INTRODUCTION TO UNIT ECONOMICS
Sometime last month, I tweeted above tweet and was subsequently asked by one of my twitter friends, 'Seyi., who is a founder based out of Ibadan here in Nigeria, to do a tweet-storm on the subject. I took on the challenge by first sharing some links with him with which to get familiar with the subject. (You will find these links at the foot of this blog post.) Earlier this morning, I got over the laziness of doing the tweet-storm and went a-tweeting. Seyi was then kind enough to aggregate the tweets into a word document sent to me to share with other founders in the ecosystem that may not yet have a firm grasp of the subject of Unit Economics for Startups and who may not have had the opportunity of following my tweet stream on the subject. Consequently, Seyi deserves most of the credit for this blog post.
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The Unit Economics of a product or service is the sum total of revenues and costs tied to selling and delivering one unit of the product or service. Each word in that definition is a key word and cannot be taken out without changing the definition. So I will first spend time explaining what each of these key words mean.
“Sum total” means “all inclusive,” “you can’t leave any relevant one out,” “all must be factored in;” “revenues” mean “what actually accrues to you in cash terms,” “what comes into your (own) pocket” and “not that which passes through it.”
Consequently, in the real sense of it, “revenues” in that definition means net-net revenues; that is, the actual cash that accrues or comes to you from customers’ payments from instances of buying the product or service. It excludes any portion of the payments accruing to partners, suppliers, manufacturers and any other third party outside of your startup that has an input into the production of your product or service. According to Generally Accepted Accounting Principles (GAAP) reporting standards, this will be what is reported as Gross Profits in your Profit & Loss statements.
In order to bring the meaning of the above home, I will use specific examples of common types of startups we have in Nigeria. If you are an ecommerce player selling own goods, it excludes your costs of goods sold, commissions given to affiliate sites, discounts given to customers, etc. If you are an ecommerce startup selling products using marketplace model, it only— repeat, ONLY! — includes the rake or commission you charge merchants or sellers to use your platform to sell their products — but it also excludes any commission you pay affiliate sites, discounts you give to customers coming to your site, etc. If you are a service-providing ecommerce player like Uber or Hotels.ng, for example, it is what you charge the drivers or hoteliers for using your platform to offer rides or their hotels to stay in — not what the Uber customers pay the Uber drivers when booking the Uber rides or what the hotel guests pay you or the hotel, as the case may be, for the periods they intend to stay in an hotel.
Having clarified the revenue side of equation, every other thing left to explain has to do with the costs side of things. The keyword here is “TIED TO,” and includes ALL costs in your P&L that are described as direct costs of serving customers, typically variable in nature and typically includes all of the cost heads in your P&L except the fixed costs. Therefore, it includes any cost that must necessarily and/or usually be borne in order to sell ( i.e. market, advertise, win new customers, retain existing customers, secure potential customers, win back lost customers, etc) and deliver (i.e. service customers, get product to customers, make customers happy with and/or help him/her consume, etc) your product or service.
What this implies is that even some costs that are traditionally defined under GAAP as fixed costs need to be allocated into your unit economics. For example, if you’re a LAAS (logistics as a service) provider or an ecommerce startup, the portion of salaries paid to staff responsible for picking, packing, routing and/or delivering items to your customers are included in your unit costs because they are a direct input into your servicing the customer; without their input, you won’t be able to serve your customers or deliver items to their doorsteps, which is exactly the job they hired your service to do for them. If you are a booking service and your business model includes any number of your staff that call or follow-up with customers after they have made a booking online, in order to serve them and/or complete their booking transactions, then their salaries are included in your unit economics. Consequently, same logic applies to the salaries of any number of staff of an ecommerce player that call customers to confirm Cash on Delivery (CoD) orders, which is very common with most ecommerce startups in Nigeria. (My startup, Gloo.ng, avoids this. We use software to accomplish this, removing the need for us to manually do the same.)
Furthermore, the costs accounted for include the depreciation and amortisation costs of all the assets that you directly use to service customers or deliver the product to them. In the case of a LAAS provider and ecommerce startup, that will include the depreciation and amortisation costs of your delivery bikes and delivery vehicles used to deliver items to your customers. (Of course, it already includes all the costs involved with fuelling, repairing and maintaining the said bikes and vehicles.)
Finally, what is left after you have subtracted all these costs I have explained from the net-net revenues as I have earlier described is what translates to your unit economics (PC 3 in the above example diagram). The soundness of your business model is a function of what percentage this portion that is left after deducting all the costs described above (PC3) constitutes out of your net-net revenues, as I have earlier described. It is the unit of value (as earlier described in the foregoing) which you capture internally into your organisation for every unit of net-net revenue that you create (as earlier described above).
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