What is unit economy?
Konstantin RnD
???? IT Lead Product manager | B2B | B2C | Digital | Mobile and Web Apps | R&D |
Magical guide about?#productmanagement?. Part 7 article #53
Unit economics?is an economic analysis tool that allows you to calculate the profitability of a business by aggregating “units”. In simple words, with the help of unit economics, we can find out how much we earn on one unit or lose from it. Also, the unit economy helps the enterprise to track its viability, and not to hope for luck. Let’s explain the features of this method in human language. You will have to count a lot, but the data obtained will help you predict profitability, understand how to develop a business, how many resources you need to invest, and what you can refuse.
The unit economy was invented by American investor David Skok. He invested money in startups, but before that he needed to understand what and how this company would earn. At first, startups filled out multi-page forecasts: they wrote how many customers were waiting, who their customers were, and why customers would pay.
But it is very difficult to write such forecasts for a new business. Imagine a bakery that plans an assortment for the opening day. She needs to answer the question: how many buns to bake so that everyone has enough, but it remains at a minimum. A bakery can go to a similar bakery on the next street and ask: how many customers did you have on the first day? a hundred? and how many buns did they buy?
You can collect information on several bakeries and understand what to prepare for. But if a company launches a new product and nothing like this has happened before, how does it know who its customers are, how they will pay and what expenses are planned.
When investors asked for multi-page reports, companies at some point began to invent figures, and this was no good. Investor David Skok thought and reversed the principle of counting: there was a unit of goods, there was a person.
Why do we need a Unit-economy?
Unit analysis is useful for a large circle of stakeholders: investors, top managers, company owners. With the help of unit economics, we can:
What is a unit?
Depends on the business. Don’t look for general rules and don’t look at others. Be guided by common sense and the specifics of your business.
A unit is a basic, revenue — generating unit that you can and want to scale.
If you produce and sell a product, a unit is a unit of production. If there is a subscription model or frequent repeat purchases, the unit is a client. Consulting services — contract. Outsourcing /outstaff with the sale of resources by the hour — man-hour. Etc.
There may be nuances here, because businesses are different. Suppose you manufacture and sell equipment, and you sell the equipment itself at a loss, but you earn on the commissioning service. In this case, the unit will be a contract for the supply of equipment with the service.
If you sign a contract for equipment maintenance with annual prolongation, then it would be more logical to take a client as a unit.
Example
The city cafe chain plans to open a subscription lunch delivery. In their case, a unit is a client that generates income, i.e. a subscriber. If the subscriber brings in more money than the cafe spends on attracting him, preparing lunches for him and delivering, then the model is profitable. Therefore, it is required to calculate how many subscribers there should be in order for the new service to pay for itself.
Here is the basic calculation of the unit economy, which demonstrates the viability of the business model:
LTV (lifetime value, lifetime customer value) / CAC (Customer acquisition cost, customer acquisition cost)
It is better to take a client for a unit. Products or services are counted as a unit when there is no accurate data about customers. And this method will give a less realistic picture.
Let’s say a unit is considered a unit of goods. In this case, the one who made the purchase falls out of the formula. Businesses will see fluctuations in sales, but why did they happen? Will the situation change if we increase advertising? All hypotheses will be controversial, because the business is essentially missing the circumstances of the sale.
How the unit economy influences decisions
The company “Uber” appeared in its usual form, because the initial unit economy did not converge. The founders of the company wanted to reach as large a segment of the market in New York as possible, but for this they needed to offer something that no one else has. It is impossible to offer only low prices, the market is limited: there is a limit to the number of customers, and they will not cover the investment.
So, it is necessary to expand the market — for this you need to go outside the city. But for people to travel with them, prices should still be low. This means that it is necessary to cover as many cities as possible so that in total customers bring profit. And to reduce the cost of investments: private drivers, not taxis, will drive, and this is minus the cost of a license.
Uber could stay within the borders of New York; set high prices to recoup investments; try to compete with taxi companies. But they had an idea to make trips cheap, and they came up with a way to preserve the concept and make the economy converge.
How to count a Unit?
Define a unit.
Calculate how much profit or loss this unit has brought. It is important to take into account all expenses and income associated with the unit.
That’s it, that’s enough.
So, let’s calculate the unit economy of one client of the company “Salmon”. To do this, first we will calculate how much we spent on attracting him, and then how much we earned from him.
We calculate how much we spent on attracting a client using the formula:
All costs per customer / number of customers = how much was spent on attracting one customer.
Substitute the numbers:
500,000 rubles / 100 clients = 5000 rubles is worth one client.
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How much did you earn using the formula:
Gross profit from customers / number of customers = how much you earned from one customer.
Here, gross profit is the difference between revenue and the cost of the service. We do not take into account fixed costs in the cost price.
Substitute the numbers:
1,000,000 rubles / 100 clients = 10,000 rubles brings one client.
It turns out that we spend 5,000 rubles to attract a client, and we earn 10,000 rubles from him. However, we admit, this rarely happens in life.
We have given an example of the basic calculation of the unit economy for the client, as well as for the product: they calculate the cost, profit and correlate.
In the client’s unit analysis, the economy is not counted to a penny, and the company’s fixed costs are not taken into account. Because it doesn’t matter — it’s important to understand in general whether the business is profitable or not. The fact is that fixed costs change more slowly than the number of customers and sales revenue.
Only the costs associated with sales change — variables. For example, bank acquiring or interest to the sales manager. The more sales, the more these expenses. So they are taken into account.
What indicators to track
The formula we used above shows whether the company earns from one client or not. But it does not show why the company has a loss or how it can grow further. And here there are additional add-ons to the main formula, they are called metrics. We have collected the main:
The formula we used above shows whether the company earns from one client or not. But it does not show why the company has a loss or how it can grow further. And here there are additional add-ons to the main formula, they are called metrics. We have collected the main:
Metric: Cost per customer:
What does it mean: How much does the company spend per person
How to count: Advertising budget per channel / number of clients from this channel
Metric: The cost of one registration
What does it mean: How much does the company pay for a potential client to register on the site
How to count: Advertising budget per channel / number of registrations from this channel
Metric: Average check
What does it mean: For what amount, on average, customers buy at a time
How to count: Amount of orders / number of orders
Metric: Average revenue per customer
What does it mean: How much the company earned on average from one client
How to count: Revenue for the period / number of customers
Metric: Customer’s Vital Value
What does it mean: How much the client brings in money for a period — it can be a month, a year or since the first acquaintance with the company
How to count: Average receipt * number of purchases for the period * gross profit from the purchase
Metric: Conversion
What does it mean: The person who viewed the site is a potential customer, and who bought the product is already a customer. Conversion shows how many potential people become real customers
How to count: (Number of buyers / number of potential buyers) * 100%
Each metric works by itself and in combination with others.
Conclusions
Counting the Unit-economy is not an easy task, often a large number of nuances come up that seek to prevent the receipt of figures relevant for analysis: what should I choose as a “unit” in the product? where is it necessary to apply a complex formula, and where can a simplified one be dispensed with? how to draw conclusions from metrics correctly?
Nevertheless, if you are applying for a product position or are striving to develop in the IT field, you cannot do without the skills of calculating the unit economy.
Thank you for your attention ??