Calculating gross margin on embedded payments revenue
For vertical SaaS companies launching or re-launching embedded payments, one of the most pressing questions is how much margin you’ll actually earn on embedded payments volume. The answer depends on your revenue recognition model, processing costs, and sell price.
This article will dive into revenue recognition and processing costs. At the end, we’ll also share a free resource that demystifies embedded payments pricing strategy for vertical SaaS platforms.
Revenue recognition models
You’ll get to choose between recognizing net revenue or gross revenue. Ultimately, this won’t impact your profit, but it will determine how you report on and talk about the financial performance of your embedded payments product.
Option 1 – Net
With net revenue recognition, your payment provider collects processing fees from merchants, nets out interchange passthrough and provider fees, then distributes the residual to your bank account.
This option generates less top-line revenue for the platform because only residuals are recognized as revenue. However, the profit margin is extremely high because direct costs are so low.
Option 2 – Gross
With gross revenue recognition, the SaaS platform collects processing fees from merchants, then remits passthrough and provider fees to the payment provider.
This option allows the platform to recognize much more revenue because the platform can recognize the entire merchant processing fee. However, the profit margin is significantly lower because interchange passthrough and payment provider fees are recognized as costs.
Example comparing net vs gross revenue recognition
For example, let’s assume $100M processing volume at 3% merchant processing fee, 2% passthrough costs, 30 basis points (0.30%) in payment processing fees – leaving 70 basis points (0.70%) as the net.
Net revenue recognition:
- Revenue = $100M x 70 basis points = $700k
- Cost = negligible
- Profit = $700k
- Margin = nearly 100%
Gross revenue recognition:
- Revenue = $100M x 3% = $3M
- Cost = $100M x 2.3% = $2.3M
- Profit = $700k
- Margin = 23%
Either way, the platform is generating $700k on a volume of $100M, or 70 basis points on processing volume.
With net revenue recognition, the platform is recognizing $700k of revenue at a nearly 100% margin. With gross revenue, the platform is recognizing more than 4x the revenue, but at a margin of only 23%.
Understanding costs
Total payment processing cost consists of passthrough fees, payment provider fees, and internal costs.
Passthrough fees include interchange fees (determined by card networks and paid to issuing banks) plus dues, fees, and assessments paid to the card networks. Passthrough fees are the biggest overall driver of payment processing costs. For platforms with > $100M/yr card processing volume, passthrough often accounts for more than 80% of overall payment processing costs and the primary driver of passthrough costs is interchange. For this reason, the biggest opportunity to drive down costs is usually interchange optimization.
Payment provider fees include the buy-rate, revenue share, and other fees paid to the payment provider. For platforms with > $100M/yr card processing volume, payment provider fees usually account for less than 20% of overall payment processing costs. Payment provider fees can be reduced to a point, but low-cost payment providers tend to lag in quality and support, which can reduce adoption and even cause churn. Also, because payment provider fees represent a much smaller portion of overall payment processing costs, a 50% reduction in payment provider fees might yield less margin improvement than a 10-15% reduction in interchange.
Internal costs include the ongoing support and maintenance of your payment product. The choice of payment provider will have a massive impact on internal support costs. For example, if the payment data isn’t accurate, your support team will field a lot of requests around payment status, deposits, and reconciliation. This will drive higher support costs. With a high-quality embedded payments product, support costs will be so low that they’re difficult to measure. There may be a small incremental increase in support requests compared to not having a payments product at all, but for many software companies the increase barely moves the needle on overall support costs.
Calculating margin
When you know your passthrough costs, payment provider fees, and internal costs, you can do two things.
- You can calculate your margin by substituting your payments revenue and costs into the earlier examples.
- You can use your costs and desired margin to determine the minimum sell price needed to achieve your target payments margin.
Our Embedded payments pricing guide for vertical SaaS platforms steps through this process in detail, including how to find your interchange, converting flat “per-item” fees to basis points based on your average payment size, and expert pricing strategies to help you grow payments revenue.
