Why We’re In Love With Unit Economics (And You Should Be Too)
Who doesn’t love an exquisite, hand-tied bouquet of unit economics? OK, so the Valentine connection is a little tenuous. But knowing exactly how much it costs to win and retain your customers is the best way you can show your business true love. It may not be the most romantic of gifts, but good unit economics will keep your startup growing, long after the bouquets have wilted. Here’s why:
They’re a great way to evaluate early-stage startups
In fact, unit economics was created by VCs back in the 1990s (with Netflix as an example) to solve the problem of evaluating a company which isn’t yet profitable. If your company is big and profitable, it makes sense to analyse cash flow and come up with an evaluation of the business that way. But if not, you need something different – and that’s where unit economics come in.
They divide businesses up into units. For airlines, units could be seats sold, while for a SaaS business, a unit is a customer. Work out how much you have to spend to get a customer and the revenue over the customer’s lifetime. Can you make more profit from a customer than the cost of winning that customer? If so, that’s a solid foundation for your startup.
At a high level, the point of unit economics is to understand how much profit a business makes before fixed costs. so you can estimate how much a business needs to sell in order to cover fixed costs. They’re an essential part of your break-even analysis.
They allow you to easily compare different models
If you’ve got a struggling business model, the cost of acquiring a customer is always going to be higher than the revenue you get from that customer. But that doesn’t mean you have to give up on this idea. If you know your UE model, you can use it to investigate why that might be. You can look at marketing, product costs, delivery systems, subscription models – everything that allows you to tweak and produce another model which will be profitable and scalable.
They’re gloriously data-driven…
…But they’re not too complicated, so you don’t have to be a financial genius to understand them. Just familiarise yourself with two acronyms: LTV (customer lifetime value) and CAC (customer acquisition costs.) Ideally, you’ll want your LTV to CAC ratio to be 3:1 – each customer should be earning you three times what you spent on getting them. If the ratio is low, you’re spending too much to get customers: how could you cut down? If the ratio is too high, you’re not spending enough: could you be missing out on even more customers?
They help your financial planning
Of course, your business’ UE are not set in stone. You’ll always be revising them and altering them as you grow, or circumstances change, or costs rise. But good planning is essential: your business needs it and potential investors need it. Picture an investor asking you how you know your business will be earning £x by 2025. The answer is your UE.
Oh, and investors love them too
Unit economics is like a slot machine: put a coin in the top and see it come rolling out as profit from the bottom. That’s why investors will always want to see your UE. If they make sense, a good investor will also be able to see how you’ll make money long-term and how you’ll increase profits by scaling up, even if you’re not in profit now.
Understanding the basics
How do you calculate the economics of “one unit”?
There are two main ways to measure this and it depends on how your business defines a unit.
- If a unit is defined as one sale (of a product or service), the contribution margin (the amount of revenue from one sale that, once stripped out of all variable costs associated with that sale, contributes toward paying fixed costs. in (Contribution margin = price per unit - variable cost per unit).
- If a unit is defined as one customer, then CAC and LTV is the common metric.
What’s the definition of unit cost?
- It’s the total expenditure by a company to produce, store and sell one unit of a business’ sale of product or service. Unit costs are synonymous with cost of goods sold (COGS)
Whats a fixed cost?
- Fixed costs are those that do not vary with the output or sales volume. Examples include office costs, team salaries, certain technology costs and the costs of tangible assets such as intellectual property.
What’s included in a variable cost?
- Variable costs are those directly related to the sale of one unit of the company’s products or services. Common examples include the cost of goods sold (COGS), shipping and packaging costs for eCommerce products and sales costs for enterprise/B2B businesses.
Want more information about unit economics? Check out our previous blog post and webcast featuring Co-founders, Sara Green Brodersen and Andre Karihaloo.“Everything you need to know about unit economics”
If you want to visualise your unit economics in real-time delivered through a dynamic, intuitive dashboard, Discover Canaree today.