Unit Economics - 1.docx

How to estimate your unit economics before you have any customers   

Understand your business model fully and forecast your transactional revenues and costs; Don’t forget to understand the cost of acquiring a customer and how this inputs into a transaction’s economics; Where you don’t have exact data estimate using some freely available tools and also ask around.

What are unit economics and how do you work them out? The purpose of working out your unit economics is to understand the revenue behaviour of your business on a ‘per unit’ basis. This means we want to understand how every transaction looks like with regard to revenue and cost. It’s a basic measure of how you propose to make revenue out of the thing (aka unit) you’re planning on selling. It’s worth remembering that units vary wildly for different businesses, so let’s consider these web-based examples: Example 1 is an e-shop selling T-shirts. 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:  

(sale price) - (manufacture cost + packaging cost + postage cost) (£35) - (£10 + £2 + £3) = £20

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. Example 2 is an affiliate website directing traffic at the T-shirt e-shop. 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: 

(£35 x 15%) = £5.25 of commission.

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: 

1000 UVs x 5% = 50 purchasers

We have already learnt that the affiliate takes £5.25 per purchase. So: 

(50 x £5.25) = £262.50 of revenue

The affiliate had £100 of cost, so that leaves us with: 

(£262.50 - £100) = £162.50 of profit

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: 

(£162.50 / 1000) = £0.1625 or 16p

So as you can see unit economics are very different for differing businesses.

Unit Economics vs Customer Economics? In the above section we talked about unit economics, but in some cases this doesn’t tell the full picture of how your business is going shape up. Let’s look at Example 1 again to really understand why this is sometimes the case and why we need to go a step further and understand the customer economics of the T-shirt e-shop. In theory the T-shirt shop is making £20 of profit per sale. This is a pretty rosy outlook, however we’ve forgotten to include any costs involved in acquiring the customer in the first place. Let’s consider that the T-shirt e-shop only gets customers through its affiliate partner in example 2. In example 2, above, we found out that the affiliate is taking £5.25 for every successfully transacting customer. So although the T-shirt eshop is making £20 per unit, it’s actually only making (£20 - £5.25) = £14.75 per customer. It’s a slight nuance, but an important one to appreciate. When you look at working out your unit and customer economics, you may find that your unit economics work out to be positive, however your customer economics work out to be negative (i.e. you have lost money after the customer has transacted). Don’t panic, whilst not perfect, this can be ok as long as you can estimate some sort of lifetime value effect for your acquired customers. Modelling lifetime value is covered in this article.

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.

What if I don’t know how much it’s going to cost me to acquire customers? In this scenario, you will need to estimate to your best ability using what data you have available. Some things to think about are:   

Have you asked someone who works in a competitive or similar industry? Have you used the Google Keyword Planning tool to understand the typical bids required to get clicks using paid search? Have you used Facebook Power Editor’s bid estimates to understand how much you may need to pay for a click for a certain audience on Facebook?

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.



Infrastructure service provider: There are instances when a provider’s service is made available in different geographical locations. Telecommunications companies, for instance, have their physical infrastructure, such as wireless towers and data centers, distributed in various places. It follows that each of these physical infrastructure come attached with significant capital investment. In this case, the unit is not just the customer, but also physical infrastructure itself. In cases where there are multiple units, it is advised that a core unit be identified, with the other units designated as secondary units.

Identify the Fundamental Unit Economics Once the unit has been determined and clearly pinned down, it is time to identify the exact unit economics of the business. 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.

Perform Calculations: Inflows and Outflows Now that you were able to identify your unit and the levels of unit economics applicable to your business, it is time to proceed to the calculations in order to build your unit

economic model. There are several inputs that are required in your calculations, and they are classified according to what you are calculating: inflow or outflow.

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

Who are your customers?

o

How many customers does the business have?

o

What do you do to attract new customers?

o 

What are you doing to foster customer loyalty and keep them coming back? Frequency of purchase or transaction by the customers

o

How often does the customer buy your product or service?

o 

What do you do to encourage customers to buy more frequently? Size of the transaction

o

What is the average transaction size?

o

How big is the order?

o

How many products or services are purchased or availed of?

o  o

What do you do to encourage customers to buy more? Price How much are you selling your product or service for?

o

How much is the customer paying for the product or service?

o

What pricing strategies do you have in place?

