Breaking costs and revenues down into individual units is a powerful way of analyzing the performance of a business. Unit economics are calculated to see if the cost of producing and selling each unit outweighs the revenue received from it, allowing businesses to track their progress over time.
What is Unit Economics?
The success of any business is complex and often difficult to determine accurately. Unit economics provides a straightforward approach to evaluating profitability by looking at the cost associated with each unit or customer versus the revenue generated from that single customer or unit.
In unit economics, a “unit” is defined as a customer, product, service, or other item for which it is possible to calculate the costs and revenues associated with its sale.
For instance, the unit economics of a retailer would be the profit they make from each customer sale divided by the costs associated with that sale.
Similarly, a rideshare app’s unit economics would be the profit from each ride divided by the costs associated with the ride.
In short, unit economics answers a vital question: Can the business profit more from each customer than it costs to acquire them?
It’s a simple yet powerful way for entrepreneurs, startups, and scaled businesses alike to assess their business model, identify which customers or products offer the most value, forecast future revenue, and streamline resources.
- Unit Profitability: The profitability of each individual unit (i.e., customer unit economics).
- Cost of Goods Sold (COGS): The cost associated with making and delivering a product or service.
- Customer Acquisition Cost (CAC):The amount it costs to acquire a new customer for the business.
- Lifetime Value (LTV): A measure of how much revenue is generated from an individual customer.
- Unit Economics Ratio: A ratio that measures the profitability of each unit, calculated by dividing revenue by costs.
Why Unit Economics is Important
Assessing business efficacy, profitability, and overall health is often complicated. Unit economics is essential for numerous reasons, primarily regarding business strategy, budgeting, and customer acquisition.
- Shows current business success on a per-customer or unit basis. When communicating with investors, stakeholders, or board members, unit economics metrics illustrate the success of a business on both an individual and collective level (with fewer, more definitive numbers).
- Helps organizations decide whether to increase or decrease production or levels of service. Whether or not it makes fiscal sense to add more products or features can be determined by how many new customers they can serve, and at what cost.
- Allows entrepreneurs and early-stage startups to identify which customers or products offer the most value. For SaaS startups, quickly understanding which customers are driving the most revenue improves their targeting for sales, marketing, and product development.
- Enables accurate forecasting of future profits and expenditure levels. Poor data quality is responsible for an average of $15 million in yearly losses. Unit economics helps navigate these risks by providing simple, concrete metrics that drive decision-making.
- Provides valuable insights into the profitability and cost-effectiveness of different strategies. Revenue optimization and cost-saving measures can be identified and implemented with greater accuracy.
- Shows businesses how much capital they need to break even. When developing pricing strategies, unit economics can help determine the minimum price to be charged to break even.
- Optimizes resource use to minimize waste. By analyzing unit economics, businesses can identify areas of inefficiency and implement changes to streamline processes.
Unit Economics Metrics
At its core, unit economics is the measure of customer profit divided by the cost of acquisition. But there are several metrics that impact the final value.
Customer Acquisition Cost (CAC)
The customer acquisition cost (CAC) is an essential metric for understanding the unit economics of a business.
It’s the summation of all costs associated with acquiring a customer, including:
- Marketing costs: Advertising, public relations, and sales promotion expenses.
- Sales costs: Salaries, commissions, and other compensation for employees involved in the sales process.
- Technology costs: Software and hardware used to facilitate customer acquisition.
- Overhead costs: Utilities, rent, and other overhead expenses associated with lead generating business activities.
- Variable costs: Shipping costs, payment processing fees, and other variable expenses associated with a customer purchase.
CAC is often calculated taking into account the total cost of acquiring a customer over a certain period of time (e.g., a month), divided by the number of customers acquired.
Lifetime Value of a Customer (LTV)
LTV is a metric that gauges the overall net profit generated by an ongoing customer-product relationship.
This metric measures the potential long-term return on a customer acquisition investment in unit economics. It is the main value compared against an organization’s CAC to determine the profitability of a customer.
