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Gross margin, but like, in real life
What real companies put in their gross margin
Before we dig in on Gross Margin, make sure to check out this week’s Run the Number’s Podcast with Brandon Deer, the Chief Strategy Officer at UiPath.
We talk about the perils of speed at all costs, how B and C players can kill companies, and a funny Jim Kramer story.
You listen on:
I’ll admit it - I probably talked about Gross Margin in hand wavy, theoretical BS kinda way for the first five years of my career (OK, first six). I kinda sorta understood what was shoved up there from an academic angle (not to toot my own horn, but I did pass level 1 of the CFA (on the second try)). But the emperor truly had no clothes when I was asked to apply it to a real company in real life.
As any good financial analyst will recite:
Gross profit is Revenue less Cost of Service.
And Gross Margin is Gross Profit as a percentage of Revenue.
And conceptually speaking, the higher your gross margin, the more money you have to run the rest of the business.
A gross margin of 74% (the median for software companies) means that for every $1 the biz brings in, 74 cents is left over for salaries, rent, and those uncomfortable Gildan tee shirts you got at the last company All Hands.
Said another way - a high gross margin “frees” up money for investment in other areas.
So the Revenue piece of the equation is easy to understand…. But what Expenses are tagged up above?
That would be your cost to maintain a successful customer. Some companies call this Cost of Service, some call it Cost of Revenue, and some call it Cost of Goods Sold if they actually sell a “thing” (like a Peloton bike).
Generally speaking, for software companies, Cost of Revenue includes:
Customer support (headcount): Help when something breaks
Customer success (headcount): Enhance the customer’s experience and get them to use more features and modules
Hosting (compute): Cloud costs (AWS, Azure, or GCP or the dusty ass servers in your basement)
Royalties / Licensing (subscriptions): Data you buy or license from others that is embedded into the delivery of your product
Data Communication (infrastructure): The plumbing that links all your stuff together so the users can use your stuff.
Today I want to peel out some real life examples that I’ve collected from company 10K’s to “bring gross margin to life”. This is how I finally got the concept to click.
Let’s look at a few.
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Spotify: Includes musical royalties (e.g., the cost of Taylor Swift, Drake, and Future), podcast content rights (Check out Run the Numbers!), credit card processing fees for your monthly subscription, and streaming costs.
“Cost of revenue consists predominantly of royalty and distribution costs related to content streaming. We incur royalty costs, which we pay to certain record labels, music publishers, and other rights holders, for the right to stream music to our users.
Cost of revenue also includes credit card and payment processing fees for subscription revenue, customer service, certain employee compensation and benefits, cloud computing, streaming, facility, and equipment costs, as well as the amortization of podcast content assets.”
Twilio: The network carrier fees to deliver text messages, like AT&T, and the cost of buying phone numbers for you to use.
“Cost of revenue consists primarily of fees paid to network service providers. Cost of revenue also includes cloud infrastructure fees, direct costs of personnel, such as salaries and stock‑based compensation for our customer support employees … Our arrangements with network service providers require us to pay fees based on the volume of phone calls initiated or text messages sent, as well as the number of telephone numbers acquired by us to service our customers.
Our arrangements with our cloud infrastructure provider require us to pay fees based on our server capacity consumption.”
Gitlab: Basically the cost to store all your code in the cloud and track the updates you make. This generally scales with the number of customers.
“Cost of revenue for self-managed and SaaS subscriptions consists primarily of allocated cloud-hosting costs paid to third-party service providers, personnel-related costs, including stock-based compensation expenses, associated with our customer support personnel, including contractors, and allocated overhead. We expect our cost of revenue for self-managed and SaaS subscriptions to increase in absolute dollars as our self-managed and SaaS subscription revenue increases. As our SaaS offering makes up an increasing percentage of our total revenue, we expect to see increased associated cloud-related costs, such as hosting and managing costs, which may adversely impact our gross margins.”
Meta: The cost to store your selfies, the bandwidth for you to play Farmville, and the compute associated with scrolling through pictures of your ex.
“Our cost of revenue consists primarily of expenses associated with the delivery and distribution of our products. These include expenses related to the operation of our data centers and technical infrastructure, such as depreciation expense from servers, network infrastructure and buildings, as well as payroll and related expenses which include share-based compensation for employees on our operations teams, and energy and bandwidth costs.
Cost of revenue also includes costs associated with partner arrangements, including traffic acquisition costs and credit card and other fees related to processing customer transactions; cost of products sold; and content costs.”
Zillow: Listing service fees for the house in that neighborhood you’ll never be able to afford. And the hosting fees associated with the database of houses all over the country.
“Our cost of revenue consists of expenses related to operating our mobile applications and websites, including associated headcount expenses, such as salaries and benefits and share-based compensation expense and bonuses, as well as credit card fees, ad serving costs paid to third parties, revenue-sharing costs related to our commercial business relationships, costs to generate leads for customers, multiple listing services fees and costs associated with the operation of our data center and customer websites.”
Simply put, the cost buried in gross margin is what it takes to perform your core service for existing customers so they are successful and stick around. And service means different things for different companies: when I think of Spotify I think of artist royalties, for Twilio text message costs, for Gitlab repository storage, for Meta data centers, and for Zillow listing fees.
So, the million dollar question: what’s in your gross margin? Feel free to sound off in the comments.
What CFOs Hate and Love – A Message from Rho
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Learn how our finance automation platform can support your business today!
Quote I’ve been Pondering
“Variations also act as purges. Small forest fires periodically cleanse the system of the most flammable material, so this does not have the opportunity to accumulate”
-Antifragile, by Nassim Taleb