Unit economics is a method of measuring the profitability of a product or service by using specific units. A unit is a quantifiable entity that creates business value. Therefore, unit economics calculates how much income each unit generates.
To calculate the unit economics, you need to define the measurement unit. It can vary by industry and business model, but typically a unit is a single product, order, or customer. With this method, you can even measure the effectiveness of a sales representative.
Examples. For SaaS startups, a unit is a software user; for a brick factory, a customer. An airline would count units as sold seats, while car ride apps (similar to Uber) typically use single rides.
Benefits of unit economics for startups
Founders can sometimes be overly optimistic about their business concept. Therefore, many startups are launched without thinking about product-market fit, pricing strategies, cost structure, customer acquisition, and accounting. If these factors are ignored, they can destroy the founders’ dream of a perfect startup. The money will eventually run out.
The sooner a startup starts tracking the unit economics, the more likely it is to establish a strong market position and achieve healthy growth. It’s important to understand that unit economics are indicators that need to be checked constantly, keeping track of changes.
Here’s a list of the advantages of using unit economics.
- Upper hand in decision-making. It’s easier for managers to calculate break-even points and marginal profit.
- Communication with investors. Unit economics is useful for communicating with sponsors interested in understanding a startup’s business model.
- Evaluation of market sustainability. It’s easier to assess a product's potential, which is especially relevant for early-stage startups.
- Profit forecasts. Calculating revenue per unit creates a more realistic picture of the time needed to achieve profitability.
- Product optimization. Unit economics helps you understand whether a product is overpriced or underpriced.
- Course correction. Accelerated growth is sometimes accompanied by an inevitable profit reduction. By tracking key metrics with unit economics, founders can steer the business towards sustainability.
The main difference between unit economics and other profitability indicators is that it only takes into account variable costs while ignoring fixed ones. Thus, unit economics helps calculate at what level the enterprise should be operating to compensate for fixed costs. If the money is wasted before a startup can cover fixed losses, growth becomes impossible.
How to calculate unit economics
Methods for calculating unit economics vary depending on the business model. As a rule, a unit is seen as one product or one new customer. The bottom line is to determine how much money it costs to sell or acquire one unit, how much money it makes, and what the ratio of both indicators is.
1 unit = 1 client
SaaS startups usually see one unit as one customer. To calculate unit economics, they need to know two main factors:
- unit acquisition cost (in this case, CAC)
- total unit revenue (LTV).
CAC, or Customer Acquisition Cost, is the cost of acquiring a unit. It is calculated by summing up all marketing costs: pay-per-click advertising campaigns, employee salaries, expenses for various advertising channels, etc. Then, the amount should be divided by the number of acquired customers for the same period.
Example. In a month, a SaaS startup spent 200,000 dollars on advertising and sold 100 subscriptions to its software. The CAC of a startup is 200,000 / 100 = 2,000 dollars.
LTV, or Lifetime Value, is all the value brought by a customer. It’s calculated by summing all the income received from the unit’s first purchase.
Example. A subscription to the software costs 1,100 dollars per month. A customer has been paying for the subscription for the last 3 months. It means that this client’s LTV is 1,100 × 3 = 5,500 dollars.
1 unit = 1 sale
Hardware startups and businesses that define a unit as a sold product estimate their revenue-to-expenditure ratio using marginal profit. It is calculated as the difference between the revenue and variable costs.
Marginal profit is the revenue that’s remaining after deducting all variable costs. It is also used to pay for fixed ones. Listing all variable costs carefully is important for unit economics because skipping even one parameter can have a significant impact on the path to a break-even.
The best advice for a founder is to be thorough and include as many variable costs as possible to prepare for the worst-case scenario. This way, any deviation will only be a pleasant surprise. It also motivates business founders to pay attention to even the smallest costs that would otherwise go unnoticed. If you mistakenly account for variable costs as fixed costs, the rate at which you burn money will soon begin to drastically differ from what is indicated in the business plan.
Example. A smartphone in an online electronics store costs 25,000 dollars. Variable costs amount to 15,000 dollars. Therefore, the marginal profit of this unit is 25,000 − 15,000 = 10,000 dollars.
The ideal ratio
It is important to calculate the ratio of income and expenses per unit. The ideal ratio is 3:1, meaning that the income received from the customer should be at least three times the cost of attracting them.
If a startup shows such a ratio of income and expenses, it will send a positive signal to investors who are interested in long-term growth opportunities with low risks. Projects with a lower ratio (for example, 2:1) are encouraged to improve their unit economics by either reducing CAC or increasing LTV.
Example. Let’s go back to the SaaS startup we mentioned above. The lifetime value of the client is 5,500 dollars, the cost of attraction is 2,000 dollars. These figures are close to the ideal ratio of 3:1, where CAC is covered by LTV three times. But to actively attract funding, it’s worth adjusting the marketing campaign.