LTV can be calculated in various ways, depending on the business model:
- For subscription services, the average monthly recurring revenue (MRR) per user is multiplied by the average customer lifespan.
- For ecommerce businesses, it is the average order value multiplied by the average purchase frequency.
- For enterprise software companies, it is the amount of annual revenue multiplied by the customer lifespan.
It is important to note that calculating LTV requires the use of historical data. It is based on average spending habits, order frequency, and other factors associated with customer-product engagement.
It is also essential to consider other microeconomic factors—such as churn rate and discount rates—when calculating LTV.
When a company’s customer base is in flux, it can be difficult to accurately gauge the true value of each customer.
Churn rate is a measure used to assess how many customers are leaving at any given time. It is calculated as the number of customers lost divided by the total number of customers during a certain period (e.g., month).
It fits into the unit economics calculation by factoring in the cost of customer attrition each month.
For example, if a company has an average customer acquisition cost of $500, but also sees its customers leaving at a rate of 5% per month, it would need to make up for the lost revenue.
Since the company is not earning any return on the investment of acquiring that customer, this impacts the LTV, reducing the LTV to CAC ratio.
Unit economics can help businesses determine pricing strategies by taking into account discount rates—the rates at which customers receive discounts for their purchases.
By understanding how different discount rates impact a company’s bottom line, businesses can make informed business decisions and optimize their pricing structure.
For example, if a company were to offer customers a 10% discount on products, they would need to calculate the expected customer LTV versus CAC ratio to determine if offering discounts is in the business’s best interest.
Average Customer Lifetime
Not every customer is immediately profitable, so the average customer lifetime directly relates to unit economics.
The average customer lifetime is the estimated length of time a customer is likely to stay with a company. It takes into account factors like loyalty and customer satisfaction, as well as churn rate and purchase frequency.
By understanding their average customer lifetime, businesses can calculate LTV, helping them better predict how long it will take for them to recoup their CAC and generate a return on investment.
Customer retention is an important factor in unit economics because it impacts the LTV of a customer. It is calculated as the number of customers retained divided by the total number of customers during a certain period (e.g., month).
It is important for companies to understand their retention rate in order to determine if their products or services are meeting customer needs and keeping them engaged.
If a company has a low customer retention rate, it probably has poor unit economics—unless it is able to offset that with a high customer acquisition rate or profit margin.
Number of Transactions
The number of transactions is a small but critical factor in unit economics analysis. It is calculated as the total number of purchases each customer makes over a certain period (e.g., month).
More transactions don’t necessarily translate to more direct revenues. Businesses with expensive products might need fewer revenue streams to reach their desired LTV.
At the same time, businesses with low-margin products might need a higher transaction volume to recoup their CAC and generate a return on investment.
In any case, it shows customers’ engagement with a company’s products. Customer data like the number of transactions compared with the LTV of customers can help businesses develop better marketing strategies and pricing structures.
Number of Customers
When it comes to understanding unit economics, the number of customers is relative. Similar to the number of transactions, a business’s total number of customers can help determine its profitability.
In general, companies with more customers have strong unit economics—less dependency on any one customer makes them more resilient to possible changes in the market.
On the other hand, businesses with fewer customers should closely monitor their LTV and consider factors like retention rate, transaction volume, discount rate, and average customer lifetime when managing their revenue.
Total revenue is the sum of all income from sales over a certain period (e.g., month).
In financial analysis, total revenue is the starting point in the understanding of unit economics. It provides a basis from which all other calculations can be made.
It is important to note that total revenue does not necessarily reflect profitability, as it does not account for the cost of goods sold (COGS) or other expenses.
Gross profit is calculated as the difference between total revenue and cost of goods sold (COGS). It accounts for unit costs like materials and labor, but not other expenses like marketing, overhead, and salaries of indirect employees.
Average Order Value
Average order value (AOV) is simply the average amount each order is worth. It is calculated as total revenue divided by the number of orders placed.
Like the average revenue per customer, it is relative to the price of the product or service, and it can help businesses understand how many customers they need to succeed and how much they need to charge.
Average Gross Margin
Average gross margin is calculated as the average gross profit divided by the average order value. It helps businesses understand the profitability of each sale and how their unit costs change over time.
Knowing the average gross margin allows companies to set competitive prices and make adjustments as needed, which eventually impacts their unit economics.
Gross Margin Per Customer Lifespan
Gross margin per customer lifespan is essentially the total gross margin divided by the number of customers over a certain period. It helps businesses understand how much profit each customer brings in and whether or not their unit economics are sustainable.
For example, a low gross margin per customer may indicate that a business needs to increase its retention rate or reduce its unit costs to reach a positive return on investment.
How to Calculate Unit Economics
Unit economics calculation involves several key metrics (mentioned above). But, the basic formula for unit economics is:
Unit Economics = Revenue per Customer / Customer Acquisition Cost
Revenue per customer is calculated by taking a business’s total revenue divided by the total number of customers.
Customer acquisition cost has more variables, depending on the business model. It is often calculated as the cost of marketing activities (e.g., ad campaigns, etc.) plus product costs and other variable expenses per customer.
Analyzing Unit Economics
When using the concept of unit economics, businesses can determine product pricing.
Using these key metrics and ratios, businesses can estimate their financial performance:
Fixed Cost vs. Variable Cost
Fixed costs remain the same regardless of the number of products or services sold. They include overhead expenses like rent, insurance, and salaries.
By contrast, variable costs change depending on the production volume. These include product materials and labor involved in manufacturing a product or shipping a service.
As a business acquires more customers or produces more, it will have more variable costs like materials, labor, and shipping.
When increased fixed and variable costs are proportionately lower than new revenue generated from customer acquisition, the business has a good chance of achieving a positive return on investment.
LTV to CAC Ratio
When analyzing unit economics, your LTV and CAC are interrelated unit cost metrics that can be compared using a simple ratio.
An optimal LTV:CAC ratio is 3:1, meaning that for every customer acquisition cost, you should gain three times the value in return.
If the ratio is lower than 1:1, each new customer costs as much as or more than they will spend on your product. If this is the case, the next steps are refining sales methodologies and refining your pricing models.
A higher ratio—such as 6:1—indicates potential missed opportunities. As one customer can give a return higher than their acquisition cost, there is more room to increase spending on sales and marketing to bring onboard more customers without incurring extra costs.
Payback Period on CAC
Payback period accounts for the amount of time it takes to recover the cost of acquiring a customer.
A company spends money upfront to acquire a customer, and its payback period is the time it takes to recover that cost.
For instance, if a business spends $500 in customer acquisition costs and gains $1,000 in recurring revenue from that customer over the next six months—its payback period is six months.
The average startup payback period is around 15 months, meaning businesses need to retain customers for at least 15 months to achieve profitability from customer acquisition.
How to Improve Unit Economics
Since the unit economics equation has so many variables, businesses can improve unit economics in numerous ways:
- Increase revenue per customer
- Decrease customer acquisition cost
- Increase customer retention rate
- Reduce the cost of goods sold
- Invest in product optimization
These things can be improved by using better marketing strategies, increasing product value, optimizing cost structure, and improving the customer experience.
That said, improving one element (i.e., increasing revenue per customer) while simultaneously compromising another (e.g., increasing unit cost metrics) could still lead to a negative unit economics equation.
People Also Ask
Why use unit economics?
Businesses use unit economics to measure the profitability of each customer they acquire and their overall financial performance. Unit economics enables businesses to identify and address inefficiencies and make informed decisions on pricing, marketing, product development, and more.
What are unit economics in SaaS?
In SaaS, unit economics measures the revenue per user against acquisition costs. Since SaaS companies spend money on customer acquisition upfront (via sales, marketing, and customer success), knowing how long it takes until they make a return of investment (ROI) is essential.
Unit economics help to determine and monitor the customer lifetime value (LTV), cost of acquisition (CAC), payback period, and total revenue generated per user.