“Unit Economics”...sounds like the usual jargon of economists. Pretentious and oft removed from the pragmatic daily struggles of entrepreneurs and their teams.
But that is not the case . . . Understanding Unit Economics is critical to understanding the operations and profitability of a business and therefore incorporating the changes required to "Unit Economics"…sounds like a term you can easily find in every how-to-be an-entrepreneur textbook.
From the realistic daily problems faced by business owners and their teams, unit economics shows a simple yet effective tool that can help you better understand the foundation of your financial success.
Whether you're the CFO of a powerful company or a new businessperson trying to jump into the startup world, understanding Unit Economics is critical to understanding the operations and profitability of a business through incorporating the changes required to improve its performance.
What is Unit Economics?
Let's say you are launching a new rideshare app. A customer orders through the app generates direct income for the business.
But of course, the app doesn't automatically receive the actual payment of each customer as the app still needs to share a few percentages with the driver and other marketing expenses that comes within it.
Unit economics is an effective approach that can help you better understand your business's success from its early stages by revealing the relationship between the profit and costs of a company's business model.
In broader terms,
Unit economics relates to a business's "base unit of activity" and profitability.
The Importance of Unit Economics
The data produced by unit economics analysis is crucial to your company's short-term and long-term financial planning.
Utilizing data-driven decisions is key to ensuring that you know to comprehend the overall health and profitability of your business as you navigate the market.
Using unit economics, you can ensure that your business is being led towards the right path and that all aspects of your SaaS generate revenue and expand.
The understanding of unit economics helps companies:
· Learn its business processes
· Forecast profits
· Optimize product strategies
· Evaluate the product's demand and potential
· Assess the market
You are one step away from achieving business success from learning how to use Unit Economics.
What do we mean by "base unit"?
Before learning how to calculate using Unit Economics, it is essential to determine your base unit.
The base unit is the smallest component that adds value and can help reveal how profitable a business is or how soon it will achieve profitability.
As a result, the type of a base unit will differ based on the sector and goods your business supplies.
- The smallest economic unit for a retail company with many locations is often a single store.
- A single ship would serve as the base unit for an ocean freight company that operates a fleet of ships.
- The smallest unit for an online retailer would be a single purchase.
- The base unit for an Internet provider is typically a household or a user.
Selecting the most relevant base unit is often up to you to decide which foundation unit is the most pertinent. Every company has its quirks, and the choice of the base unit will need to fit the company's needs or standards as well as its business model.
In our case - SaaS businesses - the base unit is typically a subscription. Therefore, the calculation refers to how much profit and loss is generated from a single customer.
Calculating your cost and profitability metrics around the economic value of a single subscription can help you assess your business's efficiency and, most importantly, answer essential questions such as:
- How much does it cost me to generate a subscription?
- How long will it take for me to recover the money I spent on getting a sale?
- How much value can I extract from a typical customer or subscription?
- Are my overheads optimal?
- Am I wasting money?
- Am I making any money?
You can see where this is going.
Unit Economics is a great tool to measure your profitability. It can also help you understand your financial drivers.
For a SaaS business, your revenue and cost drivers are usually the:
- Price of the subscription
- Number of customers
- Transaction size
- Customer Acquisition Costs (CAC)
- Lifetime Value (LTV)
- Churn Rate or Retention Rate
- Associated Variable Costs per subscription
Since we have a better understanding of what Unit Economics means and why it is so important, we can now address the second most important factor, how to calculate your unit economics.
How to Calculate Your Unit Economics?
First of all, you need to understand your inflows and outflows (revenues and costs). Breaking them down and evaluating their impacts is critical (isn't that what excel spreadsheets and CFOs are made for?).
When choosing your base unit, it is crucial to understand your business model.
You may count the base unit as a single customer or item sold.
A single customer may be a business that would buy a long list of things for its operations. Accounting for the unit economics of a single customer makes more sense in this case than counting each item separately.
However, that is not typically the case for SaaS companies. Unless, of course, the usual single customer habitually purchases multiple individual subscriptions for its employees.
As previously indicated, SaaS companies often base their Unit Economics calculations on the number of individual subscriptions sold. Just in case, though, we will explore both scenarios and will leave it up to you to figure out what works best for your specific case.
Unit Economics Calculation Model
Calculate Unit Economics per Customer Sold
Let's start by considering the first situation, in which the unit economics are computed per customer.
You must have two (2) key performance indicators (KPIs) on hand in this situation.
That would be your:
- Customer Lifetime Value, which is the average total value extracted from a customer over the length of your relationship.
- Customer Acquisition Cost is the amount of money expended by your business to generate sales. Typically, these include all costs associated with sales and marketing.
Both of these are direct revenues and costs that are associated with the calculation of Unit Economics.
Customer Lifetime value
These typically cover all expenses related to sales and marketing. You can crunch these numbers by getting an acceptable level of value from a customer for the money spent to acquire them by calculating the LTV to CAC ratio.
