What is unit economics?
Unit economics is an essential part of any business’s success, which can be hard to measure correctly. Looking at the cost of each unit or customer versus the money made from that unit or customer is a simple way to determine if a business is profitable using unit economics.
As used in unit economics, a “unit” is any customer, good, service, or other thing for which the costs and profits of selling it can be calculated.
For example, a store’s unit economics would be the difference between the profit they make on each sale and the price of that sale.
In the same way, the unit economics of a rideshare app would be the profit from each ride divided by the price of the ride.
To put it simply, unit economics answers a fundamental question: Can the company make more money from each customer than it costs to get them?
Entrepreneurs, startups, and large businesses can all use this easy but effective method to look at their business model, determine which customers or products are the most valuable, predict future sales, and better use their resources.
Synonyms
- Unit Profitability: The profitability of each unit (i.e., customer unit economics).
- Cost of Goods Sold (COGS): The cost of making and delivering a product or service.
- Customer Acquisition Cost (CAC): The amount it costs to acquire a new customer for the business.
- Lifetime value (LTV): a measure of how much revenue an individual customer generates.
- Unit Economics Ratio: A ratio that measures the profitability of each unit, calculated by dividing revenue by costs.
Why it’s essential to keep track of units
Determining how effective, profitable, and healthy a business is can be challenging. Unit economics is essential for many reasons, mainly regarding business planning, spending, and getting new customers.
- It shows how well the business is doing per customer or unit. When talking to investors, stakeholders, or board members, unit economics measures show (with fewer, more accurate numbers) how successful a business is on an individual and a group level.
- It helps businesses decide whether to boost or lower service levels or output. You can figure out if adding more items or features is a good idea or not by seeing how many new customers you can get and how much it costs.
- It helps business owners and early-stage startups determine the most valuable customers or goods. Quickly figuring out which customers bring in the most money for SaaS startups helps them focus their sales, marketing, and product development better.
- Allows for correct predictions of how much money will be made and spent. Businesses lose an average of $15 million yearly because of insufficient data. Unit economics helps people deal with these risks by giving them easy, real-world metrics to use to make decisions.
- It gives valuable information about how profitable and cost-effective different tactics are. Measures to increase revenue and cut costs can be found and implemented more accurately.
- It tells companies how much money they need to make a profit. Unit economics can help you figure out the lowest price you need to charge to break even when setting prices.
- It makes the best use of resources to cut down on waste. Businesses can find inefficient areas and make changes to improve processes by looking at unit economics.
Metrics for Unit Economics
At its core, unit economics is the ratio of the profit made from a customer to the cost of getting that customer. However, several metrics change the end value.
Cost to Get a New Customer (CAC)
The customer acquisition cost (CAC) is crucial for determining how a business makes money per unit.
It’s the total of all the costs that come with getting a new customer, such as
- Marketing costs, such as those for advertising, public relations, and sales promotion.
- Sales costs include salaries, bonuses, and other forms of pay for people who work in sales.
- Technology costs, like the software and tools used to get new customers.
- Overhead costs, such as rent, utilities, and others, arise when a business seeks leads.
- Variable costs include shipping costs, payment processing fees, and other costs that change each time a customer buys something.
A common way to figure out CAC is to split the total cost of getting a new customer over a certain amount of time (like a month) by the number of new customers.
Value of a Customer Over Time (LTV)
LTV is a way to determine how much net profit a long-term relationship between a customer and a product makes.
In unit economics, this metric tracks the possible long-term return on investment in getting new customers. The significant value is compared to a company’s CAC to determine how profitable a customer is.
Depending on the business plan, there are different ways to figure out LTV:
- For subscription services, multiply the average monthly recurring income (MRR) per user by the average length of time a customer stays with the service.
- For online stores, it’s the average order value times the average number of times a customer buys something.
- For business software companies, annual revenue times the years a customer stays with the company.
It’s important to remember that you need to use past data to figure out LTV. It’s based on how much people usually spend, how often they buy, and other things linked to how engaged a customer is with a product.
When figuring out LTV, it’s also essential to consider other microeconomic factors, like the loss and discount rates.
Rate of Churn
It can be challenging for a business to figure out how much each customer is worth when its customer base constantly changes.
What is the churn rate? It tells you how many people are leaving at any given time. To figure it out, split the number of lost customers by the total number of customers during a specific period, like a month.
The cost of losing a customer every month is added to the unit economics formula to make it work.
In this case, if a business loses five percent of its users every month and the cost of getting a new one is $500, it must compensate for the lost money.
This lowers the LTV to CAC ratio because the company isn’t getting any return on the money it spends to get that customer.
Rates of Discount
Businesses can use unit economics to figure out how to set prices by looking at discount rates, which are the rates at which customers get savings on their purchases.
Businesses can make intelligent decisions about their pricing and make the most of their bottom line by knowing how different discount rates affect them.
For instance, if a business wanted to give customers a 10% discount on products, they would need to figure out the projected customer LTV versus CAC ratio to see if it is good for the business to give discounts.
Average Time with a Customer
Since not every customer brings in money immediately, the average customer’s lifetime is closely linked to unit economics.
A customer is thought to stay with a business for an average of a certain number of years. It looks at customer happiness and loyalty, the rate of customer turnover, and how often they buy.
Businesses can determine their LTV by knowing how long their average customer stays with them. This helps them determine how long it will take to recoup their CAC and get a return on their investment.
