What is unit economics?
Unit economics is a model that calculates and evaluates a business's profitability based on the profitability of a single business unit (the one which generates the income). In layman's terms, unit economics allows you to see how much profit each unit makes. The unit itself can be a customer, a product, a service, a transaction or a single sale. So, for example, if you are a school teacher and want to know how much money you make from one student, unit economics will help you find that out.
In business, unit economics for a startup or a product unit economics is indispensable because it allows you to conduct an analysis and find out:
- how much money you need to spend to attract a client or sell a product;
- how many units are required to make a business profitable;
- how much the units have to cost to earn its keep;
- how successful marketing campaigns to promote these units are;
- how much growth potential the business has.
The key indicators of the unit economics will also be useful to investors in evaluating the business and making financing decisions. For example, thanks to the unit economics, it is possible to see whether investing in a company will lead to losses. It can also help find out what kind of profit the business will generate in a month and what kind of profit it can ideally generate in the future. Similarly, the unit economics of the project and the effects of the measures introduced get calculated.
Unit economics metrics
You must first calculate the metrics in a unit economy. Typically, consider the following metrics:
- The CAC (customer acquisition cost). You calculate this as the advertising budget per channel / the number of customers from that channel.
- The CPR (cost per registration) = the advertising budget per channel / the number of registrations per channel.
- The ARPC (average revenue per client) = the total amount of purchases / the number of purchases.
- The LTV (lifetime value) = the average check * the number of purchases in a given period * the average return on purchase * the average customer lifetime.
- The CPA (cost per action) = customer cost * conversion.
- The COGS (cost of goods sold) = inventory (beginning of period) + production cost of goods – inventory (end of period).
- The ARC (average retention cost) = retention budget / the number of visitors.
- The OE (operating expenses) = (OE for a certain period / sales revenue for the same period) * 100%.
- The ACS (average cost of service).
- The MRR (monthly recurring revenue).
- The APC (average propensity to consume).
- The CV (conversion).
- The UA (user acquisition).
If needed, you can also add or omit several other unit economy metrics, depending on your situation and purpose.
Unit economics calculation
You can apply the unit economics formula in different cuts (e.g., per cohort or per product). That is why they have many variations that can be converted and combined. However, all variations get based on two basic formulas that allow for the calculation of marginal profits:
- The profit per product = UPS (price at the time of sale per product) – CPA (customer cost) – COGS (product cost) – OE (operating expenses).
- The profit per customer for the period = (ARPC (average check) * APC (average number of purchases)) – CPA (customer cost) – COGS (product cost) – OE (operating expenses) – ARC (average retention costs).
You can also use ready-made formulas to solve specific problems in the future:
- To determine how much cost goes per unit in the development phase, including the price of customer engagement, project development, marketing campaign, etc. The formula is: CAC = AC / U, where AC is the unit development cost and U is the number of units.
- To find out the total cost of acquiring, maintaining and promoting a unit. The formula is: CPA = AC/B, where AC is the cost of developing a unit and B is the number of units that produced the result.
- To find out the average revenue over the period per unit. The formula is ARPU = R/U, where R is the overall revenue, and U is the number of units.
- To find out the unit's generated revenue for all time. The formula is: LTV = (ARPPU – CAC – COGS) * B, where ARPPU is the profit per customer, B is the number of units that brought the result, CAC is the price per customer, and COGS is the cost of goods sold.
There is a special unit economics calculator for quick computations called Unit-calc. You can also use an Excel spreadsheet and its built-in algorithms for this purpose.
Unit economics examples
Let’s analyse an example of using unit economics in marketing to determine the most effective channel for promoting units in an online shop. The initial data is as follows:
- A total of $70,000 was spent on contextual advertising, resulting in 420 leads with 250 orders.
- $30,000 got spent on targeted advertising. The result was that the targeted advertising brought 280 leads. In total, they placed 100 orders.
To briefly calculate the effectiveness of each channel, we do the following:
- Contextual advertising effectiveness = $70,000 / 420. We get $166.6. Only 250 out of 420 were converted into real customers. So, we calculate the following: 250 / 420 * 100 = 59.5%. In this case, the cost of attracting one unit is calculated as follows: 166 / 59.5% = $279.
- Targeted advertising effectiveness = $30,000 / 280, which results in 107.1 dollars. Out of 280, 100 were converted into customers, so the formula is as follows: 100 / 280 * 100 = 35.7%. The price to attract one unit in this case is calculated as follows: 107.1 * 35.7% = $300.
Based on these calculations, it turns out that contextual advertising is the most advantageous promotion option for the shop, as its conversion rate of 55.5% is higher than that of targeting. This calculation disproved the shop owners' misconception in the contrary, as it showed that ad spending is not what you should rely on when choosing a channel. Sure, leads from targeting are cheaper. However, contextual advertising has cheaper customers, which is why this channel wins.
You can learn the fundamentals of unit economics with appropriate training. Also available today are books or a special course, one of which, for example, is offered by Lectera.