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What is Unit Economics?

Understanding Unit Economics in the early stages of a business is key in predicting current financial conditions and future growth. Associated with the most basic principles of a business model, you can use the unit economics concept to calculate revenues, profits and losses, and much more.

Unit Economics helps to answer just one question: whether you make money selling one unit of goods / services.

To calculate the unit economics, you are determining two primary factors:

• How much does the business spend to acquire the unit?
• How much revenue does the unit generate for the business?

Unit economics is an approach to calculating a company's profit based on income and expenses per business unit. A unit is either a user or a unit of a product sold.

!! The “unit” in unit economics is what you plan to scale.

Calculating The Economics of One Unit

You may already know main indicators for unit economics calculation as Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV). These are the direct revenues and costs associated with unit economics.
In order to calculate Customer Acquisition Costs CAC: total all of the costs associated with marketing, staff salaries, and sales over a given period. This includes everything from pay-per-click campaigns to any related wages costs and more. Then, divide this by the number of units within that same given period.

For example, a SaaS Startup spent $100,000 on advertising, marketing, and sales costs over one month. In the same period, they received 1,000 software sales. 100,000 / 1,000 = CAC is $100.

Customer lifetime value (LTV) is a metric that indicates the total revenue a business can reasonably expect from a single customer account throughout the business relationship. The metric considers a customer's revenue value and compares that number to the company's predicted customer lifespan. The longer a customer continues to purchase from a company, the greater their lifetime value becomes.

Customer Lifetime Value = (Customer Value * Average Customer Lifespan). To find LTV, you need to calculate the average purchase value and then multiply that number by the average number of purchases to determine customer value. Then, once you calculate the average customer lifespan, you can multiply that by customer value to determine customer lifetime value.

We’ll look at both components of this formula (and how to calculate them) below.
Customer Lifetime Value = (Customer Value * Average Customer Lifespan)
where Customer Value =Average Purchase Value * Average Number of Purchases


Unit Profitability

These unit economics metrics also give insight into unit profitability, which is defined as the profitability on a per-unit basis. It also explores the relationship between LTV and CAC.

You can calculate as follows:
LTV – CAC = Unit Profitability.


As you decrease the CAC and increase LTV, the unit profitability should increase; creating larger gross profit margins.

Unit economics analysis can be performed by focusing on unit profitability or other financial aspects of the business. This includes looking at the payback period, gross margins, or ROI (return on investment) of sales and marketing efforts, for example. The specifics of yours will depend on whether you have a product or service business, cash flow, whether your venture is still early stage, and long term plans.

Improving the relationship between CAC and LTV

The ideal ratio between LTV: CAC is 3:1. This means that each customer generates at least three times in profit of the money you need to acquire them. Proving this ratio is a green light for investors looking for low risk, long term financial growth opportunities.

Those with a lower ratio (2:1) would naturally look to improve their unit economics. In early-stage startups lacking cash flow, it can be challenging to optimise unit economics as there may be a lack of historical data, customers, or lack of resources to conduct the research. But it shouldn’t be impossible (even in the early stage) as these are the key fundamental metrics to track before looking at financing options.


To improve your unit economics, you need to either:

• Increase your Customer Lifetime Value (or)
• Decrease your Customer Acquisition Cost

To increase LTV, you need to increase your average order value, customer retention rate, or frequency of orders, by:

• Including add-ons or special offers at the checkout area
• Taking a closer look at your analytics or track user sentiment. How do customers feel about your business and your products?
• Tracking user cohort behaviour for more effective segmentation of your audience, leading to a lower churn rate

Improving your frequency of orders is all about customer experience. When you make it easy for customers to sail through the process, there are lower cart abandonment rates, for example.

This could also positively impact the number of new customers you take on, although this may not affect lifetime value.

Let’s take the case of Adobe, which reported a cart abandonment rate of 70.50%. Some of the most popular reasons cited for cart abandonment included:

• The site wanted me to create an account
• Too long/ too complicated checkout process
• The website had errors / crashed

Alternatively, decreasing CAC is about smart targeting. Ensure your marketing is pinpoint so that resources are not wasted on irrelevant prospects, and set-up retargeting campaigns to keep costs low.


It’s also important to continually test the copy on your campaigns, emails, and sales resources, which early-stage E-commerce app Ideall.ro highlighted in a case study. They showed that once A/B testing was applied to their copy, churn rate decreased and conversion rates improved by 22% over a 6-month period. This is likely to have made a big difference to their overall unit economics.

Of course, the longer your start-up can collect data, the more accurate and insightful these unit economics are likely to be. But continual testing is only as useful as the changes made from it, so ensuring all customer touchpoints are optimised should be the ideal goal.