LTV refers to an understanding of whether you make a profit or lose money on a particular user. Different companies may calculate LTV in different ways.
There are 2 factors that determine your LTV:
- Variable costs are costs that change depending on how much you generate. When more product units are produced, the value of the cost becomes higher. This can include the cost of raw materials and equipment, packaging, shipping, labor wages, and marketing expenses.
- Fixed costs are costs that don't change depending on how much you generate. This is because this factor does not associate itself with manufacturing and only focuses on indirect expenses such as lease, rent, insurance, fixed salaries, office supplies, utilities, and payroll taxes.
The key when calculating LTV is to understand which costs are fixed and variable.
If you sell a subscription to a customer, the cost of creating the value of the subscription from advertising and essential equipment for creating a platform for customers to find the subscription is what counts as Variable costs.
While on the other hand, the salary of the developer is what counts as Fixed-costs.
There are 2 methods when calculating LTV:
By using Predictive LTV, you can predict your customers' future behavior by using their past purchasing behavior. If there were such a thing as a business crystal ball, it would be like owning one.
Predictive LTV uses your own business data to build a realistic picture based on statistics, rather than only making educated guesses about what a customer would do.
Predictive LTV is calculated as follows:
Predictive Customer Lifetime Value = Average Monthly Transactions (T) x Average Order Value (AOV) x Average Lifetime of a Customer (ALT) x Average Gross Margin (AGM)
Let's take the scenario where your shop sells and delivers pastries. Your customers make an average of 20 transactions each month, and each paying customer stays with your brand for an average of 6 months, according to your previous sales statistics. The average order value at your business is $10, and the average gross margin is 66%.
By multiplying all of the available data and entering it into the calculation, you can determine your Average Customer Lifetime Value, which gives you a total of $792.
Not so hard, is it?
Again, your customer lifetime value may occasionally shift and become noticeably greater or lower depending on your typical transactions, gross margins, customer churn rate, etc.
This method is predictive so that it can alter at any given time, but it still offers a strong framework for you to use when making other financial choices determining your long-term customer value.
A method called Flexible LTV uses discount and retention rates to produce more accurate results at certain times, particularly when a product is being promoted.
Flexible LTV, in contrast to Predictive LTV, has been shown to be valuable for startups or businesses that are just getting started since it helps account for potential changes in revenue as they are expected to undergo changes of expansion and development.
Flexible LTV is calculated as follows:
Flexible Customer Lifetime Value = Average Gross Margin per customer lifespan (GML) x (Retention Rate / (1+Discount Rate (D) – Retention Rate))
Previously we found our Predictive LTV to be $780. Now, to find your Flexible LTV, you need to first find your Average Gross Margin per customer lifespan and Retention Rate.
Through compiling the data from last month, you found that you have served 800 Customers during that month and had spent $6000 on sales, and generated $18,000 in total income.
Prior to calculating the Average Gross Margin per customer lifetime, you must first calculate the Gross Margin for each month. To do this, you can insert the data into the following formula:
Gross Margin (GM) = (Total Revenue (T) – Cost of Sales (CS) / Total Revenue (TR)) x 100
If your cost of sales is $6,000, then you need to deduct it from your total revenue of $18,000, obtaining a gross margin of 66 percent.
Now we can enter what your Average Gross Margin per customer lifespan is:
Average Gross Margin per customer lifespan (GML) = Gross Margin (GM) x Total Revenue (TR) / Number of Customers for the period (Cb)
We can multiply our Gross Margin of 66 percent by our total revenue of $18,000 and divide it by the number of customers served over the given month, which comes to $14.85. As we have already computed our Gross Margin, we can now go to the final step.
Cb and Ce are the numbers of customers that made further purchases or extended their subscriptions at the start and end of the period. In contrast, Cn is a time frame that saw the acquisition of how many new consumers.
Using the following formula, finding the Retention Rate can be done by calculating using how many new and loss of customers from your business:
Retention Rate = (Number of Loyal Customers (Ce) – Number of New Customers (Cn) / Number of Customers for the period (Cb)) x 100
Assume that at the beginning of the month, you had 800 clients, but towards the end, you had just 400. This means that throughout that month, you acquired 200 new clients. This information will yield a Retention Rate of 25% when we enter it into the calculation above.
After compiling all of the information, we can add the aforementioned numbers to determine the Flexible LTV, which comes to a whopping $17.67.
Experts suggest an ideal ratio of 3-to-1, meaning that you are making three times the amount of money that you have spent on getting that customer. Sounds fair.
So, in case your figure for getting one single customer is below that, that would mean that you are spending too much money relative to acquire new customers. Or that the revenue from these customers is insufficient to cover the sales expenses.
Consider reviewing your pricing strategy. Or maybe your marketing is not as efficient for the dollar figure you have allocated to it.
Increasing customer lifetime value
You can increase the number of your Customer Lifetime Value by doing these five steps:
- Launch a Customer Loyalty Program
Taking better care of your current customers is one of the best things you can do to raise your Customer Lifetime Value.
