A Structured Approach to Calculating Product Margins & P&Ls for Software & SaaS Companies

Background

Product margins and P&Ls can support senior management, product management, sales, marketing, and engineering teams in making better long-term decisions. Product margins and P&Ls facilitate the evaluation of entirely new products, new design features, and special product management or engineering initiatives. They also facilitate the evaluation of existing products. For example, older legacy products may no longer be financially viable to continue to support vs. discontinue. These metrics can help SaaS companies to better optimize their product portfolio mix. Firms can better calibrate their product pricing strategies and improve overall subscriptions margins.  Product margins are a fast and effective way to know where your company stands relative to other competitors.

Calculating product margins and P&Ls for software products can be an extremely complicated and time-consuming task. One must have a complete understanding of several factors related to the process to develop a methodology that works best consistently for your company. The allocation of expenses is one of the most challenging aspects of developing product margins. I have seen software companies utilize up to 4 different variations or types of product margins, and one may be more applicable to your firm than another.  This article is designed to help the reader design a structured and methodical approach to calculating software product margins & P&Ls.

The article is broken out into several sub-topics that have been organized sequentially so I recommend reading it in its entirety to gain maximum benefits, including:

1) Product Segmentation & Classifications

It is very impractical to calculate product P&Ls and margins at the individual SKU or item level if you have more than 100 SKUs.  A better practice is to calculate these metrics at the product category or product class levels. Product category or product class then rolls up to product family level. It is critically important that a company have consistency in its product segmentation and classification categories across all groups including engineering, product management, marketing, sales, accounting, and finance. Without this consistency there is no way to guarantee that product P&L and margins will be calculated correctly. This is especially an issue for the expense allocations for products which can be severely distorted if the wrong product classification levels are utilized.

2) Calculate for All Products

Calculating software product P&Ls and margins is an all or nothing exercise. Some business unit heads want to calculate the P&Ls of only their main or more profitable products. However, this thought process is flawed for one primary reason. In order to calculate software product P&Ls you need to understand the firm’s entire cost structure to ensure proper allocations of expenses or cost pools to each software product. Thus, if you are going through this process already you might as well do your entire product portfolio.

3) Reporting Period

Software product P&Ls and margins are best calculated monthly or quarterly. Do not try calculating product margins weekly as it will not work. Keep in mind though that calculating product P&L monthly means you are subject to more volatility. An example is that cloud hosting bills may not be received within the exact month. Quarterly product P&L calculations are another option as they help smooth out any intra-month expense volatility.  Calculating product margins monthly can help dynamically optimize sales, marketing, and pricing strategies.

4) Back testing & Historical Data

A sample size of a minimum of 30 observations is recommended in traditional statical analysis as it increases the confidence interval that your calculating methodologies are stable.  Thus, it recommended that for calculating product P&Ls and margins you utilize at least a minimum of 24 to 36 months for back testing purposes. Utilizing less than 24 months of historical data will not necessarily invalidate your allocation methodology, but it will not verify if your methodology is consistent or stable over the long-term.

5) Recurring vs. Non-Recurring P&Ls and Margins

Some software companies seem to only focus on recurring revenue product profitability metrics. However, for many software companies non-recurring services make up a significant percentage of total revenues. Services P&L and margins should also be calculated as a part of any overall product P&L and margin analysis process. The calculation of service line P&L is much easier than for products because services line is mostly time and materials which are usually carefully tracked and easily allocated at the product category level. This article does not focus on service product P&L and margins because they are essentially calculated in a similar manner to software product P&Ls

6) Manual vs. Automated Calculations & Best Software to Use

Many companies continue to do product P&Ls and margins calculations manually in Excel or other spreadsheet programs. Spreadsheets are an ideal environment for the initial expense allocation methodology development and for back testing. However, due to the large amount of data that may be utilized relying on spreadsheets, long-term introduces the possibility of human error such as pasting the wrong data set into the wrong product column.

 A better long-term alternative is to automate the calculations using budgeting or data analytics software which can help make sure that you avoid such errors and never have to worry about unintentional mistakes. The two most common ways I have seen product margins and P&Ls calculated are as follows:

• Budgeting software like Adaptive Planning, Planiful or Anaplan
• Data analytics software like Tableau, Power BI or Google Looker

Some firms also try do product margin calculations in accounting software but this often is a futile process as most accounting software cannot be customized enough to handle complicated or hybrid expense allocation methodologies. I have seen NetSuite configured to do complicated expense allocation for product margins and P&Ls but this can be very expensive to develop and maintain over time.

