SaaS Contribution Margin: Discover Where Your Money Maker Lies
October 27, 2022
Challenging capital markets—like the one we’re in—are a call to revisit product roadmaps, analyze their profitability, and gauge their effectiveness. We’ve seen how gross margin is an effective tool in measuring profitability.
But if gross margin is a metric for profit, where does SaaS contribution fit in? And what does it mean for a successful business? At its core, a proper SaaS contribution margin can unearth the efficacy of your product. It shows the product’s maturity and the efficiency of its go-to-market strategy.
Why should you care about contribution margin?
If you’re a high-growth SaaS outfit that’s been in business for any time, you’re likely selling more than one product. It is inevitable. As a company grows, so do all the ideas people have carried out to expand the business.
Growth encourages us to be opportunistic. Opportunism pushes us to take risks and explore new ways to sell. New ways of selling creates multiple products that show up as one-offs, entirely new products, or the same product in new markets.
This is where your contribution margin steps in. It reveals which products are scaling well and generating cash, and it reveals the relationship between growth and profitability. A contribution margin also unveils the true cost of delivering value to a customer over time.
Knowing your contribution margin is about capital discipline. Do you know where you’re spending your money? Are you mindfully investing it into the future of the business, or is the spending on autopilot?
More than a simple formula, calculating contribution margin is an investigation. It reveals where the work is happening and why.
What is contribution margin in SaaS?
A contribution margin is a snapshot in time, and a fully loaded contribution margin takes into account the following:
- The variable cost of goods sold (COGS);
- Customer onboarding;
- Sales engineering;
- And sales and marketing expenses.
But if money is tight, or the product isn’t taking off as quickly as you had hoped, is it still worth supporting the product?
If you are close to an exit event, it may make sense to get rid of products with low contribution margins. In this case, let the new ownership decide if they want to pursue the idea. The immediate goal is to show that the business has a clear path to profitability. It is worth cautioning that this is short-term thinking driven by a near-term event. If the product is the future flagship of the company, any low contribution margin you might see currently is irrelevant.
What is a good contribution margin for SaaS?
Contribution margin can be low or even negative because it is early in the product’s or customer life cycle. There isn’t a clean answer to what’s a good or bad margin. But, any company looking at the long-term has to pave a clear pathway to improve their contribution margins.
For mature SaaS models, contribution margins tend to be negative in the first year and profitable by the third. And then they remain consistent over time.
The contribution margin formula
Calculating contribution margin is simple. In fact, it can be done with pen, paper, and a calculator. Gross profit takes into account all of the COGS, including fixed and variable expenses. For contribution margin, you’ll want to take out the fixed COGS expenses and add back all research, development, sales, marketing, and other variable costs directly attributable to that product. Divide that by the selling price, and you get the contribution margin.
Contribution margin = (revenue – variable costs) / revenue
Contribution margin vs. gross margin
The biggest difference between contribution and gross margin is the POV. Yes, there is the mathematical difference on how they’re calculated. But while contribution margin shows the profitability of acquiring and keeping the customer, gross margin shows the profitability of delivering the product to that customer.
How do you find your contribution margin? Follow the work.
Identifying the work and its workers is challenging in a large, fast-growing organization.
What is directly attributable to a product is not always clear or clean. It requires a dispassionate view of the business, no favoritism or “my-pet-project” bias. Most of all, the process demands intellectual honesty.
Let work, not revenue, decide your cost allocations
If you’re trying to allocate customer support costs between your products, using revenue as the proxy can be a recipe for disaster. In fact, your largest revenue earner may not be the reason for the most customer support calls. Similarly, your flagship product may not be the source of the most bugs.
For a vision to be realized, says the late Peter Drucker, it has to degenerate into work. The directors of an organization are the first stop where vision starts getting broken down into work. The best option is to find the directors of growth, customer service, and software engineering, who get the work done. Get their insights on where they and their teams are spending their time. The answers they provide will surprise you.
Ask questions about time spent
There is no magic sequence of questions other than to ask “a day in their life” questions like where do they spend their time, what sucks up most of their time. Questions like how much time is spent on exception processing versus executing on strategic priorities. What activities are the greatest source of annoyance in their day and what is truly accretive to their skills and their job. How much time do they spend on these activities and which products are the root cause?
At a CPaaS for example, a director of customer service may tell you that most of their agents are spending time troubleshooting browser plugins. Unrelenting customer support calls and chats leads to high customer churn. This means not only is your customer onboarding spend on that customer not improving, you’re spending more to acquire new customers.
The director of software engineering may say, most of the bug fixes are sucked up by real-time video or that most of the engineers’ time is spent as sales engineers instead of true R&D. A heads up: sales engineering is a sales and marketing expense, not R&D.
Survey and enquire with directors across all the levels to understand how the business operates.
The plain truth: 4 key takeaways
It is typical for a bread-and-butter product to underwrite the beta products. You have to only look at Google (search) and Microsoft (Windows and Office) for examples. But that’s no excuse for not knowing the financial maturity of all your products. At the very least, you need to know that:
- Contribution margin is a snapshot in time. It reveals which products are scaling well, generating cash, and ultimately the relationship between growth and profitability.
- Contribution margins are not always positive from the beginning. They tend to be negative in the first year, profitable by the third, and remain consistent over time.
- Understand how work happens. Let the work, not revenue, drive cost allocations, and for that you have to truly understand how the business functions.
- Ask smart questions. Get comfortable with asking tough questions that reveal the time-sucks and time-investments.
If gross margin anchors your product, contribution margin anchors your growth. One tells you if your product is profitable, and the other tells you if your product is sustainable.