How to Calculate Unit Economics for Your Business
Most businesses have issues sustaining their growth, cash flow, and other vital aspects of their organization. Irrespective of the business objectives you want to achieve, costs and revenues are its building blocks.
Whether you are a business owner or a company's Chief Financial Officer (CFO), you can use tools to analyze your business performance and determine its long-term sustainability. One such tool is unit economics.
This article discusses the models of unit economics and how to apply its principles to help advance your business.
Let’s get started.
What is Unit Economics?
Unit economics refers to the direct revenues and variable and fixed costs of a specific business measured per unit basis. A unit can be any significant item that adds value to the business. It can be a customer, stock-keeping unit (SKU), product category, or business line.
In other words, unit economics describes a particular business model, revenues, and costs concerning an individual unit.
When describing unit economics, the “unit” is an organization's core element that is measured and analyzed to understand its revenue source fully. For SaaS businesses, such a unit represents a customer.
Unit economics is an effective tool designed to help you better understand your business success and long-term sustainability.
Importance of Unit Economics
- Helps Organizations Get a Broader Understanding of their Business Processes: Your unit economics is what investors, management, and other relevant stakeholders use to evaluate your business’ financial performance.
- Forecast Profitability Based on a Per-Unit Analysis: With unit economics, an organization can easily predict how profitable a business is and how soon it will break even and reach a point where it is considered profitable or when it is expected to achieve profitability.
- Develop Effective Strategies for Product Optimization: Unit economics enable businesses to understand if their products are undervalued or overpriced.
- Evaluate A Product's Future Potential: Unit economics allows companies to analyze customers' preferences effectively and assess market sustainability.
Why You Should Track Unit Economics as an Early-Stage Startup
As a startup founder, you need to start monitoring the early stage of your business to have a better chance of establishing a strong footing in your market and achieving a healthy growth curve.
Most startup founders can be extremely optimistic concerning the concept behind their business. A “build the business and the customers will come” mindset is one of the biggest startup killers.
Most startup founders start their business without carefully thinking and analyzing vital factors like pricing strategy, cost structure, product-market fit concerning specific business models, customer acquisition, and detailed bookkeeping.
If these important factors are ignored, it will not take long for the startup vision to crumble as it begins to run out of running capital.
Unit economics is indispensable because its prior knowledge makes it easier for a startup founder to make the right financial projections that accurately predict the actual direction of your company's average revenue.
You can easily monitor your growth rate at the early stages of your business to ensure your business remains profitable.
Despite the perfect execution of the company's goals and plans concerning growth and profitability, a sudden acceleration in growth can be followed by a major hit on the profit margin.
By monitoring your key metrics, you can measure, enhance and properly align your marketing, product or service, and team members with the goal and direction you need to move in for sustainability.
How to Approach Unit Economics as a SaaS Startup
There are two major angles from which you can approach unit economics and apply it effectively.
A clear understanding of your unit cost as a SaaS company is important when making major business decisions.
LTV to CAC ratio
While conducting your unit economics analysis, paying close attention to your customer acquisition metrics and lifetime value is vital. Additionally, you need to consider the ratio between them.
In reality, an ideal ratio is considered to be 3:1, which means you would get three times the actual value of acquisition based on a new customer that patronizes you.
If your ratio is lower than its ideal point, for example, 1:1, it will imply that the amount each customer spends to purchase your product is equivalent to the amount you would spend to acquire one customer.
If your company has this experience, the solution lies in you finding the best means to maintain your sales, pricing models, and acquisition.
On the other hand, your ratio may be high as opposed to the initial low point of your ratio. A high ratio implies that your company could lose or miss out on valuable opportunities, which could be a turning point for the business.
Every customer is valuable to your business, especially at the beginning stage. Each customer will be more valuable with time than it costs to convert them initially. It will be wise for you to allocate adequate time and resources to sales and marketing efforts.
You will gain the money your company spends to onboard more customers and convert leads to paying customers over each customer's lifecycle. This statement implies that the money spent was invested.
The Payback Period on CAC
The payback period on CAC describes the time an organization must pay back or refund the cost of acquiring a customer. Based on gross profit margin, the average startup company has a payback period of 15 months.
When an organization has the privilege of having a shorter payback period, which requires less working capital, the startup has the opportunity to grow faster because it has less overhead cost to pay back.
A startup's shorter payback period is a great advantage because it reduces the stress involved in the process and requires less working capital.
Unit Economics Model
There are two major approaches to calculating cost and revenue, which the unit economics model proposes. The calculation is largely dependent on how an organization defines its unit.
1st Approach Unit – “One Item Sold”
If an organization defines its unit as “one item sold,” the company can easily determine its revenue and cost balance using the contribution margin.
