Unit economics: how to calculate it and evaluate business success
Unit economics helps a company track its viability instead of relying on luck. Let's explain the peculiarities of this method in layman's terms. It requires a lot of calculations, but the obtained data will help predict profitability, understand how to develop the business, how much resources to invest, and what can be dispensed with.
Unit economics helps calculate the profitability of one customer or product of a company. These are units. If the income from one unit does not cover the costs associated with it, it's time to sound the alarm. However, if the unit economics method is applied, it is likely that it will be possible to find out where the profit is being lost.
What is unit economics?
Unit economics is a method of calculations that helps evaluate the profitability of one unit (unit, in English - a unit of measurement). One unit can be a unit of goods or one customer. Traditionally, the method is used to evaluate the profitability of a company and its scaling prospects. Therefore, the metric is associated with startups, although it is suitable for most types of businesses.
Example
A city cafe network plans to launch a subscription-based lunch delivery service. In their case, the unit is a customer who generates revenue, i.e., a subscriber. If a subscriber brings in more money than the cafe spends on attracting them, preparing their lunch, and delivering it, then the model is profitable. Therefore, it is necessary to calculate how many subscribers are needed for the new service to pay off.
Here is the main calculation of unit economics, which demonstrates the viability of the business model:
LTV (lifetime value of the customer) / CAC (customer acquisition cost)
It is better to take a customer as a unit. Products or services are counted as one when there is no accurate data about the customers. And such a method will give a less realistic picture.
Suppose a unit is considered a unit of goods. In this case, the formula excludes the one who made the purchase. The business will see fluctuations in sales, but why did they happen? Will the situation change if advertising is strengthened? All hypotheses will be controversial because the business essentially misses the circumstances of the sale.
Why is unit economics important?
Unit economics has a reputation for being something complex that only the startup community understands, but that's not the case. The calculation helps to check the profitability of a business and understand whether the business model can be scaled. If the unit does not yield a profit or brings a loss, then there is no sense in expanding such a business.
The benefits of the method are universal for all types of businesses, from manufacturers to consulting agencies.
The company gains data to make decisions. This is useful for optimizing expenses, developing new products and services, as well as revising marketing. It is possible to test whether a new product or service will be profitable. Calculations help to increase the number of repeat sales, increase the average check, and conversion to purchase. A calculator and a table for recording are required for analysis based on unit economics.
What you need to know before the calculation:
There are two basic calculation scenarios:
Both formulas can be combined and do not contradict each other.
"User" and "client" are different categories of people.
Unit economics operates with English terms, which is why in Russia "users" and "clients" are often confused.
The trick is that a "user" is a person who knows about the product. If goods are sold through a website, a unique visitor is considered a "user". When a manager processes an application, the user who left it is recorded in the CRM system. Not all users become clients.
A buyer is a user who has made a purchase.
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Calculating unit economics using CAC and LTV
Let's calculate the cost of acquiring a customer (CAC).
CAC (Customer acquisition cost) is the cost of acquiring one customer. It is calculated using the following formula:
CAC = marketing expenses / number of acquired customers
It is important to note that all calculations are made within the framework of one cohort. In this case, a cohort refers to all customers acquired in one month. Therefore, marketing expenses for November are compared with those who made a purchase in that month. If cohorts are mixed, the data will be inaccurate.
Example:
In November, 1000 users came from Google advertising, and 28 of them made a purchase, while $350 was spent on advertising. Therefore, CAC = $350 / 28 = $12.5. $12.5 is the cost of acquiring one customer.
Calculation of Customer Lifetime Value (LTV)
This is the most labor-intensive indicator for calculations. The formula looks like this:
LTV = (AVp - VC x AVp) x RPR x Lifetime
Now let's explain each point:
AVp - Average order value. It shows how much customers spend on average per order. It is calculated as follows: total revenue / number of orders. Most likely, the business already tracks this metric.
VC - Variable costs. They increase proportionally to the volume of sales. This includes the cost of the product, acquiring, bank fees, taxes, etc. It is calculated as a percentage of the product's cost. For example, if variable costs make up 20% of the market value of the product, then VC is 20%.
Usually, delivery costs are not included in variable costs, as it is difficult to forecast them in advance. For example, when delivering products, a courier can make several deliveries in one trip, so the delivery cost is combined for them. However, sometimes each delivery must be made separately.
RPR - Repeat Purchase Rate. This is the number of purchases made by repeat customers on average within a year. You need to calculate the ratio of all repeat purchases to the number of customers who made those purchases. For example, suppose a company has 200 loyal customers who made 450 repeat purchases. Then, the calculation will be as follows: 450/200 = 2.25.
Lifetime - The average time during which a customer spends money on the company's services/products. For example, one customer makes purchases for an average of 3 years.
Let's calculate the LTV metric. The average order value for the company is $750 (AVp), variable costs are 20% (VC), the repeat purchase rate is 2.25 (RPR), and the average customer lifetime is 3 years. In this case, the calculation will look like this:
LTV = (750 - 20% X 750) X 2.25 X 3 = $3 037 500
This means that the average customer brings the business $3 037 500 in profit over their lifetime. For existing companies, LTV calculation will be most accurate with high-quality data: payments are counted, there are no rounding errors, and customer cohorts are not mixed. For startups, the metric will reflect a forecast that will be adjusted at launch.
It is generally accepted that an LTV to CAC ratio of 3:1 indicates the viability of a business model. Below this ratio is considered poor, while above it is considered excellent. At this stage, it becomes clear which advertising channels are the most promising. Investor David Skok was the first to mention these proportions, but his calculations were related to the SaaS model, which provides access to a service through a subscription. For example, this is how online cinemas operate. Later, the 3:1 ratio was applied to other business models as well.
Alternative calculations through ARPPU and ARPU
If a company does not have enough data to accurately calculate LTV, it is possible to build unit economics around the following metrics:
ARPPU - how much money on average one customer brings in over a certain period of time
ARPU - how much money on average one user brings in over a period of time without taking marketing expenses into account. Typically, both metrics use one month or one year as the "period."
To calculate average revenue per user taking into account advertising expenses, the following formula is used: ARPU - CPA (cost per acquisition of one user).