Unit Economics for the Financial Projections of your Startup
In this article, we will explore a fundamental concept for any entrepreneur: unit economics, or unit economics, in English. We'll break down what they are, how to calculate them, and why they are so important to the success of your business.
Unit economics are the basis on which to build solid financial projections and make informed strategic decisions.
What are Unit Economics?
In the business world, unit economics refer to the analysis of the revenues and costs associated with the sale of a single product or the acquisition of a customer. It is a fundamental approach to understanding the financial viability of your startup. There are two main approaches to calculating unit economies: per unit and per customer.
Each one adapts to different types of businesses.
Unit Economics by Unit
This approach is especially well suited to transactional sales of physical goods. Imagine you have a lemonade stand. You sell glasses of lemonade for $2 each, and the variable costs per glass, which include ingredients and a napkin, amount to $0.75.
By subtracting these variable costs from revenue, you get what is known as the contribution margin, which in this case would be $1.25 per glass.
The importance of the contribution margin lies in its ability to cover the fixed expenses of your business. If you have fixed costs of $100, such as renting space in a market, you can use this information to calculate how many units you need to sell to cover those costs.
The formula is simple: divide the fixed costs by the contribution margin. In this case, you would need to sell 80 glasses of lemonade to break even.
Unit Economics per Client
This approach is best suited for subscription-based business models or long-term customer relationships. Here, customer lifetime value (LTV) and customer acquisition cost (CAC) are evaluated.
LTV (Customer Lifetime Value) : This value represents how much money an average customer will generate throughout their relationship with your company. An example could be a coffee shop where customers return often. If a customer spends $3 on their first visit and $100 over their lifetime as a customer, their LTV would be $100.
CAC (Customer Acquisition Cost) : This value represents how much it costs to acquire a new customer. Let's say you invest $100 in advertising and attract 10 new customers. Your CAC would be $10 per customer.
The general rule in the startup world is that your LTV should be at least three times greater than your CAC. This ensures that you get an adequate return on your customer acquisition investment.
Real World Examples
Now that we've covered the theory, let's look at two real business cases to better understand unit economies and how they influence the viability of a business.
Uber is an example of a company that has grown enormously but has unit economics problems. Despite its popularity, it has never made a profit from travel.
Every trip costs them money, as the cost of drivers, bonuses and operating expenses exceeds what passengers pay. This raises an important question about the long-term sustainability of its business model.
Two Paths to Success
In the startup world, there are two main paths to success:
Income and Profits : The first approach is to generate income and make profits from the beginning. This implies that each unit sold or customer acquired is profitable from the beginning. This approach creates a solid and sustainable financial foundation for your business.
Potential Growth at Loss : The second approach involves aggressive growth, even if it means incurring initial losses. Uber is an example of this, as they have been willing to lose money on every trip to expand rapidly and dominate the market. However, this path requires a significant investment and does not guarantee profitability.
The Apple Case
An example of success based on profitability and sustainable growth is Apple. They started with niche products, such as personal computers, and refined their unit economics before expanding. Once they made sure that each product sold was highly profitable, they gradually conquered more areas of the market.
How to Get Data for your Unit Economics
A common question is how to obtain the data necessary to calculate your unit economies. The answer is simple: use online resources and search for publicly available information.
For example, if you need the gross margin for a company like Netflix, simply search “Netflix gross margin” on Google. This will give you access to key data for your calculations.
Experimentation and Learning
Don't be afraid to experiment and learn as you go. You can estimate a customer's lifetime initially, but you'll only get real data after a while. Adjust your projections as you learn more about customer behavior and retention.
Written by Moises Hamui Abadi : I am an entrepreneur, founding partner of Viceversa and SoyMacho. After leading several digital businesses and advising several other businesses; I decided to form MHA Consulting, a digital marketing consultancy dedicated to growing and enhancing digital businesses in more than 7 countries and generating more than 1,500 million pesos.
If you want more information on this topic or are looking for other options to profile your ideal client, at MHA you will find the solution you need. Schedule a call