Unit economics has become such a buzzword in the world of management consulting that it almost seems passé. Today's era is of highly publicized yet unprofitable startups raising tens or hundreds of millions of dollars. Their presumption is that they will bend toward profitability with scale, making mastering unit economics more necessary than ever. This is true for those running an actual business as well as those looking to consult for real businesses. In this article we’ll take a look at what unit economics actually is. We’ll offer an overview of how to apply the concept as a framework for real life-businesses. We'll also provide a variety of unit economics examples, to help solidify your understanding of the concept.
United States Economic System
Ask yourself: what is the economic system in the United States? It is growth-oriented capitalism, in which companies must find ways to profitably expand into the increasingly globalized network of sales and supply chains. More traditional measures of a business’s global performance at a given moment don’t tell the whole story about how that business’s performance will change as operations expand and costs vary in response to growth.
What Is Unit Economics?
On a basic level, a unit economics definition is a specific business’s profitability relative to each unit they sell. The profitability of each unit is also commonly referred to as the contribution margin. Unit economics offers a valuable framework for high-growth businesses looking to assess the health of their current operations as well as the viability of their long-term evolution & expansion.
Unit economics seeks to offer a valuable predictor of future expansions by emphasizing variable costs. As such, it attempts to ignore fixed costs in an effort to gain a more explicit understanding of a company’s true value-capturing abilities with each product sold. Unit economics asks the basic question: does each sale create or destroy value for your company?
The “unit” portion, then, refers to the minimum portion of your businesses that can be measured to assess revenue. The basic formula is:
Contribution Margin = Unit Revenue – Unit Costs.
The revenue is typically the easier portion to calculate, as it refers to the value earned by each new sale or customer. The costs of each unit are much trickier. A thorough unit economics analysis will seek to account for all variable costs, many of which are somewhat hidden or subtle. Variable costs can be mistaken for fixed costs, even though an expansion of operations will actually lead to variation in all costs (including overhead such as costs of facilities, your workforce, and your technology).
Unit Economics Examples
For many businesses operating with long-term customer relationships (especially subscription-based services), the revenue and costs may be better understood as the Lifetime Value of a customer (LTV) and the Cost of Customer Acquisition (CAC), respectively. In order to properly determine these figures, you need to know the following: the lifespan of a customer, the number of new customers acquired over a given time period, the marketing and sales costs over that same time period, the gross margin, as well as the annual revenue per customer. These can all be complicated to measure in full.
Many businesses fail to grow into profitability because they don’t fully account for the costs that vary with output. Prices associated with production are persistent, even as you project your company’s ability to outgrow them. Conversely, customers can be quite fickle, and often don’t keep patronizing a company as long as the company expects them to. To put it differently, you should be able to calculate and compare the total costs of acquiring customers with the total revenue generated by those customers over time.
Unit Economics Analysis
Unit economics analyses will differ with each company, depending on its business model. An easy example would involve a company that primarily adds value through the sale of a limited number of products, such as a car dealership. The unit would be one car sold. The revenue would be the money earned from the sale of a single car unit. The costs would involve all variable costs, including cost of car itself, commissions to the salesperson, etc.
Running a unit economics analysis on a subscription-based company is slightly trickier. Here, an analysis of the revenue would involve a deeper look at how much revenue the average customer generates over its lifetime. And since there may not be a specific product to measure the costs of, the cost would be all the expenses associated with acquiring each customer (CAC = Customer Acquisition Cost), from marketing to customer service. Many companies offer products on a subscription basis, such as regular meal delivery (think Blue Apron) or entertainment content (think Netflix). For these companies, the cost of producing and delivering those products would be factored in, averaged out over each subscription.
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Conclusion
Unit economics offers a simple and granular way to assess a business’s performance and long-term viability. In this economic environment, more and more unprofitable companies are attempting to acquire outside investment and to leverage debt in the hopes that scaling up operations will lead to an increase in profitability. However, this is often a form of magical thinking. A strong and thorough analysis rooted in unit economics, accounting for the ways costs will vary with expansion, will help determine to what extent expansion will change a company’s profitability on a unit-by-unit level. If a company’s basic operations are unable to generate profit with each unit, no amount of investment will save the company long-term.
Additional Reading:
- Top 7 Business Frameworks to Know
- Economies of Scale
- Open Innovation: What Is It?
- The Pyramid Principle