Economics isn’t something people can easily discard, as we’re perpetually engaged with it in our daily lives to varying degrees. “Unit economics” is not a novel term, but it is often not clearly defined for those who want to better understand its use in their business operations. And while those involved in businesses aren’t always that eager to study economics, unit economics is essential for analyzing any company’s performance and predicting growth potentials.
Most analysts look at a business’s financials from a company-wide stance or look at market and industry trends. Predicting potential growth values is significantly greater when financial administrators analyze a company on a unit-level basis, or with unit economics.
In the following discussion, we will cover the concept of unit economics to help you understand it fully.
Definition Of Unit Economics
To understand unit economics, we have to break it down to its simplest definition and understand how we define a unit.
What is Unit Economics?
In its simplest form, unit economics measures how much profit a company makes from selling one unit of its service or product. It encompasses a business model’s costs and revenues that are linked with an individual unit.
A unit is any item that develops value for a company and is quantifiable. A unit can be as simple as one person subscribing to a standard SaaS product such as Netflix, Spotify, or Dropbox. Unit economics shows the value each item can generate for a business, analyzing their profits or loss per each individual unit.
Calculating Unit Economics
First, a company has to decide on the unit to be measured. For a business-to-consumer (B2C) company, one could measure the profitability of service, a product, a customer, or an order. But a business-to-business (B2B) company may want to measure the profitability of a customer or the competency of a sales representative.
If a unit is interpreted as one sale, then the traditionally related metric is the Contribution Margin. However, if a unit is defined as a customer, then the most-associated metrics are Customer Lifetime Value (LTV) and its link to Customer Acquisition Costs (CAC)
A simple calculation of unit economics is:
Unit Economics = Revenue per unit – Cost per unit
The Contribution Margin is the amount a firm’s revenues will contribute to its net income and fixed costs once all variable costs and expenses have been subtracted. The amount of money that a unit contributes to cover its fixed costs and other fixed expenses.
Calculating the Contribution Margin when a unit is defined as “one sold item”
Contribution Margin = Price (Revenue) per unit – Variable costs per sale
For example, a sports shop sells a specific brand of tennis racquets for $150 each. If the variable cost for the racquet is $60, then the Contribution Margin is $90.
The shop can further calculate the total Contribution Margin value during a specific period. If one customer buys one racquet, and in the first month, 100 people bought a racquet each, then the total price of racquets will be $15,000 for that month.
The total variable cost would be $60,000, and the total Contribution Margin would be $90,000.
Contribution Margin is essential for all business models including unit economic models because it represents individual products’ profitability, including the product lines or business components and the whole business.
Customer Acquisition Costs and Customer Lifetime Value
Above, we calculated the Contribution Margin when a unit is defined as “one sold item.” Calculating the unit economics for a business model such as SaaS for a customer is not so straightforward. The business’s unit is the user, and it has two vital metrics calculated, with the unit economics being the ratio of these two different metrics.
Customer Acquisition Costs
CAC is defined as the cost to acquire one customer traditionally through sales and marketing. It also consists of the customer payback period that is the time in months to pay the CAC back. Taking Spotify as an example, what was their initial setup cost to recruit a paying customer? Costs could include:
- Marketing expenses
- Variable costs of sales
- Other actions to persuade a customer to buy the app
Let’s assume Spotify invested $500 in its initial marketing campaign cost to recruit users, and the ads enticed 450 people to go onto the app. The cost per person visiting the app is $1.11, which is the cost-per-visitor. If 200 people signed up, then the conversion rate is 200/450, which equals 44%.
To get the final CAC, divide the cost per visitor ($1.11) by the conversion rate (44%) and you get $0.025.
Calculation of customer payback period
Customer payback period = CAC / Gross Margin
Unless it’s a B2B, there should be a shorter payback period of about 6-18 months. It’s advantageous because less working capital is needed, and companies can grow faster.
Customer Lifetime Value
The LTV is the revenue the business gets from one user for the whole length of time they use a particular service, or the amount of revenue a company receives from a user before they stop using their services. Spotify may lose users for various reasons over varying periods, but the LTV is calculated per users’ length of paying time on the app every month.
For example, let’s assume 200 users signed up to Spotify at the beginning of the month, and 50 of them decided to unsubscribe by the end of the month. The churn rate would be the ratio of the number of users left at the end of the month and the customers at the beginning of the month. In this case, it would be 25% (50 / 200).
The LTV is calculated by multiplying the Churn Rate by the Gross Margin.
If the LTV is greater than the CAC, then the company has a sustainable business model; but, if the CAC is larger than the LTV, then the company is running at a loss. The business is significantly stagnant if both the metrics are equal.
Calculating the unit economics when a unit is defined as “one sold item”
Unit Economics = LTV / CAC
The ideal ratio of LTV to CAC is 3:1. There is three times the value of acquisition with each new customer.
