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Introduction to Unit Economics

  • Samiksha Paria
  • Dec 28, 2021
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There are certain things that people still miss out on while building up their firm. And a business person should always be well informed about all the essential stepping stones of business. And Unit Economics is one of the stepping stones. 

 

According to you, what are the two most essential things in a business? If you are thinking about costs and revenues, you are right. And in simple terms, Unit Economics deals with both Costs and Revenues. 


 

So, What is Unit Economics?

 


A given firm’s direct revenues and costs are quantified on a per-unit basis in unit economics, with a unit being any quantifiable object that adds value to the business. 

 

Calculating unit economics makes forecasting things like break-even points and gross margins easier. 

 

Even if they are unfamiliar with the term, most organizations undoubtedly utilize unit economics calculations on some level. However, taking maximum advantage of your unit economics needs a little more dedication and knowledge. 

 

For example, If we're talking about a retail store, unit economics relates to the monthly revenue generated by each consumer.

 

Let’s Talk about:-

 

What’s Gross Margin?

 

 

You get the gross margin when you subtract the cost of items sold from net sales. Gross margin can also be stated as a percentage, which is frequently used to compare firms of various sizes and industries. 

 

Companies prefer large gross margins because it means they can keep more capital per dollar of sales.

 

 

What do you understand when we say “Unit”?

 

On some level, a unit will always represent a consumer. However, how that is defined may differ. What matters most is that you use the term consistently in your own speech. 

 

Aside from that, your calculations will be helpful as long as you understand what units are and aren't calculating any meaningless parameters.

 

  • As a Customer:- If a large firm makes a purchase through your organization, they are likely to buy many memberships. They need to use your program for a vast number of employees. 

 

So, is the company a separate entity, or are the individual subscriptions? The firm is treated as a single unit in the units-as-customers approach.

 

  • As Products Sold:- The previous scenario is reversed in the units-as-products-sold concept. In the case of a SaaS firm, this means that each subscription is counted as a single unit. 

 

This is less prevalent with SaaS. Units as items sold are more common for material things since there are production costs per item to account for.

 

(Related Reading: 6 Levels of Startup Funding One Must Know About)

 

 

Importance of Unit Economics

 

The data derived from unit economics research is critical for a company's long-term and short-term financial planning. 

 

One of the critical differences between unit economics and other profit measurements is that it only analyses variable expenses and ignores fixed costs. 

 

Unit economics can assist in calculating the business's output level that must be running to cover fixed costs by simply considering variable costs. It's an essential part of the break-even analysis.

 

It's simple to illustrate why unit economics analysis is critical for new businesses. Startups can utilize unit economics analysis to attract and pitch venture capitalists as stakeholders during their company's growth phase. 

 

Some of the important factors are:- 


 

  • Product Optimization:- 

 

Product optimization is a term that refers to the process of improving a product. Unit economics can assist a startup in determining whether its product is overvalued or undervalued. 

 

It provides answers to questions like, is it really worth it to spend so much money on marketing? Are there any expenses that could be cut? Is it possible to improve the product in any way?


 

  • Sustainability of the Market:-

 

Because attention to detail is addressed, unit economics can accurately predict the product’s future potential. It is especially useful to startups who make the most of it in the early phases of their operations. Unit economics is what allows these businesses to get off to a fast start.

 

 

  • Profit Forecasting:-

 

The focus on per-unit profitability creates a more accurate view of the timeline required to reach stated profitability. 

 

Unit economics reduces cost of production to the smallest unit possible, increasing the accuracy of anticipated profitability levels. 

 

 

Unit Economic Matrics in Calculation

 

You must first understand the metrics that go into the calculation before we can tell you how to calculate your unit economics.

 

There are numerous ways to assess a company's success and anticipate its financial stability. 

 

Each of these has a unique set of key performance indicators that must be monitored.

 

Some of the Metrics are:-

 

 

  • Customer Acquisition Cost (CAC)

 

The total amount of money spent on sales and marketing to gain one customer is known as the customer acquisition cost (CAC). 

 

You won't gain new consumers if you spend too little. You will not make a profit if you spend too much. 

 

Because the proper amount to spend is inextricably linked to your LTV, measuring and comprehending your CAC is critical.

 

 

  • Lifetime Value (LTV)

 

The average amount of money earned per customer over the course of their association with you is referred to as customer lifetime value. 

 

This is the amount of money you make in SaaS from the moment people sign up until they cancel and don't return. Accurately calculating LTV can reveal a great deal about your company.

 

 

  • Rate of Churn

 

The percentage of your customers who quit their membership during a specific period is the churn rate.

 

 

  • Average Customer Lifetime (ACL)

 

This is the average duration of a customer's subscription before they cancel it. It is an important factor in determining their lifetime value.

 

 

  • Rate of retention(R)

 

Churn is the polar opposite of retention rate. It's the percentage of clients who stay subscribed for an extended period of time.

 

 

  • Number of Customers(C)

 

This is the total number of clients who have signed up for your service during the given time period.

 

 

  • Revenue (TR)

 

This is the total amount of money you've received from your consumers over the time period.

 

 

  • Number of Transactions(T)

 

Customers are not all billed at the same time. This metric refers to the total number of transactions made during the time period, which may or may not be the same as the total number of consumers.

 

 

  • Gross Profit(GP)

 

This is the difference between your total revenue and your cost of sales.


 

  • Gross Margin per Lifespan of a Customer (GML)

 

This is comparable to your raw LTV rate; however, it just considers margins rather than total revenue.

 

  • Average Gross Margin(AGM)

 

This is the result of dividing your gross profit by your entire revenue.

 

 

  • Rate of Discount(D)

 

The rate at which you earn a return on investment is known as your discount rate.

 

(Related Reading: 10 Top Venture Capital Firms in the World)


 

Calculation of Unit Economics


 

  • LTV Prediction

 

This formula attempts to account for changes in client preferences over time. It can help you prevent a sales slump that comes out of nowhere. The formula for computing predictive LTV is: Using the acronyms from the section outlining the measurements, the formula is:

 

(T x AOV x AGM x ACL) / C

 

  • LTV Flexibility

 

When revenue is relatively steady, predictive LTV is beneficial. This isn't always the case when you're just starting with a new business or product. 

 

Flexible LTV is a measure that accounts for retention and discount rates to deliver more accurate results during those periods. The formula is as follows:

 

GML x (R / 1 + D - R)

 

However, relying solely on your LTV measure does not necessarily provide a complete picture. It is the study of the past to forecast the future. Instead, you can make a more accurate prediction by using other metrics. 

 

There are two popular methods for doing so. Predictive LTV is a fantastic option for well-established organizations. Using a variable LTV calculation makes more sense for newer organizations or product launches if revenue hasn't stabilized. 

 

To get the unit economics, divide the result by CAC, just as you did for the simplified version above.

 

 

Conclusion

 

In recent years, India's startup ecosystem has taken on a formidable structure, resulting in it becoming the world's third-largest startup ecosystem. 

 

Government efforts, significant investment, and an ever-burgeoning home market, among other things, have all contributed to this meteoric rise. It's being dubbed a "startup revolution" by some. 

 

However, in their haste to become the next great thing, founders frequently overlook the importance of establishing sound economic and financial foundations in the business, which eventually leads to the sinking in quicksand. 

 

The concept of unit economics is frequently the missing component in their business plan, and it is a significant one at that.

 

(Related Blog:- A guide to experimental economics)

 

Unit economics assists businesses in analyzing these fundamentals and focusing on how to guide their business processes toward continuous growth.

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