What is gross margin?
Gross margin is gross profit divided by revenue, expressed as a percentage. It measures the production efficiency of the business — how much revenue is left after cost of goods sold to fund operating expenses, R&D, sales and marketing, and ultimately profit.
Formula
Gross Margin = (Revenue − COGS) ÷ Revenue
For a SaaS business with $10M ARR and $2M of hosting, support and payment-processing costs: gross margin = ($10M − $2M) ÷ $10M = 80%. The 80% is the funding pool for everything else.
SaaS benchmarks
- Software-only SaaS: 75–85% — best-in-class above 85%.
- SaaS with managed services: 60–70% — services pull the blended margin down.
- Marketplace / transactional: 30–50% — payment processing and partner economics compress the margin.
- Hardware-enabled SaaS: 40–60% — device cost is in COGS.
Gross margin vs. related concepts
- Gross margin vs. gross profit: margin is a ratio, profit is a dollar amount — both should grow.
- Gross margin vs. operating margin: gross margin stops at COGS; operating margin deducts all operating costs.
- Gross margin vs. contribution margin: contribution margin uses variable costs only; gross margin uses COGS, which mixes variable and some allocated fixed costs.
Why investors watch it
Gross margin is the single best proxy for whether the business model scales. A SaaS company with 50% gross margin will struggle to ever produce free cash flow at any scale — the math does not work. Compressing gross margin during high growth is a red flag in Series A+ DD.
Do: compute gross margin on a fully-loaded COGS basis (hosting, support, payment processing, third-party APIs); review the trend quarterly.
Don’t: exclude support or hosting from COGS to inflate the headline number — investors will normalise it back during diligence.