Contribution Margin

Most funds, experts, mentors and coaches of all sorts declare the importance of the Unit economics convergence. But not so many people can explain what these formulas are needed for and why should we use them.

To begin with let’s have a look at the Unit economics math. I’ve written enough on the subject and you can easily read up all the necessary materials (Russian). We’ll start with the basic formula that was created by Ilya Krasinsky and then disseminated by his followers and copycats.

Revenue = UA x (ARPPU x C1 — CPA)

I give you the original version of the formula for a good reason. But I don’t like the term “Revenue” that is used here. “Revenue” means sales value while Krasinsky’s formula and all the Unit economics are about how much money we make from sales to Users without including the fixed costs. So it would be more correct to use the term Contribution Margin. Contribution Margin shows our revenue from one sale without including the fixed costs.

The key concepts here are the neglect of the fixed costs, User and User acquisition. In this article I would like to take a closer look at the first one.

Why are we not interested in including the fixed costs? What are the fixed costs? To answer these questions let’s consider two types of business: project-oriented business and product-oriented business. In fact, the main difference between them is that in one case expenses increase in proportion to the revenue and in the other case they don’t, like on the picture below.

As you see, in the second case the revenue increases exponentially and the expenses continue to increase linearly. Such enterprises let their owners make more money in a shorter period of time. In fact, most IT start-ups belong to the second type.

So why is it so important to determine the Contribution Margin and not the profit that would make sense as well? The thing is the Contribution Margin is not a metric used for financial accounting. In Unit economics the Contribution Margin indicates whether your business is alive or it has already started to die. Let’s have a look at the typical business development scheme.

In this picture we see the financial development of our business. At first we have the upfront investment that we spent on business development. Then we get first investment from angel investor and drop down under zero point. At this moment we make no money. But then after some time we start to make money and money inflow starts to grow. Then we leave the death valley behind, pass the breakeven point and start to grow quickly.

In the picture you can also see two vectors: one going up, the other going down. These are CM — Contribution Margin — vectors. This value shows us whether we are able to pass the breakeven point and start making money — or not. If CM value is negative, all our actions will lead only to losses. If CM value is positive we’ll probably pass the breakeven point and our business will become profitable.

So CM negative or positive sign shows us the direction of money inflow vector and CM value shows how fast (or slow) the money inflow changes. Contribution Margin demonstrates us and investors what is happening to our business without considering the fixed costs. With the help of Contribution Margin we can estimate our decisions: if our actions make CM value positive we are going the right way and if they don’t we’d better think twice.

So the correct formula for Unit economics convergence determination is

CM = UA x (ARPPU x C1 — CPA)

One more time: we need this value to estimate the consequences of our decisions and our business sustainability but not its financial condition.