Your primary priority should be to keep them satisfied and to continue meeting their demands. Your customers will stay with you longer and spend more money with your brand if you give them trust and comfort.
- Create a Better Onboarding Experience
Another way to increase your Customer Lifetime Value is to remodel and improve your onboarding process and introduce a rewards program.
An outstanding onboarding experience gives customers the confidence to buy from your company. Your new customers are far more likely to remain around over the long run when this sort of first impression starts off your connection.
Offer them a discount on their subsequent purchase if they recommend your brand to others. This will encourage them to share positive thoughts with their friends and family.
- Offer Related Upsells at Checkout
You can suggest great pairings within your brand to your customers.
This will not only help your customers spend more money per purchase, but it may also help you satisfy more of your customers' needs. Quick tip, use the occasion to introduce them to something they would not have otherwise discovered but that you know they will like.
- Capture and Act on Customer Feedback
As was already noted, keeping customers happy is a major concern. One method to ensure you're doing that is to get their feedback and make sure you're truly applying what they say.
Even if getting feedback might be a little more difficult, the work will be worthwhile because you'll be able to give your consumers better service.
Implementing customer input can keep them on board and enable you to remain competitive, whether it's releasing new items, updating functionality, or correcting typical problems that irritate people.
- Improve Customer Service
If customers can't get in touch with or interact with your customer support personnel, they won't remain around.
Poor customer service isn't only inconvenient and casts a shadow over the rest of your brand's reputation. Customers who have previously been satisfied can leave after just one negative encounter.
Take a deeper look at your customer care teams to ensure they have everything they need to assist, collect, and act on customer feedback.
After finalizing these steps, you will see an improvement in your customers' loyalty and number in no time.
Customer acquisition cost
The CAC payback period, on the other hand, effectively gauges how long it typically takes you to recoup the money you spent on acquiring a new customer. It is generally computed using your gross margin and average revenue per account and expressed in months.
The Cost of Acquisition is calculated as follows:
Cost of acquisition = (Sales and Marketing Costs / Number of Acquired Customers)
By dividing the overall cost of sales and plugging in the 800 clients you obtained, we can utilize the previously gathered data to calculate the cost of acquiring each new customer to be at $7.5.
This number is highly useful since it will tell you if you are headed for profitability or not based on how quickly your investment in sales and marketing may be recouped. It has a significant impact on how you manage your financial flow.
Improving customer acquisition cost
You can follow a few simple actions to improve your acquisition cost, which will help your company leverage even more:
· Enhance On-Site Conversion Metrics
Setting up goals in Google Analytics and experimenting with various checkout methods may help decrease the shopping cart abandonment rate and enhance the landing page's functionality, site speed, mobile optimization, and other site components.
· Enhance User Value
The capacity to produce something that users will find appealing is what we mean by the highly conceptual idea of "user value." Customers may have desired more feature additions or quality in this regard. It could involve executing a change to the current product for better placement or creating fresh revenue streams from existing clients.
· Implement Customer Relationship Management (CRM)
Nearly all profitable businesses with loyal customers use CRM in some capacity. This sophisticated sales staff might use automated email lists, blogs, loyalty programs, or other methods to measure client loyalty.
Now onto the other scenario, whereby the unit economics are calculated on a per item sold basis.
In this instance, we can compute our Unit Economics based on the Contribution Margin.
The contribution margin evaluates your revenue to variable costs relationship, which is a measure of the revenue amount from one sale less the variable costs related to that sale.
In essence, what percentage of your income will go toward paying your fixed costs and generating a profit?
The Contribution margin is calculated as follows:
Contribution margin = (Price per Unit - Variable Costs per Unit Sold)
Contribution Margin Ratio = Contribution Margin Revenue
For instance, let's say that the variable expenses that support each new member are $20 per month, and each subscription costs $50 per month. The ratio would be 60%, and the contribution margin for that month would be $30. Simple.
There are also many ways to increase your contribution margin by simply following these tips:
- Reducing your cost of goods sold
- Reducing your labor cost
- Optimizing your prices for the maximum profit supported by your market niche
As these inputs improve, your contribution will increase accordingly.
Examining financial performance indicators linked to a single economic unit of value is the sum of all unit economics. It's crucial to get your unit economics correct for a startup or any other kind of firm, for that matter.
Suppose profitability is important to you. If it costs you too much to produce and sell one unit of value, or perhaps you cannot profit sufficiently from that unit. You may need to step up your strategies as these signs indicate that your business is at risk.
Understanding unit economics and other financial measures are essential to knowing how your business is doing. Financial metrics enable you to do the same for your firm in the same way that a gas meter can tell you how much gas is left in your tank (and therefore infer how long you can continue to go).
As a result, businesses, especially those that are technology-driven, need to use similarly sophisticated financial evaluation techniques in an increasingly complicated business environment. You can understand the facts at hand and make the best judgments with the aid of the tools and the experience that goes along with them.
Saas Financial Model Template to help you calculate your Unit Economics
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