What is Gross Profit Ratio (Gross Margin)?
The gross profit ratio is the remaining percentage of a company's income after deducting its revenue or the cost of goods and services (COGS). Cost of revenue or COGS are expenses that a company incurs while putting its products into the market. The gross profit ratio is also known as gross margin.
As a business owner, your gross margin informs you of the money you get to keep for every dollar you earn. For instance, a gross profit margin of 80 percent means that out of every dollar you bring in, you keep 80 cents. The remaining 20 cents is what you spent on your product.
The gross profit ratio may appear to be a simple metric to compare revenue to profit. But the cost of revenue or COGS is a vital factor that will differ significantly depending on the business, industry, and business model. The cost of revenue for Software as a Service (SaaS) companies typically consists of the following:
- Additional expenses for cloud computing, including performance monitoring
- Processing charges for merchant payments
- Any cost incurred for software licenses directly connected to the creation or delivery of a product
- Web hosting services from providers such as Microsoft Azure, Amazon Web Services (AWS)
- Expenses for professional services and any required travel for the implementation and support of a product
- Payroll expenses for personnel and initiatives directly related to customer support
- Costs associated with building development, including engineering salaries
Calculating the cost of revenue can be difficult. The reason is that there are no precise rules for what to include in your cost of revenue or COGS. However, regardless of your sector, operational costs like sales commissions, marketing expenses, and administrative expenses should not be considered when calculating your gross profit ratio.
Gross Profit Ratio CalculationYou can calculate your gross profit ratio by following these simple steps:
- Deduct the cost of goods and services (COGS) from your total revenue
- Then divide the result by your total revenue
- Finally, multiply the result by 100 to create the gross profit ratio
For instance, you want to calculate your gross profit margin if your SaaS business has $2,500,000 in revenue and $500,000 in COGS.
Using the formula for the gross profit margin ratio, your gross profit will be:
(($2,500,000 – $500,000) / $2,500,000) X 100=(2,000,000 / 2,5000,000) X 100= 0.8 x 100
Therefore, your Gross Profit Ratio = 80%
The Importance of Gross Profit Ratio
One of the primary methods for assessing profitability is using the gross profit ratio. The gross profit ratio provides information on how efficiently your business operates and enables you to make crucial business decisions.
For instance, a gross profit margin that is too low can serve as a clear signal to company leaders that they need to reduce the amount they spend on their products. It can also imply that their prices are not high enough, thus indicating the need for them to raise their prices. On the other hand, a high gross profit margin can help signal to company owners that it is the right time to expand or reinvest in the business.
Aside from being a vital metric for company leadership, the gross profit margin is also essential to investors, Venture Capitalists (VCs), analysts, and those seeking to acquire other SaaS businesses. Gross profit margin assists them in SaaS valuation when determining whether or not to invest in or buy a company.
Furthermore, higher gross profit margins enable businesses to invest more in their products and marketing initiatives to boost growth. As a result, gross profit margin also helps VCs, investors, analysts, and others willing to buy a company to understand company scalability.
What Constitutes a Good Gross Profit Margin?
Though it is good to understand the importance of gross profit margin and how to calculate it, knowledge means little without context. SaaS companies should aim for a gross profit margin of 75%. Any gross profit margin below 75% may raise concerns for Venture Capitalists, financial advisors, analysts, and investors.
The average gross profit margin for businesses that went public between January and September 2020 was 76.6%. The median gross profit margin for businesses surveyed for KeyBanc's 2021 SaaS survey was 73%. Gross profit margins for best-in-class SaaS companies are usually between 80% and 90% or even higher.
In essence, every industry has a different gross profit margin. However, the gross profit margin for SaaS companies is significantly higher than the gross profit margin of companies in other sectors. The reason is that the cost of goods sold in SaaS companies is lower than those sold in other sectors.
For instance, the average gross profit margin for the restaurant and dining industry is 27.60%. For household goods, the gross profit margin is 50.87%. Then for the cars and trucks sector, the gross profit margin is 9.04%.
The Challenges Businesses Encounter When Monitoring Gross Profit Margin
Getting the wrong gross profit margin can affect businesses negatively. Getting your gross profit margin wrong can affect your decision-making as a business owner. Also, it will affect your company's assessment by investors, analysts, and Venture Capitalists (VCs).
Some factors contribute to getting the wrong gross profit margin. Some of these factors include the following:
1. Not knowing Expenses to Include and Exclude From COGS
One of the significant hurdles businesses face when calculating their gross profit margin is not understanding expenses to exclude or add to their COGS. However, this can be trickier for the SaaS sector than for other industries. Not defining and recording your COGS well could affect your gross profit margin results.
As a result, this can lead to leadership and investors making decisions based on inaccurate data. For instance, if you mistakenly include a line item (that belongs to your operational expenses) into your COGS. Adding this to your COGS will make it look like you have a lower gross profit margin than it truly is.
On the other hand, if you mistakenly include something in your operational costs that belongs to your COGS, your gross profit margin will increase. As a result, this gives the impression that your performance is better than it truly is.
Therefore, understanding where expenses fit within your company is essential for obtaining the correct COGS. Also, ensuring that all your team members know what qualifies a line item to fall under COGS is vital for getting an accurate COGS. For instance, if your customer service team only assists current clients, the cost of that team should fall under COGS. However, if your customer service team also participates in sales activities, the expense of that team would fall under the operational costs of sales and marketing.
2. Possibility of Human Error During Calculations
Another challenge businesses face when tracking gross profit margin is the potential for human error during calculations when the process is manual. When using spreadsheets to track such figures, it is easier to make typographical errors, copy-paste mistakes, or miss cells.
However, automating your financial analytics process can help guarantee you avoid making such unintentional and potentially embarrassing mistakes. With an automated strategic finance platform, you can quickly and easily visualize gross profit margins over time.
Telling the Story of Your Company Using Data on Gross Profit Margin
When you have an in-depth knowledge of the gross profit margin of your company, it will enable you to delve deeper into business financial data. The reason is that a thorough understanding of your gross profit margin allows you to see where to focus your attention when considering changes to be made. Additionally, it helps you assess the performance of your company and also assists you in determining how to maximize growth.
Using a gross profit margin, you can show your potential investors how far you have come and how best you can apply that information to scale your company. You can also showcase your strategic value and encourage others to engage with your business using captivating stories supported by data.