What Are Unit Economics and How Are They Calculated?

Every business strives for success or succeeds based on one major factor: long-term sustainability. Its financial success further determines this. Unit economics is a simple yet powerful tool that helps you understand success. It also enables you to understand the sustainability of your business in the long run.

Unit economics provides an early insight into the relationship between a company's profits and costs. It also enables informed planning and strategic decision-making.

Unit economics demonstrates how each item, or "unit," contributes to the business. A clear and concise analysis helps you determine a business model's profit and loss based on a per-unit basis.

This blog explores why unit economics is important in scaling businesses, and how to calculate key metrics for measuring your business potential and growth.

Why is Unit Economics Important?

Whether you are the powerful CEO of an affluent company or the owner of a SaaS startup, unit economics will be part of your annual revenue report and overall cash flow.

For instance, an app for booking bus tickets would define 'one unit' as every ticket booked using its app. The company can now collectively analyse all the units, or every ticket booked, to assess the amount of profit or loss it generates. In the case of a general store, its unit economics will be the revenue generated from individual customers over a month.

Analysing unit economics is always beneficial. But starting this process sooner rather than later yields better results.

The availability of precise and comprehensive data enhances strategic decision-making and pricing strategy. It also gives you an upper hand by enhancing investor appeal. You lay a strong foundation for informed business strategies and sustainable growth by proactively tracking your company's unit economics.

Reasons Why Unit Economics Plays a Big Part in Scaling Businesses

Unit economics examines the fundamental costs and revenues linked to every individual component of a company's business model. By analysing the data acquired, one can forecast the company's potential profitability and how long it will take to achieve it.

Here are 3 reasons why unit economics is important for scaling businesses:

Forecast Profits

A clear understanding of unit economics helps predict a business's profitability and the time it will take to realise its full profit potential. It does this by producing a clear, granular picture of the profitability of each unit within a company.

Optmising the Company/Product

Understanding a product's unit economics helps determine whether it is undervalued or overpriced. It also determines its soundness, assessing whether the marketing expenses are yielding profits. It also helps identify strategies favourable to its improvement.

Assess the Stability of the Market

Unit economics is adept at measuring how sustainable the market is. This, in turn, helps them analyse a product/company's future potential. In the initial stages of a business, many founders and CEOs depend on unit economics to evaluate their company's future stability and potential.

Calculating Unit Economics

Unit economics is the direct costs and revenues of a specific business unit. A unit is any measurable item that adds value to the business.

By calculating unit economics, companies can forecast gross margins and break-even points more accurately. This clearly explains whether what is spent on various operations yields profits and how quickly you see the returns on those costs.

You can calculate unit economics either way, depending on your chosen unit definition. You can define a unit as "one item sold" or "one customer."

One unit is defined as “one customer". Unit economics is determined by calculating the ratio of two distinct metrics:

• Lifetime value of a customer (LTV): The revenue a company receives from customers over the time they do business with you.

• Customer acquisition cost (CAC): The cost of acquiring a new customer.

Therefore, the ratio that calculates your unit economics will be:

(UE = LTV/CAC)

i.e., the customer lifetime value divided by the customer acquisition cost.

Let’s understand these two critical metrics in detail.

Customer Lifetime Value (LTV)

From the 'revenue' side, customer lifetime value (LTV) is a common yet crucial term. It is the amount of money you receive from a single customer over the period they are associated with your company. This refers to how much you earn from a customer until they stop doing business with you.

To calculate LTV, one must know the company's gross margin, the monthly churn rate, and the average monthly customer spending.

LTV= Gross Margin % X (1 / Monthly Churn) X Average Monthly Revenue per Customer

Customer Acquisition Cost (CAC)

When we analyse based on 'cost', customer acquisition cost (CAC) is crucial in determining unit economics. It is the money you spend on attracting a new customer, including the money you spend on marketing and sales through campaigns, programs, etc., to acquire one customer.

If you are spending less, you will not acquire new customers. Paying the correct amount is directly linked to your LTV. Thus, it is crucial to calculate and understand CAC. The formula for calculating CAC is:

CAC = (cost of sales and marketing / number of customers acquired)

The LTV to CAC ratio provides important insights into your business's performance. It also serves as a crucial indicator for evaluating the effectiveness of your marketing strategies.

When your CAC is lower than LTV, it shows a healthy business model with strong profitability potential. If the two metrics are equal, it indicates stagnation. And if your CAC exceeds your LTV, it suggests a financial deficit. In this case, you must make strategic adjustments to optimise marketing expenditure and enhance overall profitability.

Summing Up

As a business progresses, unit economics are bound to change. Prevailing economic conditions or the pressure of competition can be the reasons. You must always keep track of these changes to be able to handle them efficiently.

GrowthJockey believes a business must regularly analyse its unit economics to achieve business sustainability and growth. This will help in carefully improving your business model as it scales.

Maintaining a thorough understanding of your business model's usability enables you to adapt swiftly. Consequently, you can make well-informed decisions amidst fluctuating market dynamics and shifting demand patterns.

FAQs

1. How do I improve the unit economics of my company?

The best way is to optimise your LTV. GrowthJockey offers expertise in LTV calculation, which will help you minimise churn and extend the period for a customer to stay with you. Moreover, budget reductions are advisable if the LTV: CAC ratio proves too out of proportion.

2. Why does the analysis of Unit economics matter for my company?

A thorough unit economics analysis is essential for assessing the sustainability of your business model. It also helps you gain invaluable insights into its achievements and shortcomings. Additionally, a clear understanding of the same is critical for effective communication with investors and for addressing inquiries concerning your company's unit economics.

3. Is unit economics helpful in analysing the performance of a startup?

Unit economics is crucial for startups to evaluate their market feasibility and mitigate the risk of failure. A thorough understanding of UE is essential for effective management. Benchmarking enables the prediction of conversion rates while analysing competitors' business performance facilitates the calculation of early-stage customer acquisition costs.