Why You Should Consider Unit Economics
There are some key reasons why business owners should look at unit economics, including:
- The essential points of the financial model will make greater sense
- Management will have a significant advantage in decision-making, as it’s simpler to calculate break-even points and Contribution Margins
- Easier calculation of return on investment and other tests for profitability
- Easier to predict the future profitability
- Easier to optimize products
- Easier to analyze the market sustainability
The data calculated through unit economics analysis for a company is essential to its long-term and short-term financial planning.
One of the fundamental distinctions of unit economics from other profitability measures is it considers only variable costs and ignores fixed costs. By considering only variable costs, unit economics can help calculate the business’s output level that must be running to offset the fixed costs. It’s the essential component of break-even analysis.
It’s easy to explain the importance of unit economics analysis for startup companies. In their company’s growth phase, startups can use the unit economics analysis to attract and pitch venture capitalists to be stakeholders.
The basic principle of unit economics analysis is to exhibit profitability based on variable costs so stakeholders can forecast a plausible route to profitability. Most times, startups can lose money at the beginning. However, there should be a capacity to grow into the startup’s fixed cost base. If money is lost before fixed costs are reached, then the growth capacity is limited to impossible. The calculations scrutinize the company for the preferred future profitability and consistent growth.
Unit economics analysis is worth its effort for the startup to analyze if it’s a worthwhile venture. If it is, then they can be confident enough to attract venture capitalists and lucrative stakeholders to invest in their company.
How to Use Unit Economics
Now that we understand what unit economics is and how the fundamental unit economics analysis is used, the primary themes are predictability for profitability and sustainable growth. We learned so far that the metric of unit economics calculations is simple, yet its efficiency can dictate your firm’s future or startup. It can give you great insights into the company’s transactions extending beyond costs and revenue. It also helps to avoid unnecessary scaling steps.
We have already seen how to calculate Contributing Margins, CAC, customer payback period, churn rate, and LTV. Let’s take it a step further to determine how we can efficiently utilize unit economics analysis to streamline our business ventures’ progress for more accuracy using LTV.
Modeling Customer Lifetime Value
How you measure LTV relies on the company’s revenue and business models. It means that for an accurate count for LTV, adjustments should be made to the specific industry and business strategy. There are two primary means to model customer LTV — predictive LTV and flexible LTV.
The predictive LTV model helps predict the transactional behaviors of customers in a business. Consumers periodically change their preferences that influence the way they buy. The organization has to be prepared for these types of changes.
Formula to measure predictive LTV
Predictive LTV = (T x AOV x AGM x ALT) / number of customers for a given period
Let’s define these terms through the lens of our Spotify example in CAC and LTV calculations shown above.
T – the average number of transactions, which is the number of total transactions / the timespan of transactions. For Spotify, that would be 200 / 1 month, or 200.
AOV – the average value of an order. It’s defined as the total revenue / the number of orders. Spotify had total revenue of $2,000 and 200 orders, so the AOV is $10.
AGM – the average gross margin. It identifies the actual profit against the total revenue, minus the cost of sales (CS). If Spotify’s CS was $500, then the monthly gross margin would be ($2,000 – $500) / $2,000, or 75%.
To work out the average over several periods, just calculate each GM and then average them all together.
ALT – the average lifetime of a customer. It is 1 / the churn rate. The churn rate calculated for our Spotify subscription loss of 50 is 25%.
Looking at the formula for Predictive LTV again, we can punch in our respective numbers:
Predictive LTV = (200T x 10 AOV x 0.75 AGM x 4 ALT) / 200 number of customers for a given period = $30 per user
Flexible LTV is used to cover possible changes in revenue. It’s specifically relevant for startups and new businesses, which most likely go through growth and development changes. Discount rates and retention rates are considered for a more precise measurement of prediction.
Formula to measure flexible LTV
Flexible LTV = GML x [R/(1 + D – R)]
Let’s define these terms through the lens of our Spotify example again.
GML – the average gross margin per customer lifespan. It shows the amount of profit a business generates from one customer during an average lifespan. GML = GM x (TR/customers) Using the Spotify example, we punch in the numbers to get a GML of $7.50 per user.
D – the discount rate or the required rate of return or required yield. It shows the rate of return on investment. Let’s assume for Spotify the discount rate accounts for 5%.
R – the retention rate and equals ending customers minus new customers divided by beginning customers. Assuming Spotify had 200 users at the beginning of the month, 250 users at the end of the month, and 100 new users signed up during the month, that would be 250-100/200, or a 75% retention rate
Looking at the formula for Flexible LTV again, we can punch in our respective numbers and get a Flexible LTV of $2.21 per user.
Flexible LTV = 7.5 GML × (0.25 R / (1 + 0.1 D – 0.25 R)) = $2.21
No matter where they’re in their timeline, all businesses should know their financial performance, and they can only do it with profound insight into the company’s revenue and cost equilibrium. It helps expose gaps inhibiting profitability, use optimal strategies, evaluate potential, analyze startup execution, and calculate sensible spending in the business. Unit economic analysis assists firms in steering their business processes toward consistent growth.