Rate of Retention
Keeping a customer is a vital part of unit economics because it affects the LTV of that customer. It is found by dividing the number of customers kept by the total number of customers during a specific period, like a month.
Any business that wants to know if its goods or services are meeting customer needs and keeping them interested should know its retention rate.
If a business has a low rate of keeping customers, it generally has bad unit economics unless it can make up for it with a high rate of getting new customers or a high-profit margin.
How many deals were made
The number of interactions is a small but essential factor in unit economics analysis. It is found by adding up all customer orders over a specific period, like a month.
It’s not always true that more transactions mean more straight sales. Companies that sell pricey goods may need fewer ways to make money to reach their LTV goals.
On the other hand, companies that sell low-margin goods may need more transactions to cover their CAC and see a return on their investment.
In any case, it shows how interested people are in a business’s goods. Businesses can make better marketing plans and price structures by looking at customer data, like the number of sales compared to the lifetime value of customers.
The number of customers
When trying to understand unit economics, the number of customers doesn’t matter. Like the number of transactions, the number of customers can help you determine how profitable a business is.
In general, businesses with more customers have strong unit economics. This is because they are less reliant on any one customer, which makes them more able to adapt to changes in the market.
On the other hand, businesses with fewer customers should keep a close eye on their LTV and manage their income by taking into account things like the average customer lifetime, transaction volume, discount rate, and customer retention rate.
Total Income
Total revenue is the sum of all the money made from sales in a specific time frame, like a month.
When you look at money, you start by looking at total income. This is where unit economics comes in. It gives us a starting point for all of our other estimates.
It’s essential to remember that overall revenue doesn’t always mean a business is profitable since it doesn’t consider other costs or the cost of goods sold (COGS).
Profit in Gross
The gross profit is the gap between the total amount of money made and the cost of goods sold (COGS). It considers unit costs like labor and supplies but not other costs like marketing, overhead, and the salaries of people who work indirectly.
Average Value of an Order
Average order value, or AOV, is just how much each order is worth on average. It is found by dividing the total amount of money made by the number of sales.
It depends on the price of the good or service, just like the average revenue per customer. It can help businesses determine how many people they need and how much they should charge.
Gross Margin on Average
To find the average gross margin, divide the average gross profit by the average order value. It helps them determine how much each sale makes them and how their unit costs change over time.
Companies can set competitive prices and make changes when they know the average profit margin. This has an effect on their unit economics in the long run.
Gross margin for each customer’s lifetime
The total gross margin less the number of customers over a specific time period is the gross margin per customer lifespan. This helps companies figure out how much money each customer brings in and if their unit economics can last.
For instance, a low-profit margin per customer could mean that a company needs to keep more customers or lower its unit costs to get a good return on its investment.
How to Figure Out Unit Economics
Several vital measures (mentioned above) are used to figure out unit economics. However, this is how unit economics works:
Unit Economics = Profit per Customer / Cost of Getting a New Customer
To find the revenue per customer, reduce the business’s total revenue by the number of customers it has.
The cost of getting a new customer depends on the type of business. It’s usually found by adding up the costs of marketing activities like ads and other activities plus the costs of products and other changeable costs for each customer.
Looking at Unit Economics
Businesses can set the prices of their goods by using the idea of unit economics.
Businesses can get an idea of how well they’re doing financially by using these key measures and ratios:
Price Changes vs. Fixed Costs
No matter how many goods or services are sold, fixed prices stay the same. Costs like rent, insurance, and pay are examples of overhead costs.
On the other hand, changeable costs change based on how much is being made. These include the materials and work for making a product or shipping a service.
As a business grows or gets more customers, it will have more variable costs, like supplies, labor, and shipping.
A business has a good chance of getting a good return on its investment when the extra money it spends on fixed and fluctuating costs is matched by the extra money it makes from new customers.
Rate of LTV to CAC
When you look at unit economics, your LTV and CAC are linked unit cost measures and can be compared with a simple ratio.
The best LTV: CAC number is 3:1, which means that for every dollar you spend on getting a new customer, you should get three times as much value back.
If it’s less than 1:1, each new customer costs you at least as much as those who buy your goods. Getting better at sales techniques and setting prices are the next steps if this is the case.
A more significant ratio, like 6:1, means that chances may have been missed. As a single customer can bring in more money than it costs to get them, it’s possible to spend more on marketing and sales to get more customers without having to pay more.
Time to pay back CAC
The payback period shows how long it takes to return the money you spent on getting a customer.
A company spends money upfront to get a customer. The payback period is the time it takes to get that money back.
For example, a business has six months to get its money back if it spends $500 on getting a new customer and then makes $1,000 every month for the next six months.
The typical startup payback time is about 15 months. This means businesses need to keep customers for at least 15 months to make money from new customers.
Unit Economics: How to Make It Better
Because there are so many factors in the unit economics equation, there are many ways for businesses to improve unit economics:
- Make more money from each customer
- Lower the cost of getting new customers
- Get more customers to stay with you.
- Bring down the price of things sold
- Spend money on improving your products
You can improve these things by using better marketing tactics, making the products more valuable, figuring out the best way to structure costs, and improving the customer experience.
Despite this, the unit economics equation could still be wrong if you improve one thing (like making more money per customer) while lowering another (like unit cost metrics).
