Why understanding unit economics is important to your business
In one of my favourite management books, Good to Great, author Jim Collins praises what he calls the hedgehogs – those people who can “simplify a complex world into a single organizing idea, a basic principle or concept that unifies and guides everything.”
One such basic concept is unit economics.
You hear the term tossed around a lot, but many startups don’t take the time to understand its significance to their business.
This could be a real mistake.
So what is unit economics and why is it so important?
Unit economics looks at the direct revenues and costs associated with the most basic element of a company’s business model. From this data, it is possible to project how profitable the company may be (or not), and when it can expect to reach profitability.
And profitability is a pretty important measure of success.
The first task is to identify your basic unit – the one fundamental thing you can measure and that reflects how you operate.
This may not always be obvious.
At Klipfolio, we use the customer account as our basic unit. Other companies may choose a different unit. An airline might look at seats sold, for example.
Once you have chosen your basic unit, the next step is to calculate a) how much revenue you derive from that unit and b) what it costs to achieve that revenue.
On the revenue side, a commonly used term is lifetime value or LTV. It’s how much you can expect to receive from a single customer account over the lifetime of that account with your company. If you are running a subscription business, using this sales metric is not optional.
As a refresher, to calculate the lifetime value of a customer, you need to know your gross margin, your monthly churn percentage, and how much each customer spends on average each month.
Lifetime Value = Gross Margin % X ( 1 / Monthly Churn ) X Avg. Monthly Subscription Revenue per Customer
So it is not just a simple accounting calculation.
On the cost side, the most commonly used term is customer acquisition cost (CAC). Generally this includes the total sales and marketing costs (salaries, programs, campaigns - everything) to acquire a single customer.
Cost to Acquire a Customer = Sales and Marketing Costs / New Customers Won
You now have two important building blocks for your business - your unit economics - and can start applying them.
David Skok, a serial entrepreneur turned venture capitalist with Matrix Partners, stresses the importance of focusing on lifetime value and customer acquisition costs (LTV and CAC) by expressing them as a ratio - the LTV:CAC ratio.
Ideally this ratio should be at 3:1 - your customers are contributing three times more value than your cost to acquire them. If this ratio is too lean, you need to step on the brakes and look at either the efficiency of your sales and marketing team, or the value and staying power of your product.
He also emphasizes the importance of shortening the payback period – the number of months it takes to pay off the cost of acquiring a customer and begin generating profit from the account. This is really important, but often overlooked in a world of over-capitalized companies. The faster your company can do this, the more capital light you will be, and the more cash will pile up early in your journey.
(In a recent blog, I pointed out how important it is for a startup to watch its cash in the current business environment.)
Using unit economics, you will be able to pinpoint your cash flow over any financial operating period. In fact, you can use the data as a basis for your short-, medium- and long-term financial plans.
Unit economics, at any point in time, can give you a reading on the state of your business engine. Is it time to step on the gas, coast, or tap the brakes?
Perhaps the most valuable benefit of undertaking a unit economics analysis is that it helps you to understand your own business better.
It forces you to look at different strategies to increase the LTV and decrease the CAC.
For example, you could increase your LTV by adjusting your pricing model. Unit economics can help you do A-B testing, a subject I will be addressing in future blogs.
To decrease your CAC, you might want to look at ways to increase your virality or to improve the effectiveness of your marketing engine.
One last piece of advice – don’t shortcut the process.
Done properly, a unit economics analysis will highlight opportunities, expose gaps, and direct you to optimal strategies for maximizing your profit.
What you learn can be re-examined, re-tested and reused, since it should be an ongoing process. So take the time to do it right.
Allan Wille is a Co-Founder and Chief Innovation Officer of Klipfolio. He’s also a designer, a cyclist, a father and a resolute optimist.