Unit economics of the product

Article 7/34 about #productmanagement with a focus on Hard skills.

What is unit economics?

Unit economics is a method of economic analysis used to evaluate the profitability of a single business unit, such as a single product or customer. This method is particularly relevant for digital projects, as it allows you to determine how effectively each aspect of the business contributes to overall profitability.

A unit is a basic, revenue-generating unit that you can and want to scale.

The progress and success of any business is largely determined by managerial decisions that are made at the highest level. In order for these decisions to be correct, the key importance is the ability of the manager to think strategically, envisioning various scenarios of events. Unit economics is one of the tools that allow making informed predictions about the potential success or failure of an enterprise. This method includes the use of specialized mathematical calculations to analyze the current position of the company, which helps to determine whether it is on the path of growth or decline in efficiency, and accordingly make appropriate management decisions.

The development of unit economics has been greatly accelerated by the advent and spread of internet analytics. This progress made it possible to analyze in detail the effectiveness of various communication channels and the efficiency of sales funnels, which, in turn, influenced the development of business performance evaluation methods.

The key meaning of unit economics

The basic idea behind unit economics is that it provides a way to evaluate the profitability of each customer or unit of product (unit) in the context of the overall flow. This method makes it possible to determine how much profit or loss each unit generates, taking into account the costs incurred by the company. By analyzing this data, the overall profitability of the flow can be ascertained and decisions can be made about scaling the business, attracting investment, increasing customer flow, or improving transaction margins.

A unit within this approach can be not only a paying customer (which is typical for SaaS projects), but also, for example, a new user in mobile applications and games or a subscriber to newsletters and product demos in online publications and services. It is important that the unit economy can be adapted to different types of business, where each unit has its own specificity in the context of the value it brings.

Why do we need unit economics?

Unit-economics is essential for a wide range of business stakeholders, including investors, senior managers and business owners. This method allows you to:

1. Determine the number of customers to reach the break-even point: Understanding how many customers are needed to cover the company’s expenses.
2. Calculating the Cost of Attracting One Customer: Evaluating the effectiveness of marketing and advertising investments.
3. Assessing the value of a product or service: Analyzing cost recovery and determining the optimal price for products or services.
4. Analyzing the effectiveness of customer acquisition channels and marketing strategies: Identifying the most effective methods of customer acquisition.
5. Evaluating the potential to grow and scale the company: Understanding how profitable and promising it is to scale the business.

When should you consider the unit economy?

• If you are looking for investment to grow your business.
• When you have plans to scale your business.
• If you are launching a startup and want to evaluate its potential.
• When most of your costs are related to marketing and advertising.

How do you define a “unit”?

In the business world, the concept of “unit” can encompass many aspects: users, customers, sales of goods or services, transactions. The basic rule is to choose a unit depending on the company’s goals: what do we want to scale?

It is also important to consider the company’s business scope. For digital projects, it is appropriate to evaluate the profitability of each user or subscriber, while the owner of a cafe is more relevant to the cost of a dish and other parameters.

Keep in mind that the choice of unit also affects the metrics and formulas for calculating the profitability of a business unit. For example, if we are talking about a subscriber unit, it is important to take into account its LTV (Lifetime Value) — a forecast of the total profitability that the user will bring over a certain period, as well as CAC — the cost of attracting a customer. In the case of goods and services, the focus is on margins: revenue minus all the costs of producing or providing the service.

Fundamentals of microeconomics

The fundamentals of unit economics often draw on the principles of managerial accounting and microeconomics. It is based on the basic formula of microeconomics — the profit formula:

Profit = Marginal Profit — Fixed Costs

Marginal profit = Revenue — Variable costs

Profit = Revenue — Variable Costs — Fixed Costs

All subsequent work on unit economics builds on these three formulas. If marginal profit exceeds fixed costs, the business can be considered successful. In the simplest case, variable costs are equal to the cost of the product.

Marginal profit of 1 product = Price — Cost of sales

Total marginal profit is defined as the total number of products sold multiplied by their price minus cost of production.

To estimate the profit or loss per unit of goods, the following formula is used:

Sales Price — Costs = Profit (Loss)

This is a simple way to determine how many sales you need to make for the business to start making a profit. The breakeven point formula is also used:

Fixed Costs / Profit per 1 sale = Number of sales needed

It is important to note that this formula is suitable for businesses that monetize through the sale of individual products, such as online stores.

Let’s consolidate the material we have learned

To internalize the concept of unit economics, it is preferable to use simple language, avoiding redundant terms and complexities. Otherwise, we risk complicating what may actually be simpler.

Breaking down high-level metrics into components is a useful exercise, but its value comes in the context of specific tasks. It’s more effective to analyze with specific goals in mind, rather than trying to hold all business models to the same standard.

Let’s think a little bit, for example let’s compare 2 cases:

1) We invested $1000 in campaign X and it generated $2000 profit.

2) Campaign X attracted 100 users. The cost for each of them was $10. The conversion rate to the first purchase was 10%. The average paying user made 3 purchases of $100, which generated $300 in revenue. The cost of the product was $33.3.

Both cases say the same thing. In the first case, it’s easier to understand what’s going on. In the second, however, it is much more complicated, even though there appear to be levers on how to influence the process described.

Unit economics is simple. It is only necessary not to complicate it.

The main task of any theory is to make the basic elements as simple and as few as possible without sacrificing an adequate representation of what we observe in practice.”

Calculation

On the examples we have shown how the indicators of positive unit economy look like, but it can also be negative. Therefore, let’s go through the formulas that can be used to calculate the unit-economy indicators on our own.