How to accurately assess and improve unit economics

Improving your unit economics isn’t as simple as raising prices or cutting the cost of inputs. Using the metrics outlined above can help expose levers for you to build a more sustainable path toward profitability over time. Especially in a downturn, it is critical to build long-term solutions and avoid quick fixes. Below are just a few examples of ways you can assess and improve your unit economics:

1. Keep all your data in one place
Take back control of your financial data, so you’re not digging through 10 identical excel documents for something buried in an email chain. Combine this with real-time visibility and digitized audit trails to make it easy for your accounting department. We will provide with a comprehensive template at our Task #3 Section.

2. Automate your expense reports
Miscategorizing expenses is an easy way to misjudge your unit economics. Tracking expenses, organizing receipts, and compiling expense reports are all tedious jobs that waste your employees’ time. Expense automation and automated reports can save your employees hundreds of hours each month, time that can be spent on more productive work that will actually move the needle. A good tool for that is Zoho Expense or any other SaaS service which you get used to.

3. Renegotiate contracts
The best business relationships are built on long-term partnerships. Especially as it relates to the suppliers of your input materials, renegotiating contracts can save you money where you least expect it. Look to other companies in your industry for comparable metrics and see if you can identify savings or optimize your deployments.

What mistakes do users make when working with unit economics?

Mistake #1. Use unit economics as a regular accounting tool.
Unit economics is a strategic tool. Most of the data used in unit economics calculations are approximate. These are some metrics in a vacuum, which are supplemented and refined in terms of growth and development of the company. When calculating the unit economics you don't take into the account fixed costs, such as office rent or payroll.

Mistake #2. Consider unit economics the same for different businesses.
Each business model can have its own limitations when calculating the unit economics.
For example, in mobile games, the unit will be a user. While in subscription models it is more logical to consider a subscription as a unit.

In online services, COGS (cost of goods sold) often does not include production costs, since the salaries of the development team are related to fixed costs and are counted separately. While in services like Uber or Skyeng, payments to drivers or teachers are part of the cost of the service (since they are tied to the unit). Therefore, these costs need to be taken into account in COGS.

Or one more example. If we pay a manager fee as % of client acquisition, then it should be counted in COGS and/or 1sCOGS. If a manager receives part or all of the salary, it is a fixed cost and is not considered in COGS.

Therefore, it is important to understand the main principles of unit economics, study cases of calculation for your business model and develop your own formulas.

Mistake #3. Measure unit economics only once.
Often unit economics is considered only once in order to attract investment. Unit economics is a good tool for finding growth points for a company. It is optimal if you explore the unit-economics file at least once a month and adjust the indicators.

Mistake #4. Wrong data.
Many startups make minor mistakes when working with data, which ultimately lead to global distortions of all indicators and making wrong decisions.

Here are some examples:

1. Calculation of customers' conversion taking into account recurring buyers
2. Data not collected on time.
3. Mistakes in cost accounting. Often, when calculating expenses, we forget about such important costs as acquiring fees or commissions for advertising platforms. As a result, the marginality of the unit is overestimated.
4. Another common mistake is rounding numbers.
5. Calculate the conversion without taking into account losses at each stage of the funnel. It is rare that a sales funnel is a 2-step process, like in the market: you asked for a car, I sold it to you. Usually, from the moment when the user learned about the company, to the moment when he/she made the first purchase, there are several steps. At each step you lose a certain number of customers.

We used materials from https://fundsquire.com.au/ , https://ramp.com/model/unit-economics

15 min to read

Popular Questions and Answers when Calculating your Unit Economics

LTV (Lifetime Value) should be calculated based on gross profit, not income or revenue

LTV (Lifetime Value) should be calculated based on gross profit. Gross profit is the difference between revenue and all variable costs that are directly associated with the product or service sold (COGS or Cost of Goods Sold).

Different companies might calculate LTV in different ways. So make sure to figure out how this metric is calculated in your company before using it. However, in the context of unit economics, we should calculate LTV based on gross profit, since it represents what will happen when we scale the business.

To avoid the complicated maze of financial and accounting terms, focus on the main question: are you making or losing money on a particular user? To answer this question you should calculate the LTV that the company will receive from the sale of a specific service or product. Therefore, all variable costs that are directly related to it must be deducted from the revenue.

Variable and fixed costs
The key for calculating LTV is to understand which costs are fixed and which costs are variable. If you sell a mobile game through the App Store, then the cost of a specific copy of the game is zero. The salary of the developer team is a fixed cost. It doesn’t scale with the sales of the game.

Now consider a company that develops and sells complex, expensive B2B software. For every customer, the company’s engineers must work on the integration of the software into the customers business and workflows. In this case, the costs of integration should be accounted for when calculating LTV (these are variable costs). But the costs of developing the software itself do not need to be taken into account because they are fixed and are not directly related to a specific transaction.

