“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 improve its performance.
In broader terms,
Unit economics relates to the “base unit of activity” of a given business and its profitability.
Now academic definitions aside...
What do we mean by “base unit”?
The base unit is the smallest individual item that creates value and can help you understand the business as a whole.
Hence, the nature of a base unit will vary depending on the industry and product your company offers.
- For a retail business with multiple locations, the smallest economic unit is typically a single store.
- For an ocean freight business operating a fleet of ships, the base unit would be a single ship.
- For an ecommerce company, the smallest unit would be an individual purchase.
- For an Internet Provider, the base unit is typically a household or a user.
Selecting the most relevant base unit is often contingent upon your discretion. Every company has its own peculiarities, and the choice of the base unit will need to fit the business model and take your needs into consideration.
In our case - SaaS businesses - the base unit is typically a subscription.
Calculating your cost and profitability metrics around the economic value of a single subscription can help you evaluate your businesses’ efficiency and, most importantly answer essential questions such as:
- How much does it cost me to generate a subscription?
- How long before I can recoup my investment into generating 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 I am 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 and/or Retention Rate
- Associated Variable Costs per subscription
So now that we understand what Unit Economics represents and why it is essential, we can discuss the second most critical component - 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?).
Calculating your Unit Economics will depend on your choice of the base unit. So, depending on your business model, you may count the base unit as a single customer or as a single item sold.
A single customer can be a corporate client that would purchase a laundry list of items for its operations. Accounting for the unit economics of a single client 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 mentioned earlier, SaaS businesses typically calculate their Unit Economics on the basis of single 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. (You can refer to the table below for a visual aid).
Unit Economics Calculation Model
Let’s start by considering the first scenario, whereby the unit economics are calculated on a per customer basis.
In this case, you need to have on hand two (2) important metrics or KPIs (Key Performance Indicators).
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 Costs, which is the amount of money expended by your business to generate sales. Typically these include all costs associated with sales and marketing.
Calculating the LTV to CAC ratio will help you to determine if you are extracting an adequate measure of value from a customer for the amount of money expended to attract this said customer.
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 is below that, that would mean that you are spending too much money relatively to acquire new customers. Or that you are not making enough money from these customers to justify these costs.
Maybe it is time to review your pricing policy. Or maybe your marketing is not as efficient for the dollar figure you have allocated to it.
As for the CAC payback period, that essentially measures how much time it usually takes you to make back the money that you have expended on acquiring a new customer. Typically it is measured in months and is calculated on the basis of your gross margin and average revenue per account.
This figure is very helpful because knowing how soon you are able to recoup your investment in sales and marketing will let you know if you are on the path to profitability or not. It makes a huge difference in your cash flow management.
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. Essentially what is the portion of your revenues that will contribute to covering your fixed expenses and your bottom line profits.
The Contribution margin is calculated as:
Contribution Margin = (Price per Unit - Variable Costs per Unit Sold)
For example, if each new subscription is priced at $50 a month, and the variable costs driving each subscription are at $20 a month. The contribution margin would be $30 for that month, and the ratio would be 60%. Simple.
All in all, Unit Economics are simply the evaluation of financial performance measures associated with a single economic unit of value. Getting your Unit Economics right is critical for a startup or any other business for that matter. If you care about profitability.
If it costs you too much to produce and sell one unit of value or on the other hand you are unable to extract enough wealth from that unit, then you can be certain that your business is resting on shaky grounds.
Unit economics and other financial metrics are critical to understanding your company’s standing. Just like a gas meter can tell you how much gas you have left (and logically infer how long you can keep going), financial metrics help you do the same for your business.
That is why in this increasingly complex business world, companies - and especially technology driven ones - require equally sophisticated financial evaluation tools. The tools and their accompanying expertise can help you make sense of the information at hand and make the right decisions.
Saas Financial Model Template to help you calculate your Unit Economics
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