This model is commonly applied by companies that offer physical products where there are production costs for every item sold.
Contribution Margin = Price Per Unit – Variable Cost Per Sale
The calculation is the difference between a price per item and variable sales costs. Variable costs can be described as the expenses that vary depending on your product quantity, such as materials and sales compensation.
An Mp3 music player in a gadget store costs $100. The computed variable cost per Mp3 music player is $50. Let’s calculate its contribution margin.
Contribution Margin = Price Per Unit – Variable Cost Per Sale
Contribution Margin per Mp3 Music Player = $100 – $50
Contribution Margin = $50
To calculate the total contribution value properly, calculate the total number of items sold during a particular period.
If a customer purchases one Mp3 music player for $100, it was sold to 120 customers in the first month you launched the product. To calculate the item's total price, you must multiply the number of customers by the cost of one Mp3 music player.
Total Price of Mp3 Music Players = 120 х $100
Total Price of Mp3 Music Players = $12,000
To calculate the total number of variable costs, you multiply the variable cost per Mp3 Music Players by the total number of Mp3 Music Players sold.
Total Variable Costs = $50 х 120
Total Variable Costs = $6,000
So, the total contribution margin will be:
Total Contribution Margin = Price Per Unit – Variable Cost Per Sale
Total Contribution Margin = $12,000 – $6,000
Total Contribution Margin = $6,000
2nd Approach Unit – “One Customer”
Some companies define their unit as “One Customer.” For these companies, unit economics is largely determined by the ratio of two metrics: customer lifetime value (CLV) and customer acquisition cost (CAC).
On the other hand, some other businesses include a CAC payback period instead.
Let's consider both options.
CLV to CAC Ratio
Customer lifetime value (CLV) is the total amount of money a company derives from paying customers before their preference changes and they stop purchasing from your company.
Here is how to calculate Customer lifetime value (CLV). You begin by multiplying the average value of the purchase by the total amount of times your customer buys your product in a year and the average length of your customer relationship in your customer relations in years.
CLV = Average Value of Purchase X Total Number of Times a Customer Makes a Purchase X the Average Length of Customer Relationship in Years
Customer acquisition cost (CAC) is the total amount of money a company invests toward attracting a potential customer. CAC includes the total sales of the company and marketing costs (campaigns, salaries, and programs).
Here is how to calculate the Customer acquisition cost (CAC). You begin by dividing the total sales and total marketing expenses by the number of newly acquired customers.
CAC = Sales and Marketing Cost / New Customers Won.
For example, a SaaS company spent $200 on marketing in 2021 and converted 50 customers in the same year. Calculate the company’s CAC.
CAC = Sales and Marketing Cost / New Customers Won
CAC = $200 / 50
CAC = $4
Customer Acquisition Cost (CAC) is not the same for every industry. It is influenced by certain factors such as purchase value, frequency, customer life span, sales cycle length, and company maturity.
When calculating the probability of selling your products to new customers, the figures you will arrive at a range between 5% and 20%. On the other hand, the probability of an existing customer accepting your product and purchasing it ranges from 60% to 70%.
A company must calculate the balance between the customer's lifetime value and the fixed cost of acquiring a new customer.
Based on experts' opinion, the ideal LTV to CAC ratio is considered to be 3:1. This ratio implies that a customer should be valued three times what it costs to convert the customer into a paying one.
If you find yourself in a lower ratio, for example, 1:1, you have invested excess resources in acquiring new customers. A 1:1 LTV to CAC ratio indicates that the amount your customers put into your business equals the cost of acquiring them.
Alternatively, suppose your ratio ends up being too low. For example, a 1:7 LTV to CAC ratio implies that the amount used to onboard customers to your company exceeds the total revenue your company earns from them.
CAC Payback Period
Different businesses have unique approaches to unit economies. Some prefer to use an approach that focuses on the months the company takes to begin earning money from each customer.
The CAC payback period approach is best for startups with a higher churn rate and requires enough time to adjust their product to fit specific market needs. For these companies, calculating their CLV can appear to be a rather complicated task.
Based on gross margin, the average payback time for most young businesses should be about 15 months.
A shorter payback period is more advantageous to the business since it requires less expenditure to move a customer to make a purchase and grow the business effectively.
How to Calculate Unit Economics
1. How to Model Customer Lifetime Value
Two major ways to model customer lifetime value are Predictive LTV and Flexible LTV.
With the predictive LTV method, you can easily forecast how an average is likely to act in the nearest future. This formula takes into account how customer preferences change over time.
The formula for calculating predictive LTV is Predictive LTV = (T x AOV x AGM x ALT) / the total number of customers for a particular period.