7) Challengers Tracking Product P&L & Margins

Based on my experience, many SaaS companies struggle with reporting accurately reporting product margins due the following reasons:

8) Product P&Ls vs. Product Margins

Some people use the terms product P&Ls and product margins interchangeably but there are differences. Product P&Ls are calculated in absolute dollars whereas product margins are calculated on a percentage basis. To calculate product margins, you must always first calculate product P&Ls. Calculating product P&Ls requires you to properly classify different classes of expenses as direct, indirect, COGS, COR, fixed, variable, operating and non-operating expenses. To calculate software product P&Ls you need to develop an allocation methodology for expenses which is also needed to calculate product margins.

9) Product P&Ls

A product P&L is a comprehensive financial statement that provides a detailed breakdown of all the revenues, direct costs, and indirect costs associated with a specific product. It measures the overall financial performance and profitability of the product, considering all aspects of the business related to that product.  It provides a strong, quantifiable estimate of the efficiency of the business. It is used for strategic planning, decision-making, and assessing the overall financial health of a product or product line. It helps in identifying the cost elements that need to be re-looked at to achieve greater efficiency. Product P&Ls can help determine which products require further investment and which products should be retired. A negative product P&L indicates there is probably something is either very wrong with product pricing or product costs are too high.

Product P&Ls are always calculated in monetary units such as Dollar, Pounds, Yen, Euros etc. Product P&Ls can be calculated in two ways on a total dollar basis or on a $ per unit sold:

Product P&Ls help companies provide a basic understanding if their products are profitable. However, they are not always directly comparable across different product lines and companies. This is why I prefer using product margin analysis which is the focus of this article.

10) Product Margins

There are four common margins that are utilized to calculate the profitability on a company wide basis including:

1) Gross Margin

2) Contribution Margin

3) Operating Margin

4) Net Margin

Note, the above margins can be adapted to calculate margins on a product basis by allocating different classes of expenses in structured approach. Many software companies will calculate either product gross margins, product contribution margins, product operating margins or even product net margins.

Product margins specifically focus on the profitability of a product by calculating the difference between the revenues (or selling prices) and expense types allocated to the product. A product margin that’s too low can signal to company leaders that they need to cut how much they’re spending on their product or that their prices aren’t high enough. Product margins provide a more granular view of a product's profitability and help in optimizing pricing decisions and cost control. Product margins are directly comparable across software companies and different software sub-sectors whereas P&Ls are not. Product margins are also important to investors, VCs, analysts, and those looking to acquire other SaaS companies.  Product margins help one to understand a company’s scalability since higher gross profit margins allow companies to invest more in their product and marketing efforts to boost growth.

11) Product Gross Margin

Gross margin is synonymous with gross profit margin and includes only revenue and direct production costs. It normally does not include operating expenses such as sales and marketing expenses, or other items such as taxes or loan interest. Gross margin includes all direct labor and direct materials costs, but not the administrative costs for operating the corporate office.  Gross margin represents the percentage of total revenue a company has left over above costs directly related to production and distribution. For gross margin, the higher the percentage, the more financial value-add is produced on each dollar of sales made by the company. On the other hand, if a company's gross margin is falling, it may look to find ways to cut labor costs, lower costs on acquiring materials or even increase prices.

Many software and technology companies utilize the traditional formula for calculating product gross margins as shown below:

However, some software companies substitute a modified version of cost of goods sold called cost of revenues (COR) when calculating product gross margins. COR includes certain operating expenses such as sales and marketing expenses and customer success expenses that are required to help sell the company’s product. The components of COR can vary significantly from one firm to the next but adjusted formula is as follows:

SaaS gross margin can be either positive or negative (though it will usually be positive). If the margin is negative, this indicates that the money being spent to create and deliver a product is greater than the revenue being generated from the sales.

12) Product Contribution Margin

Contribution margin is the revenue remaining after subtracting the variable costs that go into producing a product. Contribution margin calculates the profitability for individual items that a company sells. Specifically, contribution margin is used to review the variable costs included in the cost of an individual item. Contribution margin can be calculated using the following formula:

13) Product Operating Margin

Operating margin subtracts all overhead and operational expenses from revenues, indicating the amount of profit the company has left before figuring in taxes and interest. Operating expenses include items such as wages, marketing costs, facility costs, vehicle costs, depreciation, and amortization of equipment. Operating margins consider both direct and indirect costs and is a measure of profitability that reflects the overall operational efficiency of the business. It is calculated as:

14) Product Net Margin

The net margin metric (also called net profit margin) represents the accounting profitability of a company, inclusive of all operating and non-operating costs. The metric captures the full effect of all non-operating costs that are not captured in gross margin, contribution margin and operating margins. Non-operating expenses include interest payments on debt, restructuring costs, lawsuit settlement fees and taxes. Most software companies do not often calculate product net profits margins. However, doing so can give a firm the most complete picture of total product profitability including non-operating costs.

