The 62% Gross Margin That Was Actually 78%
A SaaS founder walked into our first meeting convinced his business had a gross margin problem. His income statement showed 62 percent gross margin — well below the 75 percent threshold that most investors consider table stakes for a software company. He had already started exploring ways to reduce hosting costs, renegotiate vendor contracts, and even restructure his customer success team. He was solving the wrong problem.
When we audited his chart of accounts, we found that his bookkeeper had classified $340,000 of annual engineering salaries under Cost of Goods Sold. These were engineers building new features — product development work that belongs in Research and Development operating expense, not in COGS. Another $85,000 of office rent had been partially allocated to COGS using an outdated allocation methodology that made sense when the company had an on-premise deployment model but was nonsensical for a pure SaaS product. And $45,000 of general IT infrastructure costs (the company's internal Slack, Jira, and email tools) were sitting in COGS because the bookkeeper had lumped all "technology" costs together.
After reclassifying these items to their proper expense categories, the gross margin jumped from 62 percent to 78 percent. The business did not change. Not a single dollar of spending was reduced. The only thing that changed was where those dollars appeared on the income statement. And that reclassification transformed the company from a "gross margin problem" that would struggle to raise a Series A into a "healthy SaaS business" that closed an $8 million round three months later.
This is not an accounting trick. It is correct accounting. The distinction between COGS and operating expenses is not cosmetic — it fundamentally changes how investors evaluate the scalability of your business model.
What Exactly Belongs in SaaS COGS?
The Core Principle
Cost of Goods Sold for a SaaS company should include only the costs that are directly incurred in delivering the software service to customers. The key question for every expense is: "If we acquired one more customer tomorrow, would this cost increase?" If the answer is yes, it belongs in COGS. If the answer is no, it is an operating expense.
Costs That Belong in SaaS COGS
Cloud hosting and infrastructure costs are the most obvious COGS item. This includes your AWS, Azure, or GCP compute, storage, and bandwidth costs that directly support the production environment serving customers. It also includes any managed database services, CDN costs, and monitoring tools specific to the production environment. If you host on bare metal or in a co-location facility, the server costs, facility allocation, and DevOps personnel dedicated to production infrastructure belong here.
Customer support team compensation is a COGS item when the support function is directly tied to service delivery. This includes the salaries, benefits, and equity compensation for support agents, support managers, and technical support engineers who resolve customer issues. It does not include customer success managers focused on expansion and retention — those belong in Sales and Marketing.
Payment processing fees from Stripe, Braintree, or your payment gateway are COGS. These fees are directly proportional to revenue and represent a true cost of delivering the service.
Third-party software and API costs that are consumed as part of delivering your product to customers belong in COGS. If your application relies on a mapping API, a communication API like Twilio, or a data provider that you integrate into the customer-facing product, those costs scale with usage and are properly classified as COGS.
Professional services delivery costs, if you have an implementation or onboarding team whose work is essential to getting customers live on the platform, belong in COGS. The revenue from those services is typically reported as a separate line, and the associated costs should match.
Costs That Do Not Belong in SaaS COGS
Engineering salaries for product development belong in Research and Development. This is the single most impactful misclassification we see. Software engineers building new features, improving the product, and fixing bugs are creating future value, not delivering the current service. The only engineering costs that belong in COGS are those for engineers exclusively dedicated to maintaining the production environment — and even then, many companies classify these as R&D.
Sales and marketing expenses, including customer success managers focused on upselling and expansion, belong in Sales and Marketing operating expense. General and administrative costs — finance, HR, legal, executive compensation, office rent, insurance — belong in G&A. Internal IT tools used by your team (Slack, email, project management software) are G&A costs, not COGS. Recruiting costs, even for support or DevOps hires, are G&A.
Why Does COGS Classification Matter So Much to Investors?
Gross Margin as a Proxy for Scalability
When an investor looks at your gross margin, they are not just evaluating your current profitability. They are making a judgment about the long-term scalability of your business model. A SaaS company with 78 percent gross margin is telling investors that for every additional dollar of revenue, 78 cents falls through to cover operating expenses and generate profit. Those operating expenses — sales, engineering, G&A — have significant fixed components that do not scale linearly with revenue. This is the fundamental leverage in the SaaS model: as revenue grows, operating expenses grow more slowly, and the gap between gross profit and total expenses widens, eventually producing strong operating margins.
A company with 62 percent gross margin tells a different story. Thirty-eight cents of every revenue dollar goes directly to service delivery costs, leaving less room for the fixed-cost leverage to work. Investors model out the long-term economics and see a company that may never achieve the 20 to 30 percent operating margins that justify premium SaaS valuations. The difference between 62 percent and 78 percent gross margin does not sound dramatic, but when compounded through a financial model over 5 years and $50 million in revenue, it represents a $8 million annual difference in gross profit — which is often the difference between a $200 million valuation and a $400 million valuation at exit.
