20 min to exploreWhat 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 UnitYou 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 PurchasesUnit ProfitabilityThese 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 economicsImproving 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 placeTake 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 reportsMiscategorizing 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 contractsThe 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:
- Calculation of customers' conversion taking into account recurring buyers
- Data not collected on time.
- 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.
- Another common mistake is rounding numbers.
- 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