Unit economics fundamentals
Unit economics is an economic modeling technique used to determine the profitability of a business model by evaluating the profitability of a product unit or an individual customer. A business can only be successful if one unit of the goods or services makes a profit.
- Determination of the effectiveness of the main sales channels
- Assessing the company's prospects, understanding where it is heading
- Determination of business profitability at the idea stage
- Finding the break-even point and calculating the return on investment
- Understanding how many customers you need to attract and how much each one will cost
The glossary of unit economics
User
The user is a basic entity that determines what we work with, in the general case, this is a person who got acquainted with our product through advertising. For example, a visitor to an Internet project site or a company that was called during cold sales, in fact, we are talking about a card in CRM.
User acquisition (UA)
The number of attracted users. It shows how many users we introduced to our product through marketing. For example, the number of visitors who came to the site using contextual advertising or the number of companies we called during cold calls.
Conversion (C)
User-to-customer conversion rate.
Buyer (B)
A client or the number of clients that we receive from the user flow, taking into account the available conversion rate. B = UA x C
Average Price (AvP)
The average check is the amount of money that our customer paid for our goods or services.
Cost of Good Sold (COGS)
The cost of sale is an important measure of the costs we incur on each sale. It is important to separate the fixed costs that we incur whether we have sales or not from the mandatory costs that we incur on every sale. For example if we are selling a product then COGS will include the cost of purchasing the product. For b2b sales COGS may include a bonus that we pay our sales manager on every sale.
First sale COGS (1sCOGS)
Additional costs that we incur on the first sale. It is important to understand that these are additional costs to COGS. Examples of such expenses could be the cost of running pilot projects and integrations for corporate clients or paying an increased commission to our sales agent.
Average Payment Count (APC)
The average number of payments made by one customer for the selected period. By default, it is considered for the entire lifetime. It is important to be careful when calculating this value and it should never be rounded off.
Average Revenue per Customer (ARPC)
It shows how much we earn from sales made by the client during the selected period, excluding marketing costs. Calculated using the formula ARPC = (AvP - COGS) x APC - 1sCOGS. It is an important value for evaluating business performance, comparing it with CAC, you can get an estimate of the return on investment in marketing.
Average Revenue per User (ARPU)
It characterizes the income we receive from each user, excluding marketing costs. It is calculated using the formula ARPU = ARPC x C. It is an important value for evaluating business performance, comparing it with CPA, you can get an estimate of the return on marketing investment.
Customer Acquisition Cost (CAC)
All costs that you incur to get a client are taken into account. For example, to calculate it we divide your entire marketing budget by all the clients received.
Cost per Acquisition (CPA)
The cost of attracting one user. It is calculated by dividing the total marketing budget by all users. Unlike CAC, CPA is a decision metric because it is independent of other metrics such as conversion or user flow.
Acquisition Cost (AC)
The marketing budget, all costs for attracting a stream of users.
Contribution Margin (CM)
The marginal profit from our user flow. It shows how well we sell our product or service. The main value that determines the effectiveness of our solutions. Calculated using the formula CM = UA x (ARPU - CPA) = UA x (ARPC x C - CPA)
Revenue
The turnover from the sale of goods or services. It is calculated using the formula Revenue = B x AvP x APC
Return on Marketing Investment (ROMI)
The return on marketing investment shows how effectively we have worked out our marketing budget. It is calculated using the formula ROMI = CM / AC
Gross Profit Margin (GPM)
The value characterizing the part of sales costs (COGS) in the total turnover. It is calculated using the formula GPM = CM / Revenue.
The basic formula of unit economics is based on the principles of management accounting and microeconomics:
Profit = Revenue - Variable Costs - Fixed Costs
The biggest mistake entrepreneurs make when analyzing unit economics is the misallocation of fixed and variable costs.
Variable costs are directly related to sales. Therefore, variable costs vary depending on production and subscription volumes. Common examples of variable costs are cost of goods sold (COGS), shipping and packaging costs, and so on. Careful inclusion of all variable costs in the unit/customer economic analysis is vital for correct calculations.
If you sell a mobile application through the App Store, you need to subtract the commissions of the app stores from the revenue (they grow along with sales). In this case, you do not need to subtract the cost for the team developing the application. These are fixed costs. They do not directly affect the cost of one unit of goods.
If you develop and sell SAAS, and within a particular transaction, a team of engineers is working on the integration, then the cost of such integration should be deducted from the revenue. At the same time, the costs of developing the software itself do not need to be taken into account, since they are not directly related to a specific transaction (they are fixed costs).
If you are selling t-shirts through an online store, then the variable costs associated with a particular transaction will consist of the purchase price of the t-shirts, shipping, payment processor fees, and other related costs.
1. Unit is goods
Margin = (Average Price — COGS)/Average Price.
2. Unit is a client
In mobile games and applications, a unit is usually a new user, while in SaaS it is a paying customer.
If the unit is the client, then you need to consider how much was spent on attracting him and how much it costs to provide him with the service. Revenue in this case is the ratio of LTV to customer acquisition cost (CAC).
UE = LTV / CAC.
Based on LTV and CAC, all decisions can be reduced to the following:
LTV > CAC, then the unit economy converges, i.e. may be loss-free.
LTV > 3*CAC, then the unit economy can be scalable, i.e. can show a multiple increase in revenue and financial results in relation to the volume of investments in the business model.
LTV (Lifetime Value) is calculated based on gross profit, not revenue.
Gross profit is the difference between revenue and all variable costs that are directly associated with the product or service sold (COGS or Cost of Goods Sold).
Usually LTV is calculated for a month from the moment the user arrives.
For which month should LTV be calculated
The answer to this question depends on the product and the problem being solved.
For example, venture-backed companies often aim to recover the money spent on acquisitions in 12 to 18 months (sometimes even more).
If a company develops with its own money, then it rarely can afford to wait for the return of the money invested in attracting users for more than 2-6 months.
For some products, LTV reaches a plateau fairly quickly. In these cases, it makes sense to calculate LTV for a month, when the curve becomes almost parallel to the X-axis.
Typically, a decision has to be made well before you collect the data to calculate the actual LTV for 6 or 12 months. Therefore, it is important to learn how to predict LTV based on one or two weeks of data. This is not the easiest task, but it is solvable.
Segment users when calculating unit economics
Unit economics may converge for some acquisition channels and not converge for others. Therefore, the unit economics must be calculated separately for different acquisition channels, platforms, regions, etc.
ROI (Return on Investment) or ROMI (Return on marketing investment) is an excellent metric that replaces the entire unit economy.
ROI = (LTV — CPA) / CPA
ROI shows how much return you will receive on investing money in a particular distribution channel. In order to calculate the ROI for a channel, you need to take the gross profit (revenue minus variable costs to ensure it) received from customers attracted from this channel, subtract from it the money spent to get these customers, and divide by the same cost figure .
The key idea is that high-level metrics (CPA and LTV) are decomposed into components, which allows the team to see a specific leverage on the unit economics of the product.
This often creates confusion. So use common sense when looking for ways to influence the unit economics of your product's economy, not only formulas.
Unit economics is easy. We just should not complicate it.