How simple product economics can bring a real value for business

Any digital product that sells something, whether it is an e-commerce website or subscription-based e-learning platform or an online grocery store, exists within some economics model. Ignoring the economics metrics increases risks such as investing in inefficient ad channels and funding useless product features or blindly communicating with your customers. In this article, we will review the fundamental product economics principles and try to figure out why it’s so important for business.

The economics model can make a profit on the very first sale or it can demand hard work with users before the users become profitable for the business.

There are not so many product business metrics and they are all calculated at the level of grade school math. However, there is great business value behind their simplicity.

CPA — cost per action

Each user from different marketing and sales channels falls into your product funnel. Every channel requires a specific budget. Users complete a certain quantity of macro and micro-actions and it is important to evaluate how much the completion of each funnel step costs you. CPA allows you to calculate how much you are paying for a certain user action.

For example, we brought in 10,000 users from an AdWords campaign and only 1,000 of them added an item to their shopping cart. The given advertisement campaign cost us $500.

CPA = $500/1,000 = $0.5

Every time someone puts an item into their shopping cart we spend $0.5.

However, it would be more valuable to know how much a successful order checkout costs us (I want to make a note that in some cases an order checkout does not signify an order that has been paid)

Out of 1,000 users that added an item into their cart, only 500 successfully completed checkout.

CPA2 = $500/500 = $1

Remember this value because we will need it later.

CAC — Customer Acquisition Cost

Let’s examine the funnel further. It is very important to understand how many users paid for their order. We know that 500 users completed checkout, but only 120 of them have paid for their order.

CAC = $500/120 = $4.17

Note how much our CPA differs from our CAC. Nevertheless, we still can’t say whether these numbers are good or bad for the business. It is obvious that we are missing some variable in this formula.

ARPPU — Average Revenue Per Paying User

This is an average value of how much money we get from a user who made a purchase. Let’s imagine that the revenue from 120 successful purchases is $1500. The average bill is $12.5. On average, therefore, the order service cost is $5. Now we can calculate our ARPPU.

ARPPU = (1500/120) - 5 = $7.5

Now everything becomes more interesting.

On average the profit from one order is $7.5 — $4.17 = $3.33 We are definitely making a profit on the first purchase and that’s a good news. Additionally, we see that there is a big gap between completed checkouts and paid orders, which indicates a clear opportunity for business growth. Also, we have to take into account the fact that customers can make repeatable purchases.

LTV — lifetime value

Imagine that on average one user makes 1.5 purchases during their entire life cycle.

LTV = (($1500/120) - 5)*1,5 = $11.25

In the classic formula of product economics, LTV should be 3 times higher than CAC, but you must take into account that every business is different and you need to set this ratio based on the product specifics.

In this article, we investigated the most basic ways of calculating metrics without using predictive models or mathematical statistics. For example, using general linear models, we can predict what the LTV most likely will be in 6 months. We will talk about this in more detail in the future articles, but for now, keep an eye on the economics of your product, eventually, it is the foundation of your business.

Originally published at awsmd.com.

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