How to calculate unit economics?

Probably you’ve heard stories, when the idea which looks stupid and should never work, turns into a multimillion business. And there are even more stories when the perfect innovative idea with a brilliant team failed and burn a huge amount of money into production and promo. This shows that product-market fit often can be found by trying, not by analyzing or building logical assumptions.

This idea is not new, however, majority of startups, even if they have clients or users, still don’t include metrics in their pitch deck. And metrics is the main argument that can support all the statements on other slides. At best, startups mention the clients they have, the revenue they generate, and the speed with which they are growing. And those are some kind of metrics. But they don’t give the answer to the question is the business model of this startup has a potential. Because startup can grow and generate revenue due to the huge marketing and sales budget. It can get 1$ of revenue because it spends 5$ for promotion. It’s obvious that such a model is not sustainable and will collapse as soon as its marketing budget will be empty.

And the problem is not just in the fact that founders of the startup don’t show this information to investors. The bigger problem is that founders themselves often don’t see that their model is bad and continue funding unprofitable business because they see sales are growing.

A simple but powerful tool to understand whether your model works is the concept of unit economics. It states that you should make sure, the revenue you are getting from the average customer is higher than the average cost of acquiring him. Seems obvious, but when you have few products when some customers return and some not, when you have various promotion campaigns, it may be difficult to realize how you are doing. That’s why some startups invest more in marketing, get more sales, and repeat that again and again, until after some time, it gets obvious that customers bring less money than the company spends to acquire them. And that may be discovered much earlier if the startup constantly measures key metrics and unit economics in particular.

How to calculate unit economics?

Unit economics ratio is calculated by comparing lifetime value (LTV) with customer acquisition cost (CAC).

Lifetime value shows how much on average you earn from one customer. It may be calculated in various ways depending on the type of business. In a simplified example, lets assume the company with SaaS model offers one pricing option of $20 per month, and the average customer lifetime is 12 months. In this situation lifetime value (LTV) = $20*12=$240

Customer acquisition cost (CAC) shows how much the company spends on getting one customer. In the same simplified example, we can assume that the same SaaS company during a specific period spent $1000 on pay-per-click advertising, $3000 on the print advertisement, and $6000 on sales representative. Thanks to that campaign the company got 100 new paying customers. In this case, customer acquisition cost (CAC) will be ($1000+$3000+$6000)/100=$100. So, the acquisition of one new paying customer cost 100$.

The unit economics ratio will be LTV/CAC = $240/$100=2.4

That means that for every $1 the company spends on promotion, it gets $2.4 revenue from the new customers. That is not bad, however always there is a space for improvement. You can improve unit economics by changing factors that are influencing it. You may decrease CAC using new marketing tools, viral effect, freemium, free trial, partnerships, etc. While you may increase LTV through repeated sales, product line expansion etc.

Unit economics calculation is highly popular for SaaS model, where customers are paying for the subscription. It is an effective tool for such companies because in this model the fact of the purchase of the subscription doesn’t guarantee that it will be paid for a longer time. However, unit economics may be used in each business where you invest in marketing and sales activities, doesn’t matter if its an online business or offline one. So you may have a mobile app, barbershop, software development company, or a small restaurant, and in each of those businesses, unit economics calculation will help you to better understand your business.

Author: Bogdan Zhukevych