LTV is usually calculated for a specific moment in time
In the classical sense, LTV is the gross profit (revenue minus variable costs) of an average user over the entire period of using the product. This is a nice definition, but it is hard to apply it in practice. A more practical application is to estimate the LTV for some month from the moment the user arrives. This month is usually a successful one in a sales circle of a company.

For which month to calculate LTV
The projection period of the LTV strongly depends on the product and the problem being solved.
For example, venture-backed companies often aim to recoup the money spent on acquisition in 12-18 months (sometimes even longer).

If the company is bootstrapped and is spending its own money, then it can rarely afford to wait more than 2-6 months for returns on the investment in user acquisition.

For some products, LTV plateaus quickly. In these cases, it makes sense to calculate LTV for a month, when the curve almost becomes parallel to the X axis.

LTV must be predicted early
Usually, you can’t wait 6 or 12 months to gather enough data to calculate the LTV of your users. Therefore, you must be able to predict LTV based on one or two weeks of data. Forecasting LTV is difficult, but not impossible.

Segment users when calculating unit economics
Unit economics may be positive for some acquisition channels or countries and negative for others. Therefore, unit economics must be calculated separately for different acquisition channels, platforms, regions, etc.
One of the challenges of this case is attributing users to a specific acquisition channel.

A unit can be anything
The “unit” in unit economics is what you plan to scale. It can be a new user, a user converted into a paying user, or a user who has subscribed to the trial. You must choose a target unit and calculate both CPA and LTV for it.

However, there are some well-established conventions that are worth mentioning. In mobile games and applications, a unit is a new user. In SaaS, it is the paying customer.

ROI/ROMI vs Unit Economy
ROI (Return on Investment) or ROMI (Return on marketing investment) is an excellent metric that helps apply unit economics to marketing and product growth. ROI = (LTV – CPA) / CPA

ROI shows how much return you get on your investment in a specific distribution channel. To calculate ROI for a channel, take the gross profit of customers attracted from this channel, subtract the money spent to get these customers, and divide the result by the acquisition costs.

Sales funnel. What are the stages of a sales funnel? From what stage should UA (user acquisition) be counted? What conversion from user acquisition to payment will be provided?

• Describe the main stages of a sales funnel. For description, you can use a flowchart, excel, mind map
• Estimate the planned conversion between each stage and calculate the final conversion. Example,

View an advertisement
Go to application page
User Acquired (UA)
Logged into the application
View an advertisement for a trial
Made a trial
Go to the subscription page
Subscribed
Paid


Price and number of transactions. How much are customers in the industry willing to pay? What price is sufficient to recoup the basic variable costs?

You should analyze the prices of competitors and the data that you received when interviewing users. You should determine the best price customers in your industry are willing to pay through competitors' analysis.

What is the minimum amount that customers have to pay in order to recoup COGS (cost of goods sold)?

Think about how you can increase the average check. What goods / services can you combine into a set of services / goods? What can be offered extra to the main product?

Calculate how many transactions per year/month the client should do to make it more profitable for you. How can you increase the number of transactions per client?

Marketing budget and COGS. What is the average conversion rate on the market? How much does it cost to acquire 1 client in your industry? What costs do you incur in the sales process? What costs do you incur for the production of one unit? Does your model include the cost of the first trade (1sCOGS)?

You should look at the average cost per click/lead in your industry. Calculate how much it will cost to attract the first 1000 users (for b2b and expensive products - 100 users).

Describe the sales and customer service process and estimate what costs you incur in the process. Do not forget about transaction costs: acquiring fee, commissions to intermediaries, delivery costs, as well as % of the transaction to sales managers. Think about how you can cut costs.


What are the market limitations in terms of indicators?

Find the minimum and maximum values of clicks on ads in your industry (for contextual, targeted advertising). Find information about average conversion rates in your industry.
Try to find out how many times on average people use similar products per year / month / lifetime (if you sell one-time expensive goods and services).


We used materials from https://gopractice.io/product/unit-economics-made-easy/

A standard market-research may not always work, as relevant data for your business may not be available. Reaching out to existing entrepreneurs in the same industry/ segment of interest can help in better understanding of the market.
Once you have finalized your product / service, explore the market for competition.

There is no point in offering the same service or launching a product, which is already existing in the market, without any value addition. Once the competition mapping is completed and if a similar product or service exists in the market, ascertain how best you can better your product and service. You will be competing with an established market player with a set consumer base and if you must disrupt that model, then your product or service should be far superior.

It is also mandatory to determine whether your product / service complies with the law of the land. As witnessed in recent times, technology-backed businesses in India are facing legal hurdles simply because legislation to support them has not yet been drafted. Therefore, a business must work within the limited legal framework, which could be a potential hurdle for expansion if decisions are taken hastily. So, make sure that your product / service conforms to the regulatory standards set for the market.