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This one is pretty straightforward. In this example a T-shirt costs £10 to manufacture,
£2 to package and £3 to ship. All the T-shirts on the website cost £35. In this case
the unit economics work out to be:
So for every T-shirt sold in this example we’re taking £35 of revenue which breaks
down into £15 of cost and £20 of profit. That means that on a per unit (in this case a
T-shirt) basis we’re making £20.
This example is a bit more complicated. To understand the unit economics of this
business we need to understand how the affiliate website makes money. This
affiliate sends traffic to the T-shirt website and then receives a commission from
every successful transaction of 15% of the total revenue. So for every T-shirt sold
the affiliate would receive:
However this doesn’t tell the whole story. The affiliate is directing a lot of traffic to the
T-shirt website and only a percentage of the traffic will buy a T-shirt. So although the
T-shirt shop has units of T-shirts, the affiliate website is actually dealing in different
units. In this case the units for the affiliate are unique visitors (UV). This is then how
it breaks down: The affiliate spends £100 on advertising which attracts 1000 UVs to
the T-shirt site. Only 5% of the visitors convert to purchase:
We have already learnt that the affiliate takes £5.25 per purchase. So:
We then need to divide this profit number by the number of units involved here,
which is the UV number. Therefore, on a per unit basis the affiliate is making:
So as you can see unit economics are very different for differing businesses.
Once you know your CAC and LTV, you can make the call on how
each additional user impacts your business. If your CAC ratio,
which is your LTV divided by your CAC, is 1.5x, you are generating
50% more than you are spending to acquire that user. Is this good?
The answer depends on your business’s specific situation. A CAC
ratio < 1 may be fine for your first 10 months if you have reasonable
plans to improve it and enough in the bank. But if it’s under 1 and
you have 3 months of cash in the bank with no plans for
improvement, you’re in trouble. Some businesses target a CAC
ratio of 3x. Others are happy if they are over 1, with plans for
improvement, money in the bank, and growing.
This will give you some idea of the costs to acquire users to your product, however
you’ll have to then estimate some conversion rates on your (maybe unbuilt) website.
Some sort of benchmarking should be used to estimate conversion rates. Typical
web ecommerce visitor to purchase conversion rates usually vary from 1% to 3%,
and up to 5% for deal or offer led sites (but be aware that this will vary by vertical). A
bullish landing page sign-up conversion rate would be around 30%, but will decrease
with the number of form fields required. With all of these benchmarks, you should
probably underestimate the conversion rates of your product against these as your
product will probably be at the minimal viable product (MVP) stage and as a result
not fully conversion optimised.
UNIT ECONOMICS ANALYSIS
Identify the Unit
We have already determined that unit economics figures are expressed on a per unit
basis. Therefore, the first thing you should do when it comes to analyzing a company’s
unit economics is to pick, determine, or identify the unit.
The “unit” is the fundamental business measurement, and it will depend on the nature of
the company or business operations. Here are some examples:
Merchandising or manufacturing company: Usually, the unit is the customer, but the
unit can also be based on a product segment. Therefore, one customer is one unit. A
bag retail store’s unit is a buyer, while the unit of a shoe manufacturer is a purchaser of
shoes.
Service provider: One client represents one unit. The unit of an internet service
provider is a user.
The examples above described companies with single units. That is not a fixed setup,
though, since there are some businesses that have multiple units.
One of the examples previously mentioned was the internet service provider. This
company’s unit is the user, and it has two fundamental unit economics:
Cost to acquire or recruit one user (or the Cost per Acquisition). This answers the
question, “how much will the company spend in order to get one user to avail of its
internet service?”
The amount of revenue generated from one user for the entire length of time that he or
she avails of and uses your internet service. This is also called LTV, or Customer
Lifetime Value.
In the case of a retail store, its unit economics will be concerned with the amount of
revenue generated every month for every active buyer that it was able to acquire or
recruit. Some express it as “average monthly revenue per customer” or “average weekly
revenue per customer”, depending on the period used by the company for its unit
economics analysis.
1. Inflow inputs
Revenue
Revenue refers to the receipts or income that a company receives and earns from its
normal operations or business activities, be it the sale of products or of services. While it
is true that there are also revenue derived from non-operating sources, these are often
one-time events only and non-recurring. Thus, they are not usually considered when
analyzing the profitability and financial performance of a business.
For easier understanding, it would be a good idea to present in relative detail the various
revenue drivers of the business. The most common revenue drivers include the
following:
The customers
o What are you doing to foster customer loyalty and keep them coming back?
Frequency of purchase or transaction by the customers
Duration
This input refers to the usable life of the unit that you have previously identified.
In the example where the unit is the customer or the user, the duration is the average
customer or user life or lifetime. In the telecommunications company example, the
duration is the useful life of the physical asset (wireless tower or data center) that was
set up.
It could be expressed in months or years, depending on the coverage or period you want
to analyze your business viability.
2. Outflow inputs
A clear distinction must be made between CapEx and Revenue Expenditures. Revenue
expenditure are the operating expenses that are incurred by the business over the short-
term, most often over the normal operating cycle of the business, and do not essentially
prolong the life of assets or their usability.
For example, the construction of a new factory building is a capital expenditure; the
salaries of the cleaning staff of the building are revenue expenditures. Replacement of
the roof of the factory building will fall under capital expenditures; the repair of a couple
of broken roof tiles will be classified as revenue expenditures.
The costs will depend on the customer lifecycle or conversion behavior, so they will
naturally vary from industry to industry and company to company.
In the example of an internet company that sells applications and widgets, the CAC will
include the following costs:
Out of the total 550 visitors, 200 purchased a widget or an app from the company. Those
200 visitors have been successfully converted into customers. This means that the
company has a conversion rate of 40%, computed by dividing the 550 visitors by the 200
purchasing customers.
To get the final CPA or CAC, divide the cost per visitor by the conversion rate.
The Contribution Margin is the figure that represents the amount that the company’s
revenues will contribute to its fixed costs and net income, after all variable expenses and
costs have been deducted. Another simple description of it would be as the amount of
cash that a unit contributes to cover the overhead and other fixed expenses of the
business.
Contribution margin is especially important in unit economic models – and all business
models as a whole – because it is also a representation of the profitability of individual
products, of entire product lines or business segment, and of the whole business.
By computing the contribution margin, you will be able to know the number of months it
would take for a unit to produce a positive contribution margin.
Illustration:
The bag retail store’s unit is a single customer. It has been determined that one
customer purchases an average of one bag per month, at an average price of $100. On
average, a customer remains loyal to the store for 12 months. For the first month, there
were 125 customers, increasing by 10% in the succeeding months. The computed
variable cost per bag is $65, while the store incurs monthly fixed expenses of $6,000.
Continuing from the earlier illustration, the break-even point is computed as follows:
= $6,000 / 35%
= $17,143
In order to break even, 172 customers should purchase one bag at $100 at the store
($17,143 / $100 per bag = 172 customers).
From the assumption stated, the following figures can be estimated as to the number of
customers per month.
The break-even computation indicates that the company will only break even on the
5thmonth, and even turn a profit by then. Take a look at the summarized table below.
The table indicates that the store will sustain a loss in its first 4 months. Somewhere
halfway through the 5th month, it will reach its break-even point, and by the end of Month
5, will have turned up a profit.
CONCLUSION
Forecasting is one of the many activities that businesses cannot do without, and unit
economics forecasting is seen as one of the key metrics and best tools for management
to come up with decisions for its business operations. Thus, it is important for you to
make unit economics as an integral part of your business model.