What is Unit Economics: definition, importance, model
All companies work around their business model, i.e., a set of strategies directed at achieving their organizational goals. Yet, no matter what strategies are in the act, the building blocks of any business are always the same: costs and revenues. That’s what unit economics deals with.
What is unit economics?
Unit economics is a method applied to analyze a company’s cost to revenue ratio in relation to its basic unit, hence the term.
The “unit” in unit economics is a company’s core element measured to understand the source of its revenue. For SaaS businesses, as a rule, such a unit is a customer. Thus, unit economics for them boils down to the calculation of profit and loss per client.
Importance of unit economics
The understanding of unit economics helps companies:
- Get a clearer picture of their business processes. Adopting unit economics is the first step for the company’s management, investors, and other stakeholders to analyze its financial performance.
- Forecast profitability. Based on a per-unit analysis, unit economics shows how profitable a business is or how soon it will achieve profitability.
- Develop strategies for product optimization. Unit economics allows companies to understand whether their product is overpriced or undervalued. This can help them identify what and how should be optimized.
- Evaluate a product’s future potential. Relying on unit economics, businesses may analyze what customers love more, thus keeping up to sustainability standards.
Unit economics model
The unit economics model presupposes two approaches to calculating revenues and costs depending on how companies define their unit.
Approach 1. Unit defined as “One item sold”
If a unit is defined as “one item sold,” a company can determine its revenue/cost balance using the contribution margin. It is calculated as a difference between a price per item and variable costs per sale:
Variable costs are the expenses that vary depending on the quantity of the product you produce, e.g., materials, sales compensation, and so on.
A particular laptop in a computer hardware store costs $150. The computed variable cost per laptop is $60, so the contribution margin will be:
Contribution margin per laptop = $150 – $60
Contribution margin = $90
To count the total contribution value, you should calculate the number of items sold during a certain period. Say, one customer purchases an average of one such laptop (which costs $150). For the first month, it was sold to 130 clients. To count the total price of items, you should multiply the number of customers by the cost of one laptop:
Total price of laptops = 130 х $150
Total price of laptops = $19,500
To count the total number of variable costs, you should multiply the variable cost per laptop by the number of laptops sold:
Total variable costs = 65 х 130
Total variable costs $8,450
So, the total contribution margin will be:
Total contribution margin = $19,500 – $8,450
Total contribution margin = $11,050
Approach 2. Unit defined as “One customer”
For companies that define a unit as “one customer,” unit economics is commonly determined by the ratio of two metrics: customer lifetime value (CLV) and customer acquisition cost (CAC). Some businesses, however, count a CAC payback period instead. Let’s consider both options.
CLV to CAC ratio
Customer lifetime value (CLV) is how much money a business gets from a customer before they stop purchasing from the company. To calculate CLV, you should multiply the average value of purchase by the number of times your customer makes purchases a year, as well as an average length of your customer relationship in years:
You may find more information about CLV in this glossary article.
Customer acquisition cost (CAC) is how much money a business allocates in attracting a customer. This includes the total sales and marketing costs (campaigns, salaries, programs, and so on).
To calculate CAC, you need to divide the total sales and marketing costs by the number of new customers won.
A SaaS company spent $150 on marketing in 2020 and acquired 100 customers in the same year. Their CAC will be:
Cost to acquire a customer = $150 / 100
Cost to acquire a customer = $1.5
CAC varies from industry to industry and depends on many factors such as purchase value, frequency, length of a sales cycle, company maturity, customer life span, etc.
The probability of selling to a new customer ranges between 5 and 20%, while the likelihood of selling to an existing customer is 60-70 %. This is why a company needs to count the balance between CLV and the cost of obtaining new customers.
Experts claim that an ideal LTV to CAC ratio is considered to be 3:1. In other words, the value of your customers should be three times the cost of obtaining them.
If your ratio is lower (e.g., 1:1), it means you spend too many resources on acquiring new clients. If your ratio is too high (e.g., 7:1), it means the revenue you get from a customer exceeds the money it costs you to onboard them. In this case, you spend too little.
CAC payback period
Some businesses prefer using an approach that focuses on how many months it takes to start making money from each customer. This is more suitable for startups that have a higher churn rate and need time to adapt their product to meet the needs of a market. As a result, counting CLV for them is rather complicated.
The average payback period for young businesses lasts 15 months based on gross margin. However, a shorter payback period is more advantageous since it requires less expenditure on moving a customer to the purchase, enabling a business to grow faster.
Having elements of unit economics in mind, let’s consider how the unit economics model looks like:
Every business, no matter how mature it is, should be aware of its financial performance, which is impossible without having a deep insight into its revenue and costs balance. Unit economics helps companies analyze these basics and focus on directing their business processes towards constant growth.