Unit economics are some of the most important factors to consider when it comes to evaluating the viability of a business model. If you have strong unit economics, it means that you’re making a healthy profit on the products you’re selling with your current customer acquisition costs and churn rate. To calculate unit economics, you essentially need to compare the costs your business incurs per unit of product or per customer with the revenue it generates. While you can carry out unit economics analysis for each user, transaction, product, etc., it is most common to apply it to a single customer.
The Basics of Unit Economics Analysis
When conducting a unit economics analysis, you need to calculate three main parameters:
- Customer lifetime value (CLV)
- Customer acquisition costs (CAC)
- Payback period
Here are the formulas you can use to calculate each of these:
Customer Lifetime Value = Revenue per Customer per Month * Customer Lifetime in Months * Contribution Margin
Customer Acquisition Costs = (Sales Costs per Month + Marketing Costs per Month)/Number of New Customers Acquired per Month
Payback Period = Customer Acquisition Costs /(Contribution Margin * Revenue per Customer per Month)
The Key to Achieving Strong Unit Economics
Having strong unit economics is essential, and the only way to ensure that you achieve this goal is to generate product-market and product-channel fit. If you have a product-market fit, it means that your product solves a real problem for your customers, and they are willing to pay a premium for your products or services. Additionally, a product-channel fit ensures that you sell your products through a channel that allows you to acquire customers at a relatively low cost.
If you want to improve the unit economics situation in your business, you need to deconstruct your numbers and look at each of the parameters separately. Figuring out how you can make even small improvements to each parameter can help you get much closer to having an economically viable product.
So, what can you do to make your unit economics stronger? Let’s look at each parameter separately:
Customer Lifetime Value
The lifetime value of a customer can be increased, for example, by boosting the revenue an average customer brings in every month. This can be done by increasing the frequency with which the customer purchases your products or services each month, the average amount of money the customer pays during each transaction, or both. Ideally, you should be selling your product at or near the maximum price your customers are willing to pay. You can also go even further and try to determine why customers don’t purchase your products more often or aren’t willing to pay more money for them. By remedying those issues you can further increase the value of your product to your customers. However, it’s worth noting that while many business owners are often reluctant about increasing the prices of their products, price increases generally work very well and allow you to bring in more revenue without losing many clients. Of course, this only happens if your product has a significant competitive advantage over other similar offers. It’s also a good idea to test out all price increases in a small market first to ensure that they don’t drive away your customers.
You can also improve CLV by lowering the costs associated with manufacturing your product or providing services and running your business, thus increasing the contribution margin. One effective solution is to try to minimise human touchpoints and substitute them for digital solutions such as chatbots and digital guides. You can also work on reducing your churn rate, therefore improving the customer lifetime.
Customer Acquisition Costs
When it comes to customer acquisition costs, there are two things you can do: you can try to acquire more customers without increasing your marketing and sales budgets, or you can reduce your sales and marketing spend but still generate the same number of customers. In any case, this can only be done by optimising each step of your conversion funnel.
Payback Period
You can shorten the payback period by minimising your customer acquisition costs, improving the contribution margin, and increasing the average monthly revenue per customer.
A Note On Averages
You will need to use a lot of averages when calculating unit economics parameters. However, if you do this blindly, you may end up with figures that are incredibly misleading or simply meaningless. Thus, it’s always necessary to carefully scrutinise the numbers and look further than the averages, considering different cohorts of customers.
Resist the Temptation to Manipulate the Numbers
Having a good command of the parameters associated with your unit economics is essential for growing your business and attracting new investors. However, while many founders realise that it’s crucial to have good unit economics, some business owners misguidedly opt to inflate those numbers, intentionally or not. There are several ways this commonly happens. First of all, some founders choose to disregard the contribution margin, especially if their business provides SaaS solutions. Instead, they simply report their entire revenue as profit, which usually results in overly optimistic unit economics. Other business owners don’t go as far, but instead, they fail to take into account costs of goods sold and various other expenses on technology infrastructure support, product delivery, packaging, customer support, etc.
Another common mistake founders make is disregarding brand marketing costs. Many CEOs reason that brand marketing costs are not incurred with the goal of attracting customers. However, this is wrong because while brand marketing doesn’t aim to attract customers immediately, the expectation is that it will pay off with lots of new customers eventually.
Overall, you need to be as honest and objective as possible when calculating and evaluating unit economics. This is the only way you will be able to determine the right direction for your business to move in to achieve stable, sustainable, and successful growth. However, you must also be patient. It is imperative to develop strong unit economics before scaling your business. Otherwise, you’re risking diluting your stake in the company and burning through huge sums of money without achieving the desired results.
Key Conclusions
- The concept of unit economics allows each founder to better understand their business, its viability, and the direction the company needs to move in. At the same time, it allows the founder to evaluate whether the business model they’ve chosen is economically viable.
- It’s most common to calculate unit economics by looking at a single customer and evaluating the customer lifetime value, customer acquisition cost, and payback period.
- It’s key to develop strong unit economics before starting to scale your business.
