What should my gross margin be for a custom software company?

[Jon L]

I have a custom software business that is now, finally, growing. I've hired a sales rep and an assistant. I'm also going to switch from me doing all of the development work to hiring out all of the dev work, and me doing project management. Eventually, I will hire out PM as well.

So, my question: How would I figure out what a healthy profit margin is for a project? I'm going to calculate cost of goods sold as follows for any particular project:

1) Cost of all Dev time
2) Cost of all expenses directly related to that project (servers I have to spin up on Amazon for testing, etc)
3) Cost of my time if I hired it out for PM and requirements gathering work
4) Cost of any other assistance provided by helpers that directly relates to that project
5) cost of commission paid to my sales rep for the project

I'm thinking that 50% margin is what I should shoot for. If I happen to run over on an estimate, it won't kill me. And, if I'm correct on my estimate, it will provide plenty of profit do everything else with that I need to do to run the company, plus pay my salary and provide a profit on top of that.

I tried Googling, and ran across a study that said that custom software companies range from 8% (for $25M+ annual revenue companies) to 20% for small ($500K or less) companies - this was net profit margin. It didn't say anything about gross margin per project. Everything else that I found was for software companies that make a product that they then sell to end users. (and those gross margins are INSANE...like 90-95%)

Thoughts?

 

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[chriss.greig]

The reality is it will be dictated directly by the needs of the business and how much support you want to give it.

My recommendation would be to figure out how much revenue you want to make for the next three years. Subtract what you need to make as a base profit to be happy and then work backwards from those remainders.

Subdivide into specific revenue per month / quarter and then use that to figure out the actual manpower needs for each month / quarter (And mutliply salaries by about 1.2x to cover any additional costs of having employee)

Subtract your other variable and fixed costs and then.. if you are really lucky.. there will be extra.

You can add that to your happy pile or think about using it to increase the pace of growth from year 1. (This would of course modify the year 2-3 goals)

If you are unlucky reality will come crashing in and then you need to decide if you not labouring in the business is realistic.

If its less than 10% on a small business its questionable if it is worth the effort. 20% or more and you can make a go of it.

Gsnerally if you can run the business in thirds (33% profit / 33% labour / 33% cogs) you are healthy enough to survive.

Once you have your first template for that specific business this gets really easy. PS have a staff member in charge of strictly tracking actuals on a weekly basis as well. Don't do your numbers at the end of the year and no guessing.

(You should know your ytd numbers at all times)

Again. Once you do this.. it becomes and easy and very enjoyable process.

Cheers!

 

[GIlman]

Software is different than most businesses, because the reproduction cost is near zero now days, so a big up front cost can continue to generate revenues for years with much less cost on an ongoing basis.

I have had prior online software making well into the 6 figures and our profit margin was about 90%, but that's because I did all the dev myself and had the billing automated. Is this a subscription service or a one time purchase, subscription is a better route for pretty obvious reasons if it can be applied to your software.

Depending on your niche, competition, size of the market -> all of which will impact your cost of acquisition of customers -> then this will determine how much profits you can reap. That is why you see such high variance for net profits, some markets are poorly served and easy to get customers. Some have intense competition and acquiring customers is costly. Support is usually a minor expense unless your software is terrible, many customers need no to low hand holding to setup and use things. My prior business we filed about 2-3 support requests per week.

 

[chriss.greig]

I run a video game studio as well with about 25 paid employees but it will certainly never net 80-90%.

It currently does about 30-40% net for the investors which by any account is good money.

Any business where you do all the work is a completely different spreadsheet so to speak

 

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[Jon L]

Thanks guys. This is all really helpful for me to think about. I really like the idea of running a business in "thirds." 1/3 COGS, 1/3 employees and other, 1/3 profit. I think a healthy target to shoot for is 30% overall profit margin.

My business is in writing completely custom software, so I don't have the advantage that productized software has - I can't duplicate my effort from one customer to another with just a few clicks of a mouse.

I'm going to bid based on 30% gross profit target, and probably hit 50% on average. This plus a low overhead format (no offices, everything virtual, etc) will help me get to the 30% overall profit target.

 

[GIlman]

Have you read listened to the book rework? This is how I have always run my businesses, this is Just In Time with as few people and infrastructure as possible.

More people, more costs == more risk and less flexibility. But this is not a matter of planning but responding and using expense when appropriate to solve a problem.

In other word instead of thinking about what you will budget, just make it work as lean as you can. If it truly takes 45% of revenue for COGS then it does. But design processes that are intentionally lean.

With software, I have seen incredible things put out by 1 or two people that it has taken other companies teams of 20 people to do.


Sent from my iPhone using Tapatalk

 

[Jon L]

Have you read listened to the book rework? This is how I have always run my businesses, this is Just In Time with as few people and infrastructure as possible.

More people, more costs == more risk and less flexibility. But this is not a matter of planning but responding and using expense when appropriate to solve a problem.

In other word instead of thinking about what you will budget, just make it work as lean as you can. If it truly takes 45% of revenue for COGS then it does. But design processes that are intentionally lean.

With software, I have seen incredible things put out by 1 or two people that it has taken other companies teams of 20 people to do.


Sent from my iPhone using Tapatalk

Yes I have, and I've followed their blog too. I really asked this question because I tend to grossly underbid, and I need to force myself to run the company with enough margin so that it makes sense. If we can make more than that ... awesome

 

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