Using Gross Margin to Score Your Product’s Maturity
February 11, 2021
Gross margin is the complete, consistent indicator of business maturity. It documents the business your product is building. And yet it’s often tucked away in a financial update while a medley of product metrics enjoy the spotlight.
This treatment is a disservice to the value an in-depth, methodical, and iterative analysis can unearth. It needs to be treated as a top-level operational metric that a founder must know and understand.
At its core, gross margin (GM) speaks to the relationship between sales and its costs. For every dollar of product you sell, how much do you earn?
For example, 84% GM means that for every dollar of product sold, a business keeps 84 cents. As a founder, you can use this 84 cents to pay salaries, office rent, dividends, or invest in R&D.
Three activities can help drive the analyses and further our understanding of gross margin:
- Segment customers using a common core action
- Understand the levers of costs, also known as cost of goods sold (COGS) or cost of sales (COS)
- Make managing and reviewing gross margin an organization-wide priority
Fighting skewed data with segmentation
First, segment the users of your product in a way that removes any bias that skewed data may hide. The goal is to look at each segment as a stand-alone profit and loss (P&L) statement. Pick a common anchoring metric that measures a core customer activity. It tracks the quality of engagement with your product and is a non-financial leading indicator of your product’s usage.
Nir Eyal and Sarah Tavel call it the core action. For Pinterest, it’s the number of pins to a Board. For YouTube, it is the number of views. And for Twitter, it’s Tweets.
“Gross margin is the complete, consistent indicator of business maturity. It documents the business your product is building, yet it’s often tucked away in a financial update while a medley of product metrics enjoy the spotlight.”
It’s natural to go to payments per user or even user logins, but they rarely indicate user engagement. The anchoring metric needs to be something that demonstrates product usage.
With the anchoring metric identified, you can now select your customers into segments. The first step, as in any power law distribution, is to pick a base.
In most businesses (as in everyday life), 10 is an intuitive base. In this scenario, the distribution ranks the top 10, then the next 100, next 1000, next 10,000, and next 100,000, so on and so forth.
For example, if you had 500,000 customers, you’d have about five segments. Now, for each segment, isolate its revenue and COGS. Carried through to its logical conclusion, you’re creating five different P&L statements.
Segmentation prevents the biggest customer from drowning out the smallest. A thousand small but profitable customers could be making up for someone who’s writing a big check, but unprofitable. Therefore, you want to discuss each segment instead of the entire customer population. If revenue hides all sins, gross margin reveals them via segmentation. Done right, it then helps understand margin compression.
“If revenue hides all sins, gross margin reveals them via segmentation. Done right, it then helps understand margin compression.”
Margin compression is a company’s response to the demands of selling. While inevitable and with multivariate causality, it speaks to the product’s maturity and business model. It can happen due to either revenue-based factors like a freemium or a free trial, or expense-based issues like poor vendor relationships.
Offering free usage is par for the course as a SaaS customer acquisition strategy. You’re giving away the product for free forever (freemium), or a set period (free trial). The signature of such compressions is that they are short term. There’s an inflection point at which either the customer becomes profitable, or the converted customers pay for the ones who are using it for free.
Pricing wars are another source of margin compression. While it’s true that there are no bad margins, you maximize them when your product ranks high on the buying hierarchy of functionality, reliability, convenience, and price.
Popularized by Clayton Christensen, the buying hierarchy states products are successful if they score highest on functionality rather than price, reliability instead of convenience. In other words, if customers are purchasing the product only because of price, either you’re in a commodity market or your feature set lacks competitiveness.
When this happens, fix the product, pivot the business model, or expand the distribution channels. Watching margin compression ensures vigilance against irrelevance.
Margin compression also occurs when your variable costs increase disproportionately to your revenue. Scale reveals the depths of operational leverage. The best GMs happen when dramatic revenue increases don’t come with severe cost increases. Getting to this state requires careful product planning as well as strong vendor management.
Operational efficiency and COGS
The pressure that growth puts on operations increases COGS, thereby compressing margins. Most of this comes from customers using your product. This usage leads to increased vendor bills.
There are two ways to control vendor costs:
- Build vendor neutrality from the ground up
- Ensure deep relationships with strategic vendors
Optionality begets neutrality. This begins early in the product’s design. The best way to ensure optimal costs is by creating a reward and punishment framework where vendors are continually competing for your business. Creating a marketplace does just that. It’s also the best way to future-proof expenses (more on this later).
