Business models can get complicated. The path to growth and profitability isn’t necessarily a straight line. It’s common to change the target market, product or service offering, pricing strategy, cost model and anything else in an effort to boost revenues and profits. With so many changes taking place it’s possible to lose sight of a basic question: how profitable is your business model? You many know how to run a business smoothly but it won’t help if you are in the wrong business.
The way to answer this question is by looking at unit economics. Unit economics expresses the relationship between the revenues generated per “unit” of a business versus the cost incurred in serving that “unit”.
What represents a “unit” for a particular business can vary greatly. For a Software as a Service (SaaS) company, the unit is a user. The revenues generated are defined as the Customer Lifetime Value (CLV) and the cost per unit is the Customer Acquisition Cost (CAC). Since SaaS companies tend to have very high gross margins, the true cost to compare is the CAC.
Example: Online training website
An online training service which provides pre-recorded educational videos offers subscriptions for $25 per month. The average subscriber is a member for 6 months before canceling. The CLV in this case is $25 x 6 = $150. The company gains all of its new customers through Pay-per-click (PPC) advertising on search engines. It typically pays an average of $1 per click and enjoys a 2% conversion rate, meaning that for every 100 website visitors, 2 become paying customers. The company must therefore pay for 50 clicks to secure one customer. Therefore the CAC is $50.
With a CLV of $150 and a CAC of $50, the unit economics are viable. Assuming the unit economics stay consistent overtime, the company should raise as much money as possible and deploy it acquiring as many customers as possible.
What if the opposite were true?
Taking the same example, let’s assume that the CLV were only $50 and the CAC were $150. The unit economics in this case indicate that the company does not have a viable business model. They lose money with every single customer they acquire; acquiring more customers means