What is Unit Economics? (The reason why startups shut down despite double-digit growth)

Imagine.

You’re a SaaS startup owner.

Your product, ‘LinkedIn Schedule’, assists people to schedule their posts on LinkedIn and track content’s performance.

The paid subscription plan starts at $30 every month.

Are you earning profits on the addition of every new subscriber? Is the subscription model correctly priced, overpriced, or undervalued?

As per ‘unit economics’, you should calculate the profitability on a per-unit basis to measure the viability of a business model.

Wait, what is ‘unit economics’? Why is it a crucial concept that most startups overlook?

Let’s understand in detail:

What is Unit Economics?

Unit Economics is a sum total of all economic activities related to 1 unit. It denotes the profitability of your product or service on a unit level. A unit could be:

• 1 unit of your product or service;
• 1 customer.

If you are earning profits on the sale of 1 product or service or if the customer’s acquisition cost is lower than the customer lifetime value, your business model is considered to be profitable and scalable.

Why is unit economics crucial?

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Unit economics helps in:

1. Forecasting profits: Based on the profit (or loss) earned from an individual unit, you can project how profitable your business will be (or when it will achieve profitability).
2. Optimizing the product price: Initially, when you launch a product, you may not be able to evaluate if the product is correctly priced. Unit economics helps you to understand if the product is overpriced or undervalued. Then, you can accordingly optimize the price.
3. Analyzing sustainability: Unit Economics is a perfect metric to determine a product’s future potential. If your business is profitable on a per-unit basis, it will confirm the overall market sustainability of the product.

How to calculate unit economics?

First Method: Contribution Margin Method

In this case, we’ll calculate the contribution margin on the sale of a product or service.

Contribution Margin = Revenue (-) Direct Cost of Goods Sold (-) Variable Indirect Cost

Let’s understand this through an example:

Shane runs a garment shop. On the sale of 100 pairs of garments, her revenue and costs are detailed below:

Revenue:

Costs:

Contribution Margin on the sale of one unit = $1,300/100 = $13

Since Shane can earn a contribution margin of $13 on the sale of a pair of the garment, the business model is sustainable. However, this isn’t a net profit yet since Shane will have to deduct fixed costs from the contribution margin.

But as Shane sells more pairs of the garment, her contribution margin will increase, resulting in higher profits.

Second Method: LTV: CAC ratio

In this case, we’ll calculate the Lifetime Value (LTV) of a customer and the costs incurred to acquire a new customer.

Lifetime Value (LTV)

Lifetime value represents the lifetime value (revenue) that a business can earn from an individual customer.

For example, our ‘LinkedIn Schedule’ app is priced at $100 per month. If the average customer buys the subscription plan for 3 years before churning, the LTV of a customer will be $3,600.

Customer Acquisition Cost (CAC)

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Customer Acquisition Cost is the cost incurred on marketing and sales to acquire a new customer.

Since the marketing and sales cost can’t be attributed to every customer individually, the total marketing and sales cost is divided by the total number of new customers to calculate the average CAC.

For instance, in our case, for acquiring 10 new customers, you’re spending $8,000 on marketing and $4,000 on sales. So, the average CAC for acquiring a new customer = $(8,000+4,000)/ 10 = $1,200.

Please note that the definition of customer acquisition is different for every business. For some businesses, it will be the first purchase, for some, it will be the 3rd organic purchase, and for a few others, a mere sign-up will be sufficient.

What does it imply?

The LTV: CAC ratio, in this case, is $3,600/$1,200 which is 3:1. This ratio is considered healthy under the unit economics model since it implies that for every $1 spent on acquiring a new customer, the business will earn $3.

So, the business model is sustainable, and you can now invest more money to scale up the business quickly.

Closing Notes

It’s important to measure profitability on the unit level so a business can always be in control of its revenue and costs. Unit Economics should be a considerable metric right from the 1st day in any startup or business.

If a business starts losing money on a per-unit basis, it will never be able to grow and succeed, despite acquiring new customers or even registering double-digit growth.

What are your thoughts? Let me know if you have any further questions on unit economics. I’ll be happy to answer them.