Sometimes vendor neutrality isn’t an option. For example, if you want to call or send a text to a Verizon phone, there’s no way to get to that phone via AT&T—it just doesn’t work. Similarly, if you’re in the credit card business, at some point all roads lead to Visa, Mastercard, or American Express. In other words, there’s an underlying interconnected network monopoly that just cannot be ignored—even when your product is challenging it.
The bigger you scale, the higher the chances of working directly with the monopolizer. When that isn’t possible, you’re dealing with a limited set of resellers. Whether working directly with the monopoly or the reseller, avoid paying list price. Buy your discount or earn it.
One way to buy discounts is through minimum commits. It’s a risky proposition, as it makes bets on future growth that may never materialize. This is especially true if the commitment is made during good times.
Alternatively, you can earn your discount by baking in volume-based triggers that either give you step-function improvements in costs or give you a runway to get to volume.
Finally, don’t let size stop you from talking to the monopoly provider. Long term, keeping communication lines open builds good relationships. In the near term, it keeps your reseller in check.
Protecting optionality is a classic Drucker one-decision-to-save-a-thousand moment. Once you become intentional about keeping all options on the table, it clarifies vendor choices and even partner selection.
For example, when coming to a cloud vendor, deciding to be vendor agnostic at the time of product design ensures you aren’t tied down to AWS, Microsoft Azure, or Google Cloud. But if that’s not possible, one way to counter it is to build strong relationships higher up in the vendor organization and continue to keep the relationship warm with others. This ensures that your vendor is always motivated to give you the best prices.
Margin compression is all about usage. It would then seem that margin expansion is good. Not always.
Spoilage is the opposite of usage. It’s an accounting treatment when the customer has paid but didn’t use the product.
Here’s how it works: Your terms of service (ToS) states a date after which whatever unused product the customer has purchased expires. In the short term, it inflates your gross margin as you paid for the product but bore no costs. But in the long term, it’s rarely good for business.
Let’s say your product costs $29.99/month, and your ToS states that the billing cycle resets at the end of every month. If the customer used only $15, that’s $14 ($13.99 to be exact) of the customer’s money you get to keep with no associated costs.
Even though you have 84% GM (from the example above), your gross margin on this customer is a whopping 92%. At face value, it feels like a windfall. However, it shows an imbalance between the customer’s wants and what the product delivers. The customer will realize it and decide that either the overpayment is worth it (this is rare) or cancel their plan.
It’s logical, therefore, that spoilage is a leading indicator of churn. Look at spoilage as a loan from the customer. If it’s not paid back soon, the customer will collect by canceling the subscription or requesting a refund.
In the ordinary course of business, spoilage is inevitable. Most subscription plans have it. Wireless carriers, for example, have been depending on it for decades. But if you find systemic spoilage where customers buy a feature they don’t use, be worried.
Be especially concerned if it’s the reason for a significant increase in gross margins. You have to act on it quickly. Here’s where having a mature segmentation model comes in handy. Look at the customer segments, identify the key segments contributing to spoilage, and build a cross-functional team to aggressively address the issue.
Managing gross margin
The only way it can get the focus, attention, and care it deserves is to have a senior executive for whom gross margin is a top-level metric.
This executive is the company’s chief punch-me doll. The series of tradeoffs required when managing for top-line growth make it such that GM will get a lot of pressure. The job is thankless and necessary—it requires spine. It needs the foresight to preserve optionality when possible and to walk into decisions with an open mind and a guarded heart, and it requires an acknowledgement that GM is just a number that reflects your choices and yet not get beholden to it.
“The only way it can get the focus, attention, and care it deserves is to have a senior executive for whom gross margin is a top-level metric.”
Lots of bad things have happened when metrics dogma sets in, and people chase a goal for a goal’s sake—or, worse, try to tell a story that isn’t grounded in facts.
As the owner of the metric, you’re aware that the market reserves the best rewards for top-line growth. Focus relentlessly on responsible growth and see your gross margin improve as an outcome of that focus. You’ve got to lead by influence, yet have the gravitas to make the tough calls when needed. A founder/CEO typically best fits this mold.
Telling the story
Your gross margin is a packed metric that reflects the value network on which it rests. It requires an in-depth knowledge of the product and a nuanced understanding of the pressures it faces.
It also requires vigilance. You can juice your margins by spending on new business and disguising underlying disengagement. A high-churn business can be a high-margin business, but the money your product makes is the story your gross margin tells. It keeps you intellectually honest by looking at all aspects of the business.
Cash is the ultimate leverage, and gross margin reveals your product’s ability to generate it. Once you know GM, its other marginal friends—namely contribution and operating—become easier to understand and tell you even more about your business.