B2B companies love gross margins. They always use them as some sort of key indicator of financial performance. It’s usually common that we see companies boast about gross margins of 90% or more, creating a cool showing of their “robust profitability.” While this metric looks really good on a LinkedIn post and sometimes on paper, it can be misleading if it isn’t analyzed with a critical eye (please hire an accountant). One issue everyone overlooks is the Customer Acquisition Cost (CAC) on those impressive gross margins.
To put it easily, Gross Margins are calculated when you take revenue less the cost of goods sold (COGS). When you look at a software company, COGS will include marginal costs like discounts, affiliate fees, or other expenses directly tied to the sale of a product. This will show gross margins to be in the range of 80%-90%. Yes, they seem financially correct, however, the picture hasn’t been painted completely.
You might’ve read what we just said and though “Well, what would complete the picture?” and you’d get a star for a good question. The calculation misses on variable costs such as paid media spend, sales expenditures, and more, which all play a key part in acquiring your revenue. Ignoring these costs will give a skewed perspective on the company’s profitability. For example, on paper a company can have massive margins but still struggle with cash flow issues due to higher CAC.
The issue with this all is that companies with over 90% gross margins face higher CAC payback periods. Some of which will extend beyond three years or more. The CAC payback period is the time in which it takes a company to recover all of the money they spent getting the new customer. When this period stretches too long, it can severely strain cash flow and flush out the perceived profitability.
When trying to understand the financial health of any company, it’s essential to consider the real cost of revenue. This means taking into account the costs associated with acquiring new customers. If you do this, your business will get a better, more accurate picture of their financial viability.
Now, let’s talk about how we can fix the issue at hand. For starters, keep a constant eye on your gross margins through the lens of CAC. By integrating CAC into your newly found analysis, you’ll have a better understanding of cash flow and identify future strategies to push effective improvement. This helps get a collective view of your company’s financial performance and helps avoid pitfalls of relying just on the traditional gross margins calculations.
While Gross Margins are an important financial metric, it can also be misleading if it isn’t analyzed correctly. Taking CAC into consideration can give you a more realistic picture of your company’s profitability and sustainability. B2B companies should learn and adopt this comprehensive approach to ensure they’re not blindsided by seemingly impressive gross margins.