Owning the Unit Economics

As I survey the various new products/services available to consumers, it seems like pricing is determined by the way the wind blows and less by business logic. At a time where it seems like the capital cycle might be tightening, there’s even more of a need to understand and own the unit economics of a product.

To make sure we’re on the same footing, unit economics are the simple revenues and expenses associated with serving a single unit, or one customer. I believe that the best product people understand and take accountability for the unit economics of their product. After all, they know what it takes to keep the product going to the standards they set — it goes far beyond developers or customer support.

Pricing Dynamics

Broadly speaking, prices in most businesses are dictated by two things: the market and the value the business places on the product. A healthy business will take both into account when determining product pricing.

With the rise of on-demand, sharing, insert-your-buzz-word-here businesses, pricing seems to be overwhelmingly dictated by playing to the market. Prices are kept low, often times yielding negative gross margins to gain market share in hopes that one day “the switch” to greater margins can be flipped. Spoiler alert: that’s easier said than done. It’s quite hard to retake control once it’s been ceded. This is what a negative margin pricing strategy effectively does. If customers are sticking around simply because a business is maintaining the lowest prices vs peers, it’s likely not an attractive market to be in — you very well might be providing a commodity. If you can’t sell it at a reasonable cost to at least break even (but hopefully make a reasonable profit), you likely don’t have proof of utility.

The value a business places on the product is ultimately driven by the costs associated with it. Rationally, it doesn’t make sense to spend time and money on a product when the prospects of recouping that investment are slim (granted there are exceptions based on business model). Another way to frame this, why offer something where you’ll lose money on? A business creating value should charge for it in a manner that allows for meaningful margin. That margin is the net value the product has created and in-turn, a business can capture.

Anything that won’t sell, I don’t want to invent. Its sale is proof of utility, and utility is success.
Thomas Edison

Working Backwards

To get an idea of how to approximate a reasonable price, I tend to work backwards from the knowns, the costs. Understand that this is an art as much as a science and a tool in the price-setting tool belt. I look at the costs on a per customer or per user and then estimate some reasonable margin I would like to earn above that. For some expenses, to estimate a unit basis, assume some baseline of units sold — you can always sensitize around this to show the impact of fixed and variable expense. Some costs to include, granted this isn’t all encompassing and is different in each situation.

  • Development and Design
  • Infrastructure
  • Cost of Acquisition
  • Support and Customer Success
  • Warranties/Guarantees

It’s important to make sure that salaries are accounted for, appropriately.

Now that there’s a baseline of costs, per unit, take it all in. Now it’s time to do some research and see where the market’s pricing similar offerings (beware of tiered pricing!). What does this pricing imply about the margin profile of the product at hand? Is there room to bring it down, should it be kept steady or increased because it’s superior? See how sensitive margins are. Get a comfortable range of prices. Comfort is dictated by strategy and management — you’ve already accounted for the market!

Take the range of pricing and test it speaking with more serious customers and if possible, through A/B testing. If the product is as valuable as you believe it to be, the pricing should show itself through this process.

So what if pricing doesn’t hold up? Then it’s time to seriously rethink strategy and move quickly to change course. Was customer development properly conducted? If it was, this should have been caught early on — pricing is not when a team should realize they’ve been working on the wrong thing (see: The Lean Startup). Is pricing still too high? Is the product itself “broken” (buggy, not solving the problem it states it will, et al)? Is spending outsized relative to the value being built? Note that it’s hard to determine if pricing is too low, so start high when sounding out ideas.

It’s important to have a clear understanding and ownership of the unit economics of a product. Ultimately, strong unit economics will prevail through cycles — weak ones won’t.