaS companies, COGS includes expenses like web hosting, cloud services, and payroll for customer support, emphasizing the importance of accurate cost allocation
• A high gross profit margin signifies strong financial health, enabling reinvestment and growth, while a low margin can indicate necessary cost or pricing adjustments
• Investors and analysts use gross profit margin as a key metric to assess scalability and investment potential, making it crucial for SaaS companies to properly define and document COGS
• Automating financial analytics and leveraging strategic finance platforms can help companies avoid calculation errors and enhance data visualization over time

Use your gross profit margin data to tell your company’s story

A clear understanding of your gross profit margin gives you more than just a snapshot of financial performance—it offers a lens into what’s working, where you can improve, and how to drive future growth. It helps you dig into your financial data with purpose, guiding strategic decisions and highlighting opportunities to scale more efficiently.

Gross profit margin also plays a key role in how you communicate your company’s value. With data-driven storytelling, you can show investors and stakeholders how your business has evolved, the results of past decisions, and the path forward. When supported by strong metrics, your story becomes more compelling—and your strategic potential more evident.

SaaS gross margin FAQs

How does gross margin differ from net profit margin?

Gross margin focuses solely on direct costs—specifically the cost of producing and delivering a product or service. Net profit margin, on the other hand, accounts for all expenses, including operational, administrative, and overhead costs. It provides a more comprehensive view of overall profitability.

Why is the gross margin important for business owners?

Gross margin is a key indicator of financial health. It shows how much profit your business retains from each dollar of revenue after covering direct production costs. A strong gross margin suggests that your business is operating efficiently and has more room to invest in growth.

How do production costs and raw materials affect gross margin?

For manufacturing and product-based businesses, raw material costs are a major component of COGS. If those costs increase and product pricing doesn’t keep pace, gross margin shrinks. Monitoring and managing production costs is critical to maintaining healthy margins.

Do different industries have different gross margin benchmarks?

Yes, gross margin expectations vary widely by industry. SaaS, healthcare, and pharmaceutical companies often see gross margins above 75 percent due to low variable costs. In contrast, retailers like Target typically operate with gross margins around 25 percent, reflecting higher cost structures tied to inventory and logistics.