The Valuation Multiple Connection
Public SaaS companies trading at the highest revenue multiples consistently have gross margins above 75 percent. Datadog operates at approximately 80 percent gross margin and trades at a premium multiple. Snowflake, with its consumption-based model and heavy infrastructure costs, operates at around 68 percent gross margin — and while it is still highly valued for its growth rate, the lower gross margin is a frequent point of investor concern. When investors benchmark your private company against public comparables, your gross margin directly influences which comparable set they use, which in turn determines your valuation range.
How Does ASC 350-40 Software Capitalization Improve Margins?
What ASC 350-40 Allows
ASC 350-40 (Accounting Standards Codification, Subtopic 350-40) provides guidance on accounting for costs of internal-use software. Under this standard, certain software development costs can be capitalized — recorded as an asset on the balance sheet rather than expensed on the income statement — and then amortized over the software's useful life.
The standard divides software development into three phases. The preliminary project stage includes costs for conceptualization, evaluating alternatives, and determining if the technology exists to achieve the project objectives. These costs must be expensed as incurred. The application development stage includes costs for coding, testing, and installation of hardware. These costs should be capitalized. The post-implementation stage includes costs for training, maintenance, and data conversion. These costs must be expensed as incurred.
The Practical Impact on Your Financials
For a SaaS company spending $1.5 million annually on engineering, a meaningful portion of that spend may qualify for capitalization under ASC 350-40. If your engineers spend 40 percent of their time on qualifying application development activities — building new modules, developing significant new features, rewriting core architecture — that represents $600,000 that moves from the income statement to the balance sheet. This does not change your cash outflows, but it changes your reported expenses, improving both your gross margin (if any of the capitalized work relates to production infrastructure) and your operating income.
The capitalized costs are then amortized over the estimated useful life of the software, typically 3 to 5 years. So that $600,000 of capitalized costs becomes $120,000 to $200,000 of annual amortization expense — a significantly smaller hit to the income statement than the original $600,000. Over time, as capitalized amounts accumulate and amortization catches up, the benefit moderates. But in the first 2 to 3 years of implementing ASC 350-40, the improvement to reported operating results can be substantial.
Implementation Requirements
Capitalization under ASC 350-40 is not a free lunch. It requires rigorous time tracking by your engineering team to document hours spent in the application development stage versus other stages. It requires clear project definitions that map to the standard's criteria. And it requires an accounting team or external advisor who can properly apply the guidance — over-capitalizing expenses is an audit risk, and under-capitalizing means leaving a legitimate GAAP benefit on the table. Most companies implement time-tracking tools (even simple ones like Harvest or Toggl) and establish a monthly capitalization review process.
Gross Margin Benchmarks by Stage and Category
Seed Stage: 55 to 70 Percent
At the seed stage, gross margins are typically lower because fixed infrastructure costs are spread across a small revenue base, the product may still require significant manual intervention (onboarding, configuration, data migration), and the customer support ratio is high relative to the customer count. A seed-stage SaaS company with 60 to 65 percent gross margin is within the acceptable range, provided there is a clear trajectory toward improvement. Investors at this stage are evaluating the business model's potential gross margin, not the current number.
Series A: 68 to 78 Percent
By Series A, investors expect to see gross margins approaching or exceeding 70 percent. The product should be increasingly self-serve, infrastructure costs should be scaling more efficiently, and the customer support model should be stabilizing. If your gross margin is below 68 percent at Series A and you are not an infrastructure or data-heavy product (where lower margins are structural), you need a credible explanation and a documented improvement plan.
Series B and Beyond: 75 to 85 Percent
At Series B, 75 percent gross margin is the floor, not the target. Best-in-class SaaS companies at this stage operate at 80 to 85 percent. The gap between 75 percent and 85 percent is often driven by the efficiency of the support model, the degree of infrastructure optimization, and whether the company has successfully negotiated volume pricing with cloud providers. Companies that consistently operate below 75 percent at scale — those above $10 million ARR — typically face valuation discounts of 20 to 30 percent relative to higher-margin peers.
Category Variations
Not all SaaS is created equal from a margin perspective. Pure application SaaS (CRM, HR tools, project management) typically achieves the highest margins: 78 to 88 percent. Infrastructure and DevOps SaaS (monitoring, security, CI/CD) runs slightly lower at 70 to 82 percent due to higher compute costs. Vertical SaaS with embedded payments or data services operates at 65 to 78 percent because of the revenue share and data acquisition costs embedded in COGS. AI and ML-heavy SaaS products face structural margin pressure from GPU compute costs, often operating at 55 to 72 percent. Understanding where your product sits within these bands helps set realistic targets and frame the conversation with investors appropriately.
Specific Optimization Levers That Move the Needle
Cloud Cost Optimization: 25 to 40 Percent Savings
Cloud hosting is typically the largest single COGS item for a SaaS company, representing 15 to 30 percent of total COGS. The three highest-impact optimization strategies are reserved instances and savings plans, where committing to 1- or 3-year terms with AWS, Azure, or GCP reduces compute costs by 30 to 60 percent compared to on-demand pricing. A company spending $25,000 per month on EC2 instances can often reduce that to $15,000 through a combination of reserved instances and right-sizing. Auto-scaling and right-sizing means that many startups over-provision infrastructure for peak loads that occur less than 5 percent of the time, and implementing auto-scaling policies and right-sizing instances to actual utilization patterns can reduce compute costs by 20 to 35 percent without affecting performance. Storage tiering is the third lever: moving infrequently accessed data from hot storage (S3 Standard) to cold storage (S3 Glacier or Infrequent Access) can reduce storage costs by 50 to 80 percent. For a data-heavy SaaS product, storage optimization alone can save $3,000 to $10,000 per month.