Here are the details in the given formula.
T (Average Number of Transactions)
T represents the total number of transitions divided by a given period, resulting in the average number of transactions.
AOV (Average Value of Order)
To determine AOV, you will divide the total revenue by the number of orders the company receives, ultimately resulting in the average monetary value of each order.
AGM (Average Gross Margin)
AGM is calculated by subtracting the cost of sales (CS) from the total revenue (TR) to determine the company's actual profit. Use this equation to determine the average gross margin: AGM = ((TR-CS) / TR) x 100.
ALT (Average Customer Lifetime)
ALT equals the churn rate figure divided by 1. You can obtain the churn rate by taking the number of customers at the beginning of a particular period (CB) and measuring this figure against the number of customers remaining at the end of that particular period (CE).
The formula for determining the average lifetime of a customer is expressed as Churn Rate = (CB-CE)/CB) x 100.
Flexible lifetime value allows your organization to effectively account for any potential change in your organization's revenue. This metric considers retention and discount rates to provide more exact results.
The flexible LTV method is particularly relevant to new businesses and startups because they are more likely to undergo various changes as the organization grows and develops.
The formula for measuring flexible LTV is: Flexible LTV = GML x (R/(1 + D – R))
Here are the details for the given formula.
GML (Average Gross Margin Per Customer Lifespan)
GML displays how much profit or the total profit your company has generated from a particular customer in an average lifespan.
The equation for measuring GML is Gross Margin x (Total Revenue / Number of Customers During the Period).
D (Discount Rate)
The discount rate measures the company's return on investment rate.
R (Retention Rate)
The retention rate is calculated by repeatedly measuring the total number of customers who purchased your company's product (Cb and Ce) against the number of newly acquired customers (Cn).
The equation is expressed as (Ce – Cn) / Cb) x 100.
2. How to Analyze the Cost of Acquiring New Customers
Acquiring new customers is challenging, especially for new businesses. Determining the cost of acquisition (CAC) is a vital metric for organizations that want to accurately know how much they spend on acquiring new customers.
The formula for determining CAC = (Sales and Marketing Costs / Number of Acquired Customers).
Calculating your LTV to CAC ratio will aid you in determining whether the building blocks of your unique marketing effort are sold enough or require proper adjustments.
Your business is strong if your CAC is less than your LTV. Alternatively, if your CAC exceeds your LTV, your business's financial future is in danger, and you will experience losses. On the other hand, if the two matrices end up being equal, the business is stagnant.
How Tracking Unit Economics Can Help You Grow Your Business More Profitably
Having a clear understanding and tracking unit economics gives you in-depth insight into your business's health by clearly displaying how much you are investing against your potential return on investment (ROI).
Tracking your LTV/CAC ratio is a very important task you should not take lightly. If your business costs are high, the downside is that you will find it difficult to grow, and your business may be in trouble of failing in the long run.
Tracking your customer lifetime value LTV and customer acquisition costs CAC metrics early enough will help you know the best way to run your business to stay afloat. It also helps you know how best to adapt to any challenging situation.
Predicting growth is easy with the unit economics approach. If your LTV remains above your CAC, you will naturally make profits for every single customer you have.
Additionally, your business grows as it should if you have a growing customer base while maintaining the optimal LTC/CAC ratio. Your business is guaranteed to remain afloat and not have the tendency to fail in the long run.
2. Capital Expenditure
While starting a business, you need to grow quickly. Growing your business fast will require enough capital to make this happen, but if you spend your running capital too fast, your business will end up crashing instead of growing as it should.
Understanding unit economics will greatly benefit you because you can easily calculate how many months it will take to get your CAC expenses back.
With this knowledge, you will see how fast you are supposed to spend your working capital on marketing without leaving any amount for other relevant expenses.
3. Tracks Oncoming Failure
Money is not the solution to every issue that arises in business. These are some acceptable cases where your CAC can be higher than your LTV, but this situation is uncommon.
Suppose your customer retention rate is low, and your customer acquisition cost is increasing because you keep spending money to acquire more customers. In that case, the implication is that your business will likely fail faster if your CAC rises too close to your LTV.
Tracking unit economics helps your business grow more profitably because it helps you spot when you are spending more money on customer acquisition than you are receiving on time before it can cripple your business.
4. Breaking Even
To start a business, you will require capital to acquire customers further, and launching new products will also cost the business money.
After spending so much to start a business with the sole aim of making a profit, you must have a particular income from the business for your break-even point to occur.
Properly monitoring your break-even point will help you ascertain if your business is sailing in the right direction or if you need to make necessary adjustments to how the business is being run.