Unit Economics: Simplified
“Unit economics” are now akin to “network effects” and “escape velocity” in the world of venture capital buzzwords. But unlike some VC terms, there are real reasons behind why unit economics are now being evaluated more closely. At A-Level, it is something we always incorporate in the scalability discussion.
What are Unit Economics?
Unit economics describe the direct costs and revenues associated with each individual unit. It answers the following important question: For each $1 you spend, will it generate more than $1 in value? By showing the profit/loss of each unit, you can evaluate the strength of the business model and its ability to scale as the company matures.
What is a unit?
Well, that’s up to you. There are two main ways to classify a unit, and therefore two different ways to calculate unit economics:
“Transaction approach”: Each unit represents one “transaction” - Treating each individual transaction as the unit is also known as the contribution margin. To calculate the contribution margin, you subtract the variable costs incurred from selling the unit from the price of the unit. An example of this approach might look like:
This approach is applicable to businesses where transaction frequency is low and/or unpredictable. Calculating the contribution margin to show unit economics would work best for businesses like car dealerships, restaurants, or classic retail stores.
“Customer approach”: Each unit represents “one customer” - If you choose to treat each customer as the unit, you show unit economics as a ratio of lifetime value (LTV) to customer acquisition cost (CAC). An example of this version might look like:
This version is applicable to businesses that have recurring revenues and predictable customer lifetimes. Calculating LTV/CAC is most useful for businesses with a subscription model, such as most SaaS companies.
What do you include in the calculation?
For simple business models that use the “transaction approach”, such as a lemonade stand, the unit economics are simple: sugar, water, and lemons make up your variable costs, while the price of each cup is the selling price — subtract the two and you get gross profit. This same logic applies to most “transaction approach” companies.
Take Casper for example, an online D2C company that ships mattresses straight to your home. The variable costs associated with Casper’s are the material, labor, packaging, and delivery costs. The selling price is just the price each mattress is sold for. Again, subtract the two and you get gross profit.
However, the “customer approach” can be more complex, as there is no black and white template that tells you what to include in the calculation.
For example, let’s take Salesforce, a B2B SaaS company in which each unit is a customer (customer approach). There are many things that Salesforce spends money on that you might not include in your unit economics analysis at first glance.
For CAC:
- In 2016, Salesforce spent tons of marketing dollars on placing billboards on highways in San Francisco, increasing their brand recognition and possibly driving website traffic.
- The team has also attended many trade shows, racking up travel and wage expenses.
- Salesforce spends money on developing and distributing free trials.
For LTV:
- Salesforce has a robust customer service arm of roughly 3,500 people that are paid thousands each year.
- Salesforce also offers refunds to unsatisfied customers each year.
Garbage In, Garbage Out
The more comprehensive you are with what goes into the calculations, the better. If you neglect key costs associated with the business model and make unfounded predictions of its scalability, the unit economics analysis is useless, as it won’t paint an accurate picture of profitability.
How do unit economics change over time?
As an investor, it can be easy to hope for the best and assume the unit economics will improve as time goes on, but this is often a foolish assumption to make. The cost/revenue structure is destined to change as the business matures, and this should be reflected in the unit economics.
Let’s go back to our Salesforce example. Investors had to think about how unit economics will change over time.
For CAC:
- The costs to acquire customers should decrease as the company refines its target customer.
- However, depending on how much of the initial target market had been penetrated, marketing costs might increase.
- Many of the first sales were undoubtedly made to companies within the network of the Salesforce team — marketing costs might increase as the leads become colder.
- As Salesforce got larger, more companies might use the “free trial” but not choose to purchase the full product.
For LTV:
- The software model means that the increase in demand does not require an equal increase in production costs, so development costs should decrease as a percentage of revenue.
- Once the product becomes more mature, a lower percentage of costs should be spent on pure product development.
- As more unique companies use Salesforce, a more complex backend will be necessary, increasing engineering costs.
There are many micro and macroeconomic trends to consider when forecasting the future of a company’s unit economics. It is important to take all of them into account to paint a better picture of the company’s cost structure moving forward.
Why are unit economics important?
Investors should use unit economics when analyzing companies as it allows us to see a more clear forecast of a company’s future. However, when done properly, a unit economics analysis will not only paint a picture of potential profitability, but expose weak points in a business model.
