Decoding the Unit Economics of Subscription Business Models!

Have you noticed how subscription-based business models have taken over our lives? They're everywhere, from phone plans to streaming services, making things super convenient. But here's the thing, these business models aren't just good for us; they're also a game-changer for businesses. In this article, we'll dive deep into understanding the unit economics of subscription business models, explore the formulas behind them, and provide real-world examples to understand why they're a total win-win in today's economy.

The Deal for Us Consumers

Alright, let's talk about us, the consumers. Subscriptions are awesome because they make our lives so much simpler. No more wasting hours comparing different options or stressing about upfront costs. With a subscription, we make one decision and bam! We're good to go. Plus, having a fixed monthly price makes budgeting a piece of cake. We know exactly what we're paying, and there are no surprises. Convenience and predictability? Sign us up!

The Deal for Vendors

Now, let's put ourselves in the vendors' shoes. Subscription business models are not just about convenience; they're money-making machines when done right. You know why? Because we tend to stick around once we're subscribed. Switching takes effort, and most of us are too lazy to bother unless something goes terribly wrong. That's a win for vendors who can count on us staying loyal. Plus, the steady monthly revenue from subscriptions keeps their cash flow stable. No rollercoaster rides for them!

But is it all that easy??

There are certain criteria that need to be met by the unit economics of the business. Let's dive deeper into this.

Understanding LTV

The most important part of understanding unit economics is to look at the Customer Lifetime Value (LTV). LTV measures the value a customer brings to the business over their paying lifetime. It's calculated by multiplying the monthly value generated by paying customers with the customer months.

LTV = Avg. value customer generates over a lifetime = Monthly value generated * Customer months

The value can be defined differently for different businesses, e.g. most of the subscription businesses define monthly cashflow from a customer as "value".

LTV = Monthly cashflow per customer * Customer months = [Monthly recurring revenue (MRR) - Monthly recurring costs (MRC)] * (1/Churn)

For some businesses where MRC is negligible, they consider MRR itself as customer value. Let's understand these terms quickly.

• MRR is the monthly revenue generated from subscriptions.
• MRC represents the costs incurred by the business to maintain the subscription service. This includes operational costs, customer support, and infrastructure expenses. By finding ways to streamline operations and minimize costs, vendors can increase their profit margins.
• Monthly cashflow (MRR - MRC), signifies how much a vendor?clears?from a customer.?If this amount is low every month, it’s tough for a business as the margin of error is small.
• Churn refers to the rate at which subscribers cancel their subscriptions. It's essential for vendors to keep churn low (1% - 3% monthly) to maintain a stable customer base. Keeping customers engaged and satisfied is key to reducing churn. By lowering churn rates, the average customer lifespan increases, leading to higher LTV.

Let's calculate the LTV per subscriber for a local broadband internet company. If the monthly subscription price (MRR) for the service is ?1000, and corresponding costs (MRC) are ?600 per month, the monthly cashflow becomes, MRR - MRC = ?1000 - ?600 = ?400. Let, monthly churn to be 3%.

LTV = (MRR - MRC) * (1 / Churn) = ?400 per month * (1/0.03) months = ?400 monthly cashflow * 33 months = ?13200

This means a subscriber of this company keeps on providing ?400 monthly value for 33 months on average, and the total value added by him over the lifespan is ?13200.

Understanding CAC

Now let's have a look at Customer Acquisition Costs (CAC). CAC refers to what businesses spend to acquire customers. It includes marketing expenses, commissions, and other costs related to onboarding a new customer.

CAC = Cost of acquiring new paying customer = Marketing costs + Sales costs + Onboarding costs

Let's break down the components and derive the CAC,

• Marketing spend includes brand awareness and publicity-related expenses. Now, for our broadband internet provider, assume Ad spend per view is ?10, and the conversion rate for an Ad viewer to become a subscriber is 0.5%. So, the amount spent to acquire this subscriber becomes ?10 / 0.005 = ?2000.
• Sales commissions?vary significantly by the sales channel you employ. Assuming an average commission of ?1500 per customer for the door-knocking sales channel.
• Onboarding expenses depend on the type of service provided. In our example, suppose the internet provider is giving the Wi-Fi router and installation free of cost to its new users. Let's say this costs the company around ?1500.

Totaling all these costs up, we get the CAC.

CAC = ?2000 + ?1500 + ?1500 = ?5000

This means the company is spending ?5000 just to acquire a single new subscriber.

Making Sense of this!

Using the LTV and CAC values per subscriber we can derive the following metrics to get more insights into the viability of the subscription model.

Unit Economics Profit = LTV - CAC = 13200-5000 = ?8200

The Unit Economics Profit Margin provides insights into the profitability of each subscription customer, considering the associated costs and revenue generated.

Unit Economics Cost Ratio = LTV / CAC = 13200/5000 = 2.64

The Unit Economics Cost Ratio measures the cost incurred to acquire and retain a customer in relation to their Lifetime Value. Monitoring and optimizing this ratio allows us to make data-driven decisions to improve profitability and customer value. A Cost Ratio of more than 3 is considered very good. If we want to take this cost ratio from 2.64 to 3, we need to tweak the Monthly Cashflow, Churn (by ensuring retention), reducing CAC, etc.

Payback = CAC / Monthly Cashflow = 5000/400 = 12.5 months

The payback period is another important metric that tells about when the breakeven will be achieved. In our example, we will be recovering all the CAC by 12 months. Above this, whatever value is generated by subscribers goes into the company's profits.

Conclusion

Subscription businesses rely on a strong understanding of their unit economics to drive sustainable growth. Optimizing the Unit Economics Cost Ratio, Profit, and Payback allows us to strike the right balance between customer acquisition costs and the revenue potential of each customer.

By continually refining our customer acquisition strategies, reducing churn rates, and enhancing customer lifetime value through personalized offerings and exceptional service, we can maximize the profitability of our subscription business. This will not only drive financial success but also foster long-term customer loyalty and brand advocacy.