First, let’s take a closer look at the indicators:

• CAC (price per customer) = Advertising budget per channel / Number of customers from one channel.
• CPR (cost per registration) = Advertising budget / Number of registrations from a particular channel.
• ARPC (average check) = Amount of purchases / Number of purchases.
• LTV (LTV) = Average check Number of purchases per period Profit per purchase * Average “joint lifetime value” of the customer and the company.
• APC (average number of purchases from one customer).
• CPA (cost per visitor) = Cost per customer * Conversion
• CV (conversion rate).
• UA (number of visitors).
• COGS (Cost of Goods Sold) = Inventory (beginning of period) + Production Costs — Inventory (end of period).
• OE (operating expenses) = (OR for the period / Sales revenue for the period) * 100%.
• ARC (average customer retention cost) = Retention budget / Number of visitors.
• ACS (average cost of customer service per month).
• MRR (monthly revenue per customer).

Let’s consider a very simple and primitive variant

1. Determining key metrics:

Customer Acquisition Cost (CAC): The sum of all marketing and selling costs divided by the number of customers engaged. Customer Lifetime Value (LTV): The total revenue a company can expect from a single customer over the lifetime of the relationship.

2. CAC Calculation:

Example: If a company spent $10,000 on marketing and attracted 100 new customers, CAC = $10,000 / 100 = $100 per customer.

3. LTV Calculation:

Example: If the average customer spends $50 per month and stays with the company for an average of 2 years, then LTV = $50 12 months 2 years = $1,200.

4- Unit Economics Analysis:

If LTV ($1,200) is significantly higher than CAC ($100), Unit Economics is considered positive. This means that every customer brought in makes the company profitable. If CAC exceeds LTV, the company loses money on every customer brought in, which is unsustainable for long-term growth.

5. Decision making based on Unit Economics:

When Unit Economics is positive: Investing in scaling sales and marketing. When Unit Economics is negative: Need to revise sales strategy, reduce CAC, increase LTV through product improvement, increase customer retention or increase average check.

This case study can be adapted depending on the specifics of the digital product and the data available. It is important to review these metrics regularly as they can change as the product grows and evolves.

Let’s look at a more complicated option

Let’s build a more complex Unit Economics model for a digital product using concrete numbers. The example will include calculating key metrics and analyzing their relationships.

1. Key metrics and assumptions:

• Customer acquisition cost (CAC): $150.
• Average monthly revenue per user (ARPU): $30.
• Profit margin: 70% of ARPU.
• Customer Retention Rate (Retention Rate): 90% per year.
• Average Customer Lifetime: calculated on the basis of Retention Rate.

2. Customer Lifetime calculation:

Customer Lifetime = 1 / (1 — Retention Rate). In our case: 1 / (1–0.90) = 10 years.

3. LTV Calculation:

LTV = ARPU Profit Margin Customer Lifetime. LTV = $30 0.70 10 = $210.

4. analyzing Unit Economics:

Comparison of CAC ($150) and LTV ($210). Calculation of break-even point and sensitivity analysis.

5. Calculation and Analysis:

Since LTV ($210) is greater than CAC ($150), the model looks profitable. Breakeven point: $150 / $30 = 5 months (need to keep the client with us for at least 5 months to cover CAC).

6. Analyze customer segmentation:

Suppose we have two customer segments:Segment A with CAC $100 and LTV $300. Segment B with CAC $200 and LTV $180. For segment A, the model is very profitable while segment B is unprofitable.

7. Optimization Strategies:

Focusing on segment A. Finding ways to increase LTV or decrease CAC for segment B.

8. Monitoring and Adaptation:

Regularly reviewing metrics and adapting strategies according to changes.

Tricks for working with the unit economy

To maximize the benefits of working with unit economics, consider the following tips:

1. Take advantage of online resources for calculations. You’ll find many tools that can perform the calculations for you by searching for “unit economy calculation.” Simply enter your data.
2. Analyze advertising costs carefully, as they have a significant impact on your profits. Evaluate each advertising channel.
3. If you have different products or services, calculate unit economics for each of them separately.
4. Conversion, though not directly measured, is important to your bottom line. Work on improving this metric
5. If you have a loss in your current calculations, determine the period when you can move into profit (CAC / MRR — ACS).
6. Remember that LTV should be 3 times the cost per customer. This way you will cover costs, ensure profit and leave a margin for future growth.
7. In this business, accuracy and specificity are valued, so use only data from calculations and analysis of indicators, do not limit yourself to estimates “by eye”.

https://www.youtube.com/watch?v=-ODjy8Ogp3U

Publications

• Don’t Scale an Unprofitable Business: Why Unit Economics (Still) Matter
• Guide to Unit Economics
• Business Decisions & the Economics of One Unit
• My product management toolkit (25): understanding the “unit economics” of your product
• Unit Economics: A “Must Have” at All Stages of a Startup

Books

https://www.amazon.com/Business-plan-template-example-business/dp/1519741782

Summaries

Unit-economy parsing is a task that requires attention to detail and the ability to unravel complex aspects. Questions often arise: which “unit” should be chosen for analysis in a product? Where should more complex formulas be used and where can simpler formulas be used? How to correctly interpret metrics and draw valid conclusions? Despite the difficulties, the ability to analyze unit-economics is a must for those who aspire to become a product manager or develop in the field of information technology. These skills will not only help you understand how to improve a product, but will also make you a valuable player in the industry.

Unit economics is a key tool to understand how profitable our business model will be in the future. It allows us to assess our current state and make an important decision: to move forward and climb to the next level in the market or to adjust our strategies to improve performance.