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 Capital Expenditures (CapEx) Capital expenditures are expenditures incurred by a company that has an impact on the future of the business as a whole. The most common CapEx transactions involve the purchase of fixed assets or a business segment, major repair or upgrade of a fixed asset that extends its useful life, or construction of a new fixed asset. 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 shortterm, 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.

Cost per Acquisition (CPA) or Cost to Acquire a Customer (CAC) This is the initial cost incurred by the business to acquire or recruit a customer. Its components include the variable costs of selling, marketing expenses and other costs that can be directly identified with activities that are aimed at acquiring customers and persuading them to purchase the company’s product or service. 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: 

Cost of investment in a search engine marketing campaign



Cost of advertising in social media networks (Facebook, Twitter) Let us assume that the company invested $1,000 in a search engine marketing campaign, and $500 in online advertising. At the end of the month, statistics showed that 450 visitors clicked on the offer from the marketing campaign, and 100 from the social media platforms. That means that the company has spent $2.72 ($1,500 / 550 visitors) for each visitor or potential customer. This is the Cost per Visitor. 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. Cost per Acquisition

= $2.72 / 40%

= $6.80

Marginal Operating Costs These are the ongoing costs incurred by the business to continue serving the customer (and keep him). In the case of an infrastructure business, it is the cost that is continuously incurred by the business to operate the physical infrastructure unit over its life. For example, it includes the cost of repairs and maintenance of the data centers and wireless towers over their respective useful lives.

Maintenance Capital Expenditures These are specifically applicable to infrastructure businesses and other similar entities that identified physical assets or infrastructures as their core unit. It is a reality that the value of physical assets decrease over time, so maintenance costs or maintenance capital expenditures should be factored into the unit economics of the business. Although the expenditures do not necessarily increase the life of the assets, they keep it operating while meeting a certain standard of quality already expected of the asset.

Perform Calculations: The Contribution Margin Using the inputs enumerated above, you will be able to start your calculations, starting with the Contribution Margin. 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. The key computations are as follows: Contribution Margin Contribution Margin Ratio

= =

Revenue – Variable Costs (Revenue – Variable Costs) / Revenue

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.

Contribution margin per bag

=

$100 – $65

=

$35

Total contribution margin

=

$12,500 – $8,125

=

$4,375

Contribution margin ratio

=

$ 35 / $100

=

35%

Perform Calculations: The Break-even Point In a customer-oriented business that has identified a customer as its unit, the breakeven point analysis will help them figure out how many customers are needed in order to break even, and then turn up a profit. The break-even point is the level of sales where the costs will equal the revenue, so that the company is neither earning an income nor incurring a loss. Continuing from the earlier illustration, the break-even point is computed as follows:

Break-even point (in sales)

=

Fixed Costs / Contribution margin ratio

=

$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.

Month 1

125 customers

Month 2

138 customers

Month 3

152 customers

Month 4

168 customers

Month 5

185 customers

Month 6

204 customers

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.

Month 1

Month 2

Month 3

Month 4

Month 5

Month 6

Sales

12,500

13,800

15,200

16,800

18,500

20,400

Variabl e Costs

(8,125 )

(8,970 )

(9,880 )

(10,920 )

(12,025 )

(13,260 )

Cont. Margin

4,375

4,830

5,320

5,880

6,475

7,140

Fixed Costs

(6,000 )

(6,000 )

(6,000 )

(6,000)

(6,000)

(6,000)

Income (Loss)

(1,625 )

(1,170 )

(680)

(120)

475

1,140

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. Performing financial analysis, or trying to see if your business engine is working as it should, will not be easy if you do not have a unit economic model in place. If you plan on taking your business all the way, and you have long-term goals for it, it is even more imperative to build your own unit economic model. Unit economics will help management to perform pertinent calculations to ultimately reveal the viability of the business. Making management decisions is left in the shoulders

of management, and they will need all the unit economic model as basis for their decisions.