SaaS Profit Margins
Software as a Service (SaaS) Profit margins are the first identifying financial metric that a SaaS CFO will review. The profit margin can be managed by both sales (price per service/project) and cost of sales (primarily labor). The management of these two variables can greatly determine whether a SaaS company is going to have a profitable year or a loss.
Besides adjusting the sales prices or employee wages, what are the things the company can do to develop favorable profitability trends?
Consider using SaaS financial metrics, in combination with personal experience and work factors, to estimate programming time and cost.
When a company purses a new project, whether it is a custom program or a subscription software, they need to fully understand all the time necessary to deliver the project.
Companies tend to form a pyramid when it comes to employee structure. In general, there will be more 1st and 2nd year employees as compared to supervisor and manager level employees.
The employee’s chargeable hour and corresponding salary should, of course, match their experience level. The lower level employee will have a lower salary and a corresponding lower billing rate.
These employees will do most of the entry-level-type work. The next tier employees will do more the higher-level work, and thus their salary and billing rate is higher.
Using this structure, the company should then build budgets to determine how much time needs to be worked by each level. If a project is difficult or highly technical, then the budget will incorporate more higher-level employees.
The more fine-tuned the budget for project, the better the company can plan and price.
Offer a menu pricing options based on the scope of the engagement. This will help prevent the company from losing money on individual jobs.
How many times has a company bid on a job only to see write-offs of time due to additional work that wasn’t billed for?
No matter the industry, no one likes to call the client and explain there were cost over-runs and there is an additional fee for the project.
Setting up menu pricing removes most of the dreaded ‘additional billings’ and sets clear expectations to the client.
If the client wants a change to a project, they already know the additional price. From an internal standpoint, most SaaS companies know how much additional time is needed for certain add-ons. Budget and cost for those add-ons can be calculated well in advance of the next customer.
The menu pricing will assist in prevention of lost money and unexpected billing issues for the client.
Understand the revenue per production employee.
The calculation of revenue per production employee is a key metric when reviewing profitability.
The main point is that this calculation is done on ‘production’ employees. The production employee is the one who is earning revenue for the company.
These employees are essentially the ‘cost of good sold’ driver for the company.
This threshold should be compared to the actual revenue per employee. Revenue above this threshold will contribute to an increase in profitability.
As of April 2020, the current industry average of revenue for SaaS companies (per employee) is approximately $182,000.
Search out multiple qualified vendors to get the best prices through competition, while maintaining quality.
This may sound simple. However, how many companies have been using the same vendor for the past five years?
How often has the company went out to bid on their professional services such as tax accountants and auditors?
It is natural for a company to consistently use the same vendor over and over and not search out new opportunities.
Doing a search takes time and effort and some familiarity gets built up with certain vendors. However, if the business is not continually reviewing/updating its existing and potential vendor lists, it may overspend on supplies/inventory/external professional costs.
An example would be a company using the same service provider for twenty-plus years. Often, in this situation, when a company merges or comes under new management, the new leadership will realize that the fees are substantially higher than necessary.
A company doesn’t want to sacrifice quality, but cost should be considered on a routine basis.
Generate accurate financial reports on a timely basis – within 30 days of the end of the financial period.
Most companies have their accounting records linked through a cloud service provider—from the general ledger to payroll to invoicing.
The bank account is more than likely linked to the cash accountant in the general ledger. Many SaaS companies utilize QuickBooks Online or Xero.
The virtual controller should make sure all the information is correct and accurate and make the reports available to management within 30 days of the period end. Timely financial information will help ensure the usefulness of the data for examination purposes. Good financial reports are the backbone of management decisions.
Be sure to track how much return (additional sales) the business gets from increases in advertising.
Measuring results, no matter the area, is key to determining the effectiveness or return on funding. Advertising costs should be tracked in relation to actual results obtained. This concept is similar to the practices already established by multiple online advertising options. Advertising methods should be qualified by measurable results.
Tips and recommendations:
SaaS profit margins have several variables, or levers, that can be manipulated by management to improve the company’s performance. To develop more favorable profitability trends:
- Consider using SaaS financial metrics, in combination with personal experience and work factors, to estimate programming time and cost. This can help the company improve planning and pricing, increasing profits.
- Offer a menu pricing options based on the scope of the engagement. This will help prevent the company from losing money on particular jobs.
- Search out multiple qualified vendors to get the best prices through competition, while maintaining quality. If the company is not continually reviewing/updating its existing and potential vendor lists, it may overspend on supplies/inventory.
- Generate accurate financial reports on a timely basis – within 30 days of the end of the financial period.
- Be sure to track how much return (additional sales) the company gets from increases in advertising. Advertising methods should be dictated by effectiveness.
There are multiple financial levers that management can pull to develop favorable profitability trends. Becoming familiar with multiple levers allows management to adapted and increase profits in a systematic method.