Support Model Restructuring
Customer support costs are typically the second-largest COGS item. The key metric is the support cost per customer, which should decline as you scale. Specific levers include implementing self-serve support (knowledge base, in-app guidance, community forums) to deflect 30 to 50 percent of support tickets, tiering support by plan level so that your $50-per-month customers get email-only support while your $500-per-month customers get phone and chat, and leveraging AI-assisted support tools that can resolve 20 to 40 percent of Tier 1 tickets without human intervention. A company with 500 customers and 4 support agents at $65,000 each ($260,000 annually) that successfully implements these strategies can often serve 1,000 customers with 5 agents ($325,000) — reducing the per-customer support cost from $520 to $325, a 37 percent improvement.
Third-Party API Cost Renegotiation
Many SaaS products integrate third-party APIs that are billed on a per-call or per-record basis. As your usage grows, you gain negotiating leverage. Contact your API vendors and negotiate volume pricing tiers. Move from per-call pricing to committed-use pricing. Evaluate whether you can cache results or batch requests to reduce call volume. And in some cases, evaluate whether you can build the functionality in-house when the API cost exceeds $50,000 annually — the breakeven for an internal build is often closer than founders expect.
What Investors Expect by Round
Seed Investors
At the seed stage, investors are primarily evaluating the team, the market, and the product concept. Gross margin is a secondary consideration, but it should not be alarming. If your gross margin is below 50 percent at seed, you need to explain why and show a path to improvement. Most seed investors are comfortable with 55 to 65 percent gross margins for early-stage SaaS, with the expectation that these improve by 5 to 10 percentage points per year.
Series A Investors
Series A investors are more quantitative and will benchmark your gross margin against peer companies. They expect to see 70 percent or higher and will probe deeply into your COGS composition. The conversation often goes like this: "Your gross margin is 71 percent. Walk me through your COGS line by line." If you cannot answer this question with specificity — knowing exactly how much you spend on hosting, support, payment processing, and third-party services — it signals a lack of financial maturity that makes investors nervous.
Series B and Growth Investors
At Series B, gross margin is a screening criterion. Many growth-stage investors will not take a meeting with a SaaS company below 72 percent gross margin unless the company has exceptional growth metrics that compensate. They want to see not just the current margin but the trend: is it improving by 1 to 2 percentage points per quarter? They also want to see that your COGS classification has been validated by an auditor or a qualified finance professional. Self-reported gross margins from companies that have never had a financial review carry less weight.
The Hidden Gross Margin Killer: Professional Services
Many SaaS companies generate a meaningful portion of revenue from professional services — implementation, customization, training, and data migration. Professional services revenue typically carries gross margins of 15 to 40 percent, compared to 75 to 85 percent for subscription revenue. When blended together, a company with $4 million in subscription revenue at 80 percent margin and $1 million in professional services revenue at 25 percent margin shows a blended gross margin of 69 percent — below the 75 percent threshold despite having strong subscription economics.
The solution is to report gross margin separately for subscription and professional services. This gives investors a clear view of the underlying subscription economics and allows them to model the margin improvement that will occur as professional services become a smaller percentage of total revenue over time. Most financial models should show professional services declining from 20 to 25 percent of revenue at Series A to less than 10 percent by Series C, as the product becomes more self-serve and implementation becomes standardized.
Building a Gross Margin Improvement Roadmap
The companies that successfully optimize gross margin do not treat it as a one-time exercise. They build a 12-month improvement roadmap with specific initiatives, owners, expected savings, and timelines. A typical roadmap might include executing a cloud savings plan in month 1 with a target of $4,000 per month in savings, implementing a customer-facing knowledge base in months 2 through 3 with a target of deflecting 30 percent of Tier 1 tickets by month 6, renegotiating the three largest API vendor contracts in month 4 with a target of 25 percent cost reduction, implementing ASC 350-40 software capitalization in month 5 with a target of capitalizing $400,000 annually, and restructuring the support model from all-touch to tiered support in months 6 through 8 with a target of reducing per-customer support cost by 30 percent.
Each initiative should have a clear owner, a timeline, and a measurable outcome. Track progress monthly and report results to your board. Gross margin improvement of 5 to 10 percentage points over 12 months is achievable for most SaaS companies that have not previously focused on this metric — and that improvement, when reflected in your financial model, can meaningfully impact your valuation at the next fundraise.
Northstar Financial works with SaaS companies to audit COGS classification, implement ASC 350-40 capitalization, build gross margin improvement roadmaps, and prepare financials that accurately reflect the true economics of the subscription business. If your gross margin is below 75 percent and you are not sure whether the problem is real or a classification issue, that is exactly the analysis we can help with.