What are Unit Economics?

They are your business. You can have an awesome product that is “flying off the shelves” at a record pace, being lauded by all as a miracle solutions, and solving massive problems. But unless your unit economics make sense, all of that might be an illusion. Unit economics are a financial explanation of how your core business model works.

To dig in a little deeper, unit economics can be most efficiently explained as the ratio between costs to produce one unit and the price at which you sell that unit. I know that can sound pretty rudimentary, but the trick is to figure out what the actual costs of your product can be. This is (probably) pretty simple if you are making hardware - these are the raw materials costs that go into the production of the product. But if you have a ride sharing company, a tech enabled service, or a wildly complex consumer software company, unit economics can start getting confusing.

Let’s break that down even further - what is a unit? That depends on your business, but a unit is typically the thing that gets sold and generates revenue at the minimum applicable amount. If you are a ridesharing company, one ride equals one unit. If you are an enterprise SaaS company, your unit is a contracted enterprise. So to understand unit economics, you have to understand what you are selling and how you are making money, above everything else. From there, you need to understand the costs that go into selling each unit.

Two common ratios that needs to be understood in unit economics are CAC and LTV - Customer Acquisition Costs and Lifetime Value. The CAC ratio can be found by dividing the marketing expenses that go into acquiring a customer by the amount of customers that are actually acquired (and the revenue that each customer brings in). Those marketing expenses can be multitudinous - SEO expenses, paid search fees, event marketing costs, etc. But what’s critical here is that those costs are outweighed by the revenue that gets brought back in. A high CAC ratio can be a harbinger for strong margins. What’s so interesting about technology startups is that they should be inherently high margin businesses. A lot of focus gets placed on high growth businesses that are generating revenue at a rapid clip year-over-year, month-over-month - but the key to understanding the allure of the modern-day technology company is to understand that it generates strong margins as well.

A startup should also consider the LTV. It’s not just how much each unit is going to make you upon the initial sale - it’s also important how much revenue that unit will bring in over the course of the unit’s entire lifespan. So it might take a lot to bring in a customer or to sell a unit, but if that initial sale will lock in or bring in additional revenue, then those expenses will be worth it, literally and metaphorically. And this might start to explain why so many startup companies are enamored with the idea of having a subscription-based business. So many software companies in the past two decades have switched from selling their software for unlimited use, to licensing (basically renting) the software to each customer - it locks in more revenue over a longer period of time. As a result of this recurring revenue, LTV has become more and more relevant over time.

In order to be a profitable, sustainable business (it might be surprising to hear, but that is the end-goal, after all), you need your LTV to be higher than your CAC. In other-words, you need to bring in more money than you are sending out. Sounds simple, right? Well this is one of the chief riddles that every entrepreneur is trying to solve and can be particularly confusing.

But the costs of selling a unit can be more than putting up ads on instagram, paying sales commissions, and going to the top of Google’s or Capterra’s search function. Customer acquisition costs are deeper than the actual one-to-one, cause-and-effect expenses that go into your business model. They represent everything that make selling your product possible. If you are selling a direct-to-consumer product and your brand is reliant upon educational videos that explain to users how to use the product, these costs need to be included as well. If you are selling software through already-sold hardware, you can’t just break those two things up and say that each sale / segment stands on its own. If one is unprofitable and the other isn’t, then you need to understand how they work together and what the margin of difference is between them. If you are customizing your software for each customer, you need to take into account the engineering costs it takes to change the code for each contract.

Just to drive the point home one more time - you need to study your unit economics so that you can further validate your business model. Starting a company is an exercise in two things: finding product/market fit, and validating a business model. If your business model does not work, you won’t build a sustainable organization. And if the organization is not sustainable, then you cannot generate value. So make sure you really understand how important each cost is and you can articulate it to yourself and others well.

All of this really just scratches the surface for what goes into understanding how a business effectively operates and what its unit economics are. At the end of the day, you need to make sure that the core piece of the business and the business model make sense and will continue to make sense as things move forward. You might have a great idea, but if you can’t find a way to take it to market effectively, it will remain just that - an idea.

Peter G Schmidt