At the same time, calculation and optimization can be difficult for early-stage startups. At the beginning of the journey, projects often do not have enough data, customers, or resources to conduct research. Nevertheless, the methodology is available even for pre-seed startups since CAC and LTV are key indicators that you need to track before looking for funding options.
Payback period
Unit economics also considers the time it takes for a company to recoup the cost of acquiring a customer or making a sale. The payback period determines how long it takes to start earning money from a new customer or a new batch of goods.
The average payback period for a startup is 15 months. But the shorter the payback period, the better. It means that less working capital is required, which allows the business to grow faster. The best result is if the payback period lasts from 2 to 4 months.
Example. If the cost of customer acquisition is $2,000 and the cost of subscribing to SaaS startup software is $1,100, it should take 5 to 6 months before the project shows positive unit economics (based on a 3:1 ratio).
How to get a better ratio
If the ratio is far from perfect, to improve the unit economics it’s necessary to either increase the lifetime value of the customer or reduce the cost of attracting them. Below, you will find recommendations for both options.
Ways to increase LTV
To increase Lifetime Value, you need to increase the average check, customer retention rate, or order frequency. To do this, you should use the following options:
- special offers at the checkout or in the online store cart,
- tracking feedback from users and studying their opinions on products,
- cohort analysis to increase the effectiveness of audience segmentation and reduce customer churn.
To make customers place orders more often, a startup must pay attention to their experience. By making it as smooth as possible, it will leave fewer carts unpaid. This will attract more new customers, although it will not necessarily affect LTV.
Ways to reduce CAC
An alternative to increasing LTV is to reduce CAC. It’s all about smart targeting: the more precise the marketing, the fewer resources a startup spends on irrelevant leads. Retargeting campaigns can also help keep costs down.
Also, a startup needs to regularly test its advertising materials from social networks, emails, and campaigns on a live audience. For example, simple A/B testing can help reduce churn rates and increase conversion.
In the end, collecting and analyzing data always helps. If you have enough processed information, you’ll get the most accurate unit economics. This way, the best way to reduce CAC is to optimize all touchpoints.
Unit economics’ connection to growth
Stronger unit economics generates profit from each new customer/sale, which brings the startup closer to success both in the market and among investors. Weaker unit economics, in turn, generates losses and accelerates failure.
However, even the most profitable product can one day hit the glass ceiling of development. For a product to remain in demand for a long time, the following three factors must be present:
- product-market fit,
- positive unit economics,
- ability to scale and grow.
In a sense, positive unit economics allows a startup to scale and grow. Once founders extract more money from customers than they spent on attracting them, they enter a cycle of reinvesting into their advertising campaign and increasing the number of new customers.
Not all startups manage to hold out on their own for the entire payback period. Some require funding. But investors love positive unit economics way more than negative. Therefore, moving from a minus to a plus is the most important milestone at an early stage of any business.
Once the startup model gets stronger than its competitors, founders will be able to out-compete and outgrow them, getting a market-leading position.
Unit economics for a startup: an illustrative example
Launched in 2015, Bento is a startup that delivers customizable lunch boxes. Although the project raised $2 million from investors, shortly after the launch the founders realized that the money was burning 30% faster than planned. At the same time, the startup showed good weekly growth of 15%.
After detailed calculations of unit economics, the Bento team found out: each lunch box sold for $12, but the unit production (including chefs’ work, equipment, packaging, etc.) cost $32. It meant the company was losing $20 per unit.
To solve the problem, the company cut its costs. It fired all kitchen staff and pivoted towards catering services. However, rapid development has stalled. Although the new model was more thoughtful in terms of unit economics, consumers reacted to the concept with less enthusiasm.
As a result, the startup broke even, but the profitability remained low. The founders lacked the budget to hire managers and developers. Current operational processes wasted the entire project’s capital. Finally, Bento announced its closure in early 2017.
With a timely and careful analysis of the unit economics, the gap between income and costs would have become obvious. This could allow the company to raise profits, reduce production costs, and/or calculate the payback period correctly.
Summing up
A business at any stage of development should know its financial performance. However, this is impossible without a deep understanding of income and costs. Unit economics helps startups and more mature companies analyze metrics and direct business processes towards continuous growth.
Understanding unit economics is key to predicting long-term financial prospects. The method uses the most important parameters typically available even in the early stages of business. It means that unit economics can be used for freshly-launched startups as well.
Two common measurements are used as units:
- one new customer (for example, in SaaS startups)
- one sale (for example, in hardware).
Investors often use unit economics, so any pitching can end with a discussion of its positive or negative dynamics. A business is considered a profitable investment if the income is at least 3 times higher than the expenses. The shorter the payback period, the more attractive the opportunity.
Skillful use of unit economics strengthens a startup’s position in the market space. With its help, founders can calculate the customers’ payback period and better understand their company as it develops and scales.