For the software companies that do utilize this method, allocation of non-operating expenses to various products is usually done using revenue weighted methodology. Please see the allocation section of this article for a more detailed discussion on allocation methodologies.

15) Revenues

Determine the total revenue generated by the sale of each Product Group or Product Class. This includes all income sources related to the product, such as one-time purchases, recurring subscription fees, software licenses, in-app purchases, add-ons, premium support. custom development work integration service and any other sources of income generated from the software such as royalties.  It includes all the money earned from selling the product, including any additional income such as interest.

16) Cost of Goods Sold (COGS) vs. Cost of Revenue (COR)

Some software and SaaS firms use the terms COGS and COR interchangeably but they are not the same. Cost of revenue (COR) and cost of goods sold (COGS) are related but not identical. Both represent the direct costs of producing or delivering products or services. COGS generally refers to the direct costs incurred in producing a product. In contrast, cost of revenue is broader, encompassing all direct costs related to generating revenue, such as COGS and distribution, customer support and marking costs. The generic formula to calculate cost of revenue is shown below but will vary by firm:

Companies with a physical product customer support does not impact COGS, which is why these companies categorize it as an operating expense and not part of COGS. However, SaaS companies include customer support costs to their cost of revenue since customer support is essential and directly related to providing and maintaining the product or service. Some software firms include marketing and advertising costs as operating expenses, while others include it as part of cost of revenues (COR). The cost of revenue includes all the costs the company incurs to obtain a sale (which includes any fixed costs or variable costs) plus the cost of goods sold.  A simple test to determine whether to include certain costs in your COR is to ask, “Can my customers still access and use the application if I don’t pay that expense?” If the answer is no, then the expense goes into your SaaS gross margin calculation. If the answer is yes, then you exclude it. Note, depending upon what types of expenses a SaaS firm includes in COGS or COR definitions may dictate which of the four product margins mentioned earlier are best for the firm to utilize.

17) What Makes Up COGS or COR?

If your COGS or COR are not thoroughly defined and documented, it can throw off your product margin calculations and cause leadership and investors to make decisions based on bad data. Accidentally including a

line item in your COGS or COR that should be classified as another expenses type will make it appear as if you have a lower margin than you truly do.  While COGS or COR can include both fixed and variable expenses, it is generally considered a variable cost. This is because most of these costs vary in proportion to the level of sales.

For SaaS models, COR or COGS or direct costs are those activities associated with the delivery of the hosted software. There are usually 7 main categories of expenses:

The above list of categories can vary dramatically from one software firm to the next.

If a cost isn’t directly related to your software or SaaS product, you shouldn’t include it in your COGS or COR. Instead, you would place those costs under operational expenses. Typical examples of items to exclude from COGS or COR include:

18) Direct vs. Indirect Costs

A direct cost is any expense associated with producing and delivering the software. This may include software development costs, licensing fees for third-party software or libraries, and any costs directly tied to producing the software.

An indirect cost is any expense associated with the functions required to run the business. Indirect costs are shared expenses that are not directly tied to a specific product but are essential for the overall operation of the company. These could include office rent, utilities, general administrative salaries, and other overhead costs.

19) Fixed Costs vs. Variable Costs

Fixed costs are costs that do not change with the level of output or sales. They remain the same whether the company produces/sells nothing or a large volume. Examples include rent, insurance, legal, computer equipment, HR or accounting software like, salaries of permanent staff, salaries for software developers, and marketing and advertising expenses.

Variable expenses are costs that vary or change as the quantity of software sold. Variable costs are the sum of marginal costs for the product being sold. Variable costs include many items included in COGS or COR as discussed earlier.

20) Operating Expenses

Operating expenses include all indirect costs associated with running a software business. This may include salaries and benefits for employees, information technology costs, rent or lease expenses, utilities, legal costs, accounting fees, and any other administrative expenses.  Some software firms include marketing and advertising costs as operating expenses, while others include it as part of cost of revenues (COR) as discussed earlier. Research and development expenses if you continue to enhance or update the software are usually included as operating expenses although some firms include parts of it sometimes in COR calculations.

When calculating operating margins, the allocation of operating expenses is not clear cut. If specific operating expenses such as R&D can be directly attributed to a product, then they should be allocated 100% to that product. Other operating expenses such as rent or legal costs cannot directly be attributed to specific software products, and these should be allocated using a general method such as a revenue based allocation.

21) Non-Operating Expenses

A non-operating expense is a cost that isn't directly related to core business operations including:

At privately held firms non-operating expenses except for interest expense and income taxes are typically called below the line (BTL) expenses. When calculating product net margins, the allocation of non-operating expenses is not clear cut.  Similar to operating expenses, if a non-operating expense cannot be directly attributed to a product, then it should be allocated using a general method such as a revenue-based allocation.

22) Expense Allocation Methodologies

Allocating expenses to software products can be a complex task, but it's essential for accurately assessing the cost of each product for an organization. There are several methods and weightings you can use to allocate expenses to software products, and the choice of method often depends on the specific circumstances, goals, and accounting practices of your organization. When working on allocation methodology the best rule of thumb is to try several different methodologies and to back test them using at least 24-36 months as discussed previously.  The rule of thumb is to evaluate and re-test enough historical data until you have a methodology that is consistent over time and does not yield wild swings in metrics.

Here are 10 of the more commonly utilized expense allocation methodologies use for calculating margins:

Most often companies wind up using the hybrid allocation methodology that combines a few of the other methodologies used in conjunction with each other. It's important to note that the choice of expense allocation methodologies should align with your organization's financial and reporting requirements, as well as the nature of your software products and projects.  The best method to choose is often a trial-and-error process. Back test your allocation methodologies using 24 - 36 months of historical data to ensure it provides consistent results over the long-term. If your product margin metrics have wild swings from month to month then you may need to re-think the allocation structure to reduce volatility.

23) Product Target Margin Levels

Software company product margins will vary significantly from one sub-sector to the next and due to the maturity state of a company. A fintech firm will have dramatically different product margins than an educational or industrial automation software company. Venture capital backed software companies vs. a mature publicly trade software company will have vastly different product margins. And in general software company product margins will vary significantly from a perpetual (maintenance) vs. a fully SaaS (subscription) business model.  

There are multiple factors that contribute to a software company’s ability to maintain a high gross margin; they can include a product that gives the customer high ROI, pricing discipline and power, a product that’s easy to use and requires little ongoing support from the vendor, and an efficient and scalable infrastructure. 

When comparing product margins for SaaS businesses against an industry benchmark, keep in mind that differences in business models can account for some variance. Additionally, operating practices, such as being a fully remote company vs. 100% in office, can also impact how expense items are calculated. For example, some software and SaaS companies will use COGS in their calculations of product gross margin while others will use COR which can include sales, marketing and customer support costs depending on the firm.

Typical software and SaaS industry product gross margin benchmarks are shown below. A product gross margin below 70% is a red flag and means this product group or product line is in trouble. A product gross margin greater than 75% is good. Best-in-class companies had product gross margins of at least 80%. Most products’ gross margins are typically in the 70 to 85% range on average.

Tracking this metric over time can help you determine if you are on the right track towards profitability.  A high SaaS product gross margin means that you will have more cash in hand to reinvest in product growth and improvements long-term.

24) Regularly Review and Update

After calculating the product margins for each software product, analyze the results. This will help you identify which products are more profitable and which ones might need optimization or reconsideration. While margins are important, also consider the long-term viability and growth potential of each product. Some products may have lower margins but a higher growth potential, making them more valuable in the long run. Use the margin data to make informed decisions about resource allocation, pricing strategies, and product development. You may decide to invest more in high-margin products or take steps to improve the profitability of low-margin products.

Software product margins can change over time due to market dynamics, competition, and internal factors. Regularly review and update your calculations to ensure that you are making informed business decisions.

Remember that calculating software product margins is an ongoing process, and it's crucial to have accurate and up-to-date financial data to make informed decisions about your product portfolio.

25) Ways to Improve Product Margins for Software and SaaS Companies

The best ways to improve product P&L and margins will depend on your company’s stage in the business cycle, its size and structure, its target market, and numerous other factors. However, there are still a few things that virtually all software and SaaS organizations can do to increase product margins:

Conclusion

Tracking and benchmarking your software product margin & P&Ls is key to understanding whether products are profitable or unprofitable. Calculating the product margins and P&Ls for software products is a complicated task that requires a very structured and methodical approach.  The allocation of expenses is one of the most challenging aspects of calculating product margins. Note the expense allocation methodologies utilized can vary significantly from one firm to the next. I hope this article has provided you with a basic understanding of the various factors related to the process of developing product margin & P&L calculation methodology that works consistently for your company. Please feel free to reach out to me if you have any questions.