Gross margin = (revenue − cost of revenue) ÷ revenue
Nobody argues about the arithmetic. Every argument is about what goes in cost of revenue.
What belongs in cost of revenue
- Hosting and infrastructure for the production service.
- Support, the whole function.
- Customer success, where it is required to keep customers running rather
than to grow them. Teams that do both split the cost.
- Professional services delivery, if you sell services.
- Third-party costs embedded in the product: data, APIs, licences resold
inside your service.
- Payment processing, where material.
What does not: sales, marketing, research and development, and general administration. Those are below the line.
The line items most often left out
Each one inflates the margin, and all four are common:
- Customer success entirely, on the argument that it is a growth function.
Defensible for the expansion half; not for the keep-them-running half.
- Embedded third-party data, coded as a software subscription rather than
as cost of revenue.
- The support engineering that sits inside the R&D headcount, so it never
reaches the line.
- Free-tier infrastructure, on the argument that it produces no revenue.
It is a cost of serving the product either way.
A company reporting 88% gross margin and one reporting 74% may be running identical businesses with different accounting.
Why SaaS margins are high, and what changes them
Software has near-zero marginal cost of delivery, which is where the high margins come from. Three things pull them down:
- Services mix. Implementation revenue carries a fraction of software
margin, so a services-heavy quarter drops the blended figure with no change in the software business. Report software and services separately.
- Usage-based costs. Infrastructure that scales with customer usage rather
than with customer count.
- Enterprise support commitments. Dedicated resources at named accounts.
A worked example
Annual revenue of $8,000,000: $7,000,000 subscription and $1,000,000 services. Cost of revenue: $620,000 hosting, $540,000 support, $310,000 customer success delivery, $700,000 services delivery.
Blended = (8,000,000 − 2,170,000) ÷ 8,000,000 = 72.9%
Software only = (7,000,000 − 1,470,000) ÷ 7,000,000 = 79.0%
The blended number is the honest headline. The software-only number is the one that says whether the product economics work. Reporting only the second is the standard flattery.
The traps
- Publishing a margin without the cost-of-revenue line items.
- Blending software and services and comparing to a software-only benchmark.
- Moving a cost above or below the line between periods without annotating it.
- Reading margin without sales efficiency,
which is where the acquisition cost lives.
Where this sits
Gross margin is Measurement in the Tenbound Pipeline Architecture Standard and is the furthest from pipeline work of anything in this library. It is included because it constrains what a business can spend to acquire, which is the link to sales efficiency.