Understanding Unit Economics in Startup Terminologies
Economics is a subject that we simply cannot run away from, it is in every aspect of our lives.
For instance, we often try to figure out the basic costs and prices of goods and services for a product or offer. And without even realizing we have all practiced some sort of “unit” economics in that very calculation
Unit Economics in definition is a calculation of basic business metrics like profits, sales, etc. in terms of one unit or one customer. Experts have gone on to say that unit economics are the fundamental or basic financial building blocks of a business.
Startups nowadays are relying more and more on data driven decisions to manage and grow their ventures. Unit economics is to the startup what breakeven analysis is to traditional businesses. Unit economics can help startups with limited human resources to analyse complex metrics in a simplistic manner. All companies are driven by growth and profitability, but early stage startups especially need to pay close attention to the metrics that surround this.
The per unit model can help you identify the breakeven points and also to understand how much more you can earn per unit or per customer by altering unit costs or sales prices.
The first thing you should do when it comes to analysing a company’s unit economics is to pick, determine, or identify the unit. It will depend largely on the nature of the business as to whether it is a manufacturing business, a retail business or a service provision.
The next step is to identify the exact unit economics of the business. Several inputs and outputs to consider while formulating a unit economic analysis include revenue, duration, price, costs, capex, marginal costs , etc.
Startups can approach unit economics from two angles:
Customer Lifetime Value / Customer Acquisition Costs
Lifetime Value = Gross Margin % x ( 1 / Monthly Churn % ) x Avg. Monthly Subscription Revenue per Customer
A ratio of one or lower may indicate that it costs you the same amount or more to acquire customers as much as they spend on your products and services. Customer acquisition costs are one of the most important extensive costs especially for start-ups with a business model that requires continuous inflow of new customers. If your ratio is too high, say above 6 times then you might miss out on other valuable opportunities.
As each customer ends up being worth more to your startup than it costs to onboard them, you can afford to allocate more of your time and budget to sales and marketing. The money you spend at this stage will be made back over the lifecycle of each customer.
An ideal value for this ratio is considered to be around three times the acquisition value from each customer.
Payback Period on Customer Acquisition Costs (CAC)
Customer Acquisition Costs = Sales and Marketing Costs / New Customers Won for a given period.
This is a measure of the time a company takes to recover the cost of acquiring a customer. Calculating customer acquisition costs can be tough as customers are acquired through various channels like apps, website, telemarketing, email, SMS, Social Media, Search Engines, Advertisements, Sales Promotions, etc.
Dividing the total of marketing costs from all these channels along with other sales overheads by the number of customers acquired gives the CAC measure.
The shorter the payback period the better for the firm as they are able to recover the costs quicker.
The average payback period has been calculated to be under 12 months
Unit economics forecasting is another very important activity for internal managerial decisions and external funding decisions.
The earlier you adopt unit economic measurements for your startup, the better chance you have at achieving a sustainable growth rate. The business concept of start-ups needs to be backed by such unit economics metrics. Founders often under assume the customer acquisition and marketing costs for their ventures, leading to a cash crunch due to overspending or underwhelming growth owing to less than required expenditure.
Having an understanding of unit economics early on enables you to make long term financial projections that more accurately predict your revenue trajectory. Unit economics will help provide a more accurate measure of profitability and growth. Unit economics brings financial performance of a business under a realistic view.
Unit economics enables easy division of work and also allows for dissection of revenue and costs to enable founders to understand what area requires more attention. Investors, external analysts and other stakeholders also encourage the use of unit economics as it provides them with a more clear picture of the financial performance of the firm and also proves to be a sign of transparency.
With the increasing number of ventures coming into existence, founders need to focus on these little financial details to stand out from the others and attract better and more reliable investments.