Unit economics are the revenues and costs associated with each unit of your business, such as a customer, a product, or a service. They help you understand how much value you create and capture from each unit, as well as the scalability and sustainability of your business model. Unit economics can differ based on industry, business model, and stage of growth, but some common ones include the Customer Acquisition Cost (CAC), the Customer Lifetime Value (LTV), the Contribution Margin (CM), and the Payback Period (PP). CAC is the average amount of money spent to acquire a new customer, including marketing, sales, and other expenses. LTV is the average amount of money expected to be earned from a customer over their lifetime. CM is the difference between revenue and variable costs for each unit. PP is the number of months it takes for each unit to recover its CAC based on its CM. These metrics provide insight into how quickly an investment can be recouped in each unit.
What is Unit Economics?
The success of any business is complex and often difficult to determine accurately. Unit economics provides a straightforward approach to evaluating profitability by looking at the cost associated with each unit or customer versus the revenue generated from that single customer or unit.
In unit economics, a “unit” is defined as a customer, product, service, or other item for which it is possible to calculate the costs and revenues associated with its sale.
For instance, the unit economics of a retailer would be the profit they make from each customer sale divided by the costs associated with that sale.
Similarly, a rideshare app’s unit economics would be the profit from each ride divided by the costs associated with the ride.
In short, unit economics answers a vital question: Can the business profit more from each customer than it costs to acquire them?
It’s a simple yet powerful way for entrepreneurs, startups, and scaled businesses alike to assess their business model, identify which customers or products offer the most value, forecast future revenue, and streamline resources.
Key Components of Unit Economics
Customer Acquisition Cost (CAC):
{CAC} = \frac{Total Sales & Marketing Expenses}{Number of Customers Acquired}}
This is the cost incurred to acquire a single customer. It includes all marketing, sales, and promotional expenses divided by the number of customers acquired.
Formula:Customer Lifetime Value (CLTV):
CLTV=Average Purchase Value×Purchase Frequency×Customer Lifespan\{CLTV} = \{Average Purchase Value} \times \{Purchase Frequency} \times \{Customer Lifespan}
This represents the total revenue a business can expect to earn from a customer over the entire duration of their relationship. CLTV helps determine how much a business can afford to spend on acquiring customers.
Formula:Contribution Margin:
Contribution Margin=Revenue per Unit−Variable Costs per Unit\{Contribution Margin} = \{Revenue per Unit} – \{Variable Costs per Unit}
This is the revenue a company makes after accounting for the variable costs of producing and selling a product. It helps startups assess the profitability of each customer or unit sold.
Formula:Payback Period:
Payback Period=CACContribution Margin per Customer\{Payback Period} = \frac{\{CAC}}{\{Contribution Margin per Customer}}
The payback period refers to the time it takes for a startup to recover its customer acquisition cost (CAC). A shorter payback period is desirable as it means the business can reinvest in growth more quickly.
Formula:
How Unit Economics Helps Startups
Understanding Profitability:
By comparing CLTV and CAC, startups can gauge whether they are acquiring customers profitably. For a sustainable business, CLTV should always exceed CAC.Scaling Decisions:
If the unit economics are favorable (CLTV > CAC), startups can confidently invest in customer acquisition and scaling. If not, they may need to optimize their product, marketing, or sales strategy.Investor Confidence:
Investors often look at unit economics to assess the potential return on investment. A business that can demonstrate solid unit economics is more attractive to investors because it indicates the company has a clear path to profitability.Cost Optimization:
By understanding the unit economics, startups can identify areas where costs can be reduced, such as lowering CAC or improving the contribution margin by optimizing production costs.
Importance of Unit Economics
Optimisation of Product
Unit economics helps the startup understand whether the product it is offering is overpriced or undervalued. It answers questions such as:-
- Are the expenses incurred with regard to marketing worth every dime?
- Are there any costs that can be reduced?
- Can the product be optimised in any specific way?
Assessment of Market Sustainability
Since attention is given to detail, the future potential of the product can be very well estimated with the help of unit economics. It is particularly beneficial to the startups that make the most use of it at the early stages of business. Unit economics is what gives these startups their running start.
Forecasting profits
The focus of profitability on a per unit basis leads to a more realistic picture of the timeline necessary to achieve the said profitability. Unit economics measures cost down to their bare minimum unit, thus improving the accuracy of these forecasted profitability levels.
Example of Unit Economics
Let’s assume a startup is running a subscription-based service.
- CAC (Customer Acquisition Cost): ₹500 (marketing and sales costs to acquire one customer).
- CLTV (Customer Lifetime Value): ₹2,000 (the expected revenue per customer over the course of their subscription).
- Contribution Margin: ₹1,500 (after subtracting variable costs).
Unit Economics Analysis:
CLTV/CAC ratio:
2000500=4\frac{2000}{500} = 4This means for every ₹500 spent to acquire a customer, the startup earns ₹2,000 over the customer’s lifetime, giving a 4x return on investment.
Payback Period:
5001500=0.33 months\frac{500}{1500} = 0.33 \text{ months}The startup recoups its customer acquisition cost in less than half a month, which indicates strong profitability.
Importance of Tracking Unit Economics
Unit economics comprises two important terms, namely customer lifetime value (LTV) and customer acquisition costs(CAC). The generally accepted ratio is on a 3:1 basis where the value of acquisition obtained is at least three times. In other words, the value obtained from a customer must be at least three times the costs incurred to acquire the customer.
Another important aspect of unit economics is the payback period of the CAC. This refers to the time period that a company takes to pay back the cost of acquiring a customer. However, the shorter the payback period, the better since funds required for working capital are relatively lesser.
FAQs
What is Unit Economics?
Unit economics refers to the analysis of the profitability of a single unit of product or service a startup sells. It helps measure how much revenue and profit a company generates for each individual customer, product, or transaction. This concept is essential for startups to assess the sustainability and scalability of their business model.
What is a good unit economics ratio for startups?
A typical benchmark for a healthy unit economics ratio is:
- CLTV / CAC ratio should be at least 3:1. This means that for every $1 spent on acquiring a customer, the startup should earn $3 in revenue over the customer’s lifetime.
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