The importance of gross margin
Gross margin is a key business measure that should be regularly assessed as part of CTOs’and CPOs’ strategic thinking. Many of their decisions have a significant impact on a company’s gross margin which is an important indicator of future profits. And the larger the gross margin, the more money there is to invest in product development going forward.
What is gross margin?
But what is gross margin? It is a company’s net sales revenue minus its cost of goods sold (COGS). In other words, it is the revenue a company retains after incurring the direct costs associated with producing the goods it sells and/or the services it provides. This fundamental profit metric is used by investors, creditors, and analysts to evaluate a company’s current financial condition and its prospects for future profitability.
Once a company’s gross margin has been calculated, costs such as sales & marketing, research and development and overheads (often called general and administrative) are then deducted. These expenses are typically called operating expenses and the difference between gross profit and operating expenses represents your profitability.
Therefore, gross margin answers whether a company can profitably build a product. Contrast this with operating margin which determines whether a company can operate profitably after all production costs (gross margin) for producing a product and all other factors like marketing, research and development, management salaries outside of production etc.
Most tech and product leaders, however, ignore gross margins. But, put simply, the higher the gross margins, the more cash there is to spend on areas such as sales marketing as well as product and engineering. Yet it is rare for product teams to prioritise gross margin initiatives. This is potentially a great way to lobby your CFO and CEO for increased investment, if you can demonstrate how you will generate the additional investment yourself.
Product market fit and gross margins
Many software companies today have gross margins of around 70%. But gross margins often change dramatically over the lifecycle. They can be low when a company is starting out but these margins are expected to increase after product market fit is achieved.
This means product teams can sometimes ignore gross margins in the early stages of an organisation and instead focus on product market fit. But as a company matures, it is critical that product teams look to drive long term margin growth. Investors want to be shown meaningful margin improvement and a credible path to steady state margins. If gross margins remain low, it is important for product teams to demonstrate there is potential for margin growth at some point in the future, for example through demonstrating increased loyalty and retention from later cohorts of customers.
Even if it is not a priority, teams should regularly consider how they contribute to gross margin, During companies’ growth phase there is often gross margin leakage, especially for Saas firms during the implementation of services for customers. For example, it is critical for the product teams in such firms to make client software implementation a repeatable process. But before they make it a repeatable process, pricing for implementation is often not charged. Even worse, many technical teams don’t even track the full costs of implementation and don’t always realise that they are hurting the company’s bottom line with this approach.
Sometimes CTOs and CPOs excuse losing money in implementation and dragging down performance as a natural result of scaling up. And sometimes they promise this is only temporary as they have not yet prioritised the work needed to make such implementations easily repeatable. But complex implementations cannot always be avoided as there is a long tail of complex customer environments and these constantly challenge margins. A strong technical leader will recognise this early and insist that their sales team charges customers for handling that complexity in the desired cookie-cutter approach to implementation looks elusive.
Decisions that impact gross margins
Other decisions from engineering and product leaders can also have a significant impact on gross margins. Take freemium businesses for example. These organisations grow a user base with the aim of monetising these users at a later stage. Sentiment is growing to shift the costs of attracting this huge user base out of COGs and into sales and marketing. Slack already does this (and therefore has a high gross margin). Software teams increasingly need to recognise the type of work they do and build strict definitions so costs can be correctly attributed in the organisation’s financial numbers.
Cloud costs are another hot accounting topic. Saas organisations today are increasingly putting cloud costs and some software licence costs into COGs. There are reports of companies who have failed to do this, only for investors to discover gross margins are 5-10% less than reported due to incorrect accounting on cloud costs. Without this clarity, it is hard to properly predict future profitability.
Anytime a company can’t maximize profit margins through keeping in-house systems highly utilized, they should seek to outsource the workload to an IaaS provider. For example Why purchase a server to do work 8 hours a day and sit idle 16? Part of staying competitive is focusing on profit maximization to invest those profits in other, higher return opportunities. CTOs that don’t at least leverage Infrastructure as a Service to optimize their costs of operations and costs of goods sold (if doing so results in lowered COGS) are arguably violating their fiduciary responsibility
CTOs of scale-ups are now often finding themselves being asked to reduce cloud costs in order to improve gross margins. This can be achieved, but engineers need to be very clear on any trade-offs when making these decisions (as again, these can impact predicted future profitability if not fully recognised by the finance team).
As the world looks more and more uncertain, preserving gross margin for the future will become increasingly important. In fact, some CTOs are already looking beyond gross margin to net margin with a big focus on reducing the cost of ownership across all areas of technology.
A move to more partnerships allows the buyer to focus on core competencies, increasing investments in the areas that create true differentiation. Why spend payroll on an IT staff to support ERP solutions, mail solutions, CRM solutions, etc when that same payroll could otherwise be spent on engineers to build product differentiating features or enlarge a sales staff to generate more revenue?
As a tech leader, you may feel you do not need to worry about gross margins because of your particular environment. This is true for many young companies that are still finding product market fit and even for scale-up firms that are still looking to build repeatability into their business model. However, once a team is focused on operations and execution, gross margins should not be ignored in your product and tech strategy.
And if you have low gross margins?
Finally, it is important to note, there are many hugely successful firms that have lower gross margins. Alphabet and Apple are two well known examples.
In these scenarios, we would argue the pressure on product and tech leaders is even higher. Where gross margins are low, product teams need to be obsessed about building durable competitive advantage. These teams are tasked with building moats in order to protect long-term profits, market share and to build pricing power. If you are in a lower gross margin business, the anchor of your product and tech strategy needs to be the defensibility of the moats you are building - nothing less.
AKF Partners offers financial training workshops for technology leaders. Please contact us at firstname.lastname@example.org if you would like to know more. We also include key financial training as part of our very popular CTO bootcamp