Ultimate Guide to Unit Economics
The study of economics is not really something that we can get away from; it is in every aspect of our daily lives, although in varying scale. If you are involved in business, understanding unit economics is very important. However, not everyone is all that keen on the idea of studying economics. It does sound, after all, like a complicated subject. Especially when taken in the context of analyzing the performance of a company and predicting its growth potential, it sounds like a very difficult task to accomplish.
If you look at the practice of most analysts, you will find that they are looking at the financials of businesses on a company-wide basis, or even referring to industry and market trends. However, the predictive value is much higher when analysis is done on a unit-level basis, or through unit economic analysis.
In the succeeding discussions, we will be looking deeper into the concept of unit economics in order to understand 1) the unit economics and 2) unit economics analysis.
Unit economics is defined as the “direct revenues and costs associated with a particular business model, and are specifically expressed on a per unit basis”. Some even go so far as say that unit economics are the fundamental or basic financial building blocks of a business. It is the starting point for management, outside analysts, investors, and other stakeholders to analyze, evaluate or assess a company’s financial performance.
All businesses work around a financial model that is designed specifically according to their key assumptions and for the accomplishment of their organizational goals. A lot of resources go into making sure that all the bases are covered, from their product to the market that they are in. However, there is one other factor that should always be taken into account: the company’s economics, and if it is reasonable under the circumstances.
Startups or businesses that are relatively new and just getting off the ground are sure to feel daunted by the thought of having to look into the economics of their financial model. That is why unit economics is very helpful. This way, the intimidating and seemingly large and long-winding process is broken down into smaller, more manageable tasks. By using a unit economics model, work can be divided, attention can be distributed equally among all the important points, and the job can be done.
By gaining an understanding of unit economics,
- The key points of a business’ financial model will make more sense;
- Management will have an easier time determining break-even points and contribution margins, to aid in decision-making;
- Calculation of return on investment and other profitability tests will be facilitated; and
- Forecasting or predicting the future profitability of the company will be easier.
UNIT ECONOMICS ANALYSIS
Identify the Unit
We have already determined that unit economics figures are expressed on a per unit basis. Therefore, the first thing you should do when it comes to analyzing a company’s unit economics is to pick, determine, or identify the unit.
The “unit” is the fundamental business measurement, and it will depend on the nature of the company or business operations. Here are some examples:
- Merchandising or manufacturing company: Usually, the unit is the customer, but the unit can also be based on a product segment. Therefore, one customer is one unit. A bag retail store’s unit is a buyer, while the unit of a shoe manufacturer is a purchaser of shoes.
- Service provider: One client represents one unit. The unit of an internet service provider is a user.
The examples above described companies with single units. That is not a fixed setup, though, since there are some businesses that have multiple units.
- Infrastructure service provider: There are instances when a provider’s service is made available in different geographical locations. Telecommunications companies, for instance, have their physical infrastructure, such as wireless towers and data centers, distributed in various places. It follows that each of these physical infrastructure come attached with significant capital investment. In this case, the unit is not just the customer, but also physical infrastructure itself. In cases where there are multiple units, it is advised that a core unit be identified, with the other units designated as secondary units.
Identify the Fundamental Unit Economics
Once the unit has been determined and clearly pinned down, it is time to identify the exact unit economics of the business.
One of the examples previously mentioned was the internet service provider. This company’s unit is the user, and it has two fundamental unit economics:
- Cost to acquire or recruit one user (or the Cost per Acquisition). This answers the question, “how much will the company spend in order to get one user to avail of its internet service?”
- The amount of revenue generated from one user for the entire length of time that he or she avails of and uses your internet service. This is also called LTV, or Customer Lifetime Value.
In the case of a retail store, its unit economics will be concerned with the amount of revenue generated every month for every active buyer that it was able to acquire or recruit. Some express it as “average monthly revenue per customer” or “average weekly revenue per customer”, depending on the period used by the company for its unit economics analysis.
Perform Calculations: Inflows and Outflows
Now that you were able to identify your unit and the levels of unit economics applicable to your business, it is time to proceed to the calculations in order to build your unit economic model. There are several inputs that are required in your calculations, and they are classified according to what you are calculating: inflow or outflow.
1. Inflow inputs
Revenue refers to the receipts or income that a company receives and earns from its normal operations or business activities, be it the sale of products or of services. While it is true that there are also revenue derived from non-operating sources, these are often one-time events only and non-recurring. Thus, they are not usually considered when analyzing the profitability and financial performance of a business.
For easier understanding, it would be a good idea to present in relative detail the various revenue drivers of the business. The most common revenue drivers include the following:
- The customers
- Who are your customers?
- How many customers does the business have?
- What do you do to attract new customers?
- What are you doing to foster customer loyalty and keep them coming back?
- Frequency of purchase or transaction by the customers
- How often does the customer buy your product or service?
- What do you do to encourage customers to buy more frequently?
- Size of the transaction
- What is the average transaction size?
- How big is the order?
- How many products or services are purchased or availed of?
- What do you do to encourage customers to buy more?
- How much are you selling your product or service for?
- How much is the customer paying for the product or service?
- What pricing strategies do you have in place?
This input refers to the usable life of the unit that you have previously identified.
In the example where the unit is the customer or the user, the duration is the average customer or user life or lifetime. In the telecommunications company example, the duration is the useful life of the physical asset (wireless tower or data center) that was set up.
It could be expressed in months or years, depending on the coverage or period you want to analyze your business viability.
2. Outflow inputs
Capital Expenditures (CapEx)
Capital expenditures are expenditures incurred by a company that has an impact on the future of the business as a whole. The most common CapEx transactions involve the purchase of fixed assets or a business segment, major repair or upgrade of a fixed asset that extends its useful life, or construction of a new fixed asset.
A clear distinction must be made between CapEx and Revenue Expenditures. Revenue expenditure are the operating expenses that are incurred by the business over the short-term, most often over the normal operating cycle of the business, and do not essentially prolong the life of assets or their usability.
For example, the construction of a new factory building is a capital expenditure; the salaries of the cleaning staff of the building are revenue expenditures. Replacement of the roof of the factory building will fall under capital expenditures; the repair of a couple of broken roof tiles will be classified as revenue expenditures.
Cost per Acquisition (CPA) or Cost to Acquire a Customer (CAC)
This is the initial cost incurred by the business to acquire or recruit a customer. Its components include the variable costs of selling, marketing expenses and other costs that can be directly identified with activities that are aimed at acquiring customers and persuading them to purchase the company’s product or service.
The costs will depend on the customer lifecycle or conversion behavior, so they will naturally vary from industry to industry and company to company.
In the example of an internet company that sells applications and widgets, the CAC will include the following costs:
- Cost of investment in a search engine marketing campaign
- Cost of advertising in social media networks (Facebook, Twitter)
Let us assume that the company invested $1,000 in a search engine marketing campaign, and $500 in online advertising. At the end of the month, statistics showed that 450 visitors clicked on the offer from the marketing campaign, and 100 from the social media platforms. That means that the company has spent $2.72 ($1,500 / 550 visitors) for each visitor or potential customer. This is the Cost per Visitor.
Out of the total 550 visitors, 200 purchased a widget or an app from the company. Those 200 visitors have been successfully converted into customers. This means that the company has a conversion rate of 40%, computed by dividing the 550 visitors by the 200 purchasing customers.
To get the final CPA or CAC, divide the cost per visitor by the conversion rate.
Cost per Acquisition = $2.72 / 40% = $6.80
Marginal Operating Costs
These are the ongoing costs incurred by the business to continue serving the customer (and keep him). In the case of an infrastructure business, it is the cost that is continuously incurred by the business to operate the physical infrastructure unit over its life. For example, it includes the cost of repairs and maintenance of the data centers and wireless towers over their respective useful lives.
Maintenance Capital Expenditures
These are specifically applicable to infrastructure businesses and other similar entities that identified physical assets or infrastructures as their core unit. It is a reality that the value of physical assets decrease over time, so maintenance costs or maintenance capital expenditures should be factored into the unit economics of the business. Although the expenditures do not necessarily increase the life of the assets, they keep it operating while meeting a certain standard of quality already expected of the asset.
Perform Calculations: The Contribution Margin
Using the inputs enumerated above, you will be able to start your calculations, starting with the Contribution Margin.
The Contribution Margin is the figure that represents the amount that the company’s revenues will contribute to its fixed costs and net income, after all variable expenses and costs have been deducted. Another simple description of it would be as the amount of cash that a unit contributes to cover the overhead and other fixed expenses of the business.
Contribution margin is especially important in unit economic models – and all business models as a whole – because it is also a representation of the profitability of individual products, of entire product lines or business segment, and of the whole business.
The key computations are as follows:
Contribution Margin = Revenue – Variable Costs
Contribution Margin Ratio = (Revenue – Variable Costs) / Revenue
By computing the contribution margin, you will be able to know the number of months it would take for a unit to produce a positive contribution margin.
The bag retail store’s unit is a single customer. It has been determined that one customer purchases an average of one bag per month, at an average price of $100. On average, a customer remains loyal to the store for 12 months. For the first month, there were 125 customers, increasing by 10% in the succeeding months. The computed variable cost per bag is $65, while the store incurs monthly fixed expenses of $6,000.
|Contribution margin per bag||=||$100 – $65||=||$35|
|Total contribution margin||=||$12,500 – $8,125||=||$4,375|
|Contribution margin ratio||=||$ 35 / $100||=||35%|
Perform Calculations: The Break-even Point
In a customer-oriented business that has identified a customer as its unit, the break-even point analysis will help them figure out how many customers are needed in order to break even, and then turn up a profit. The break-even point is the level of sales where the costs will equal the revenue, so that the company is neither earning an income nor incurring a loss.
Continuing from the earlier illustration, the break-even point is computed as follows:
|Break-even point (in sales)||=||Fixed Costs / Contribution margin ratio|
|=||$6,000 / 35%|
In order to break even, 172 customers should purchase one bag at $100 at the store ($17,143 / $100 per bag = 172 customers).
From the assumption stated, the following figures can be estimated as to the number of customers per month.
|Month 1||125 customers|
|Month 2||138 customers|
|Month 3||152 customers|
|Month 4||168 customers|
|Month 5||185 customers|
|Month 6||204 customers|
The break-even computation indicates that the company will only break even on the 5th month, and even turn a profit by then. Take a look at the summarized table below.
|Month 1||Month 2||Month 3||Month 4||Month 5||Month 6|
The table indicates that the store will sustain a loss in its first 4 months. Somewhere halfway through the 5th month, it will reach its break-even point, and by the end of Month 5, will have turned up a profit.
Forecasting is one of the many activities that businesses cannot do without, and unit economics forecasting is seen as one of the key metrics and best tools for management to come up with decisions for its business operations. Thus, it is important for you to make unit economics as an integral part of your business model.
Performing financial analysis, or trying to see if your business engine is working as it should, will not be easy if you do not have a unit economic model in place. If you plan on taking your business all the way, and you have long-term goals for it, it is even more imperative to build your own unit economic model.
Unit economics will help management to perform pertinent calculations to ultimately reveal the viability of the business. Making management decisions is left in the shoulders of management, and they will need all the unit economic model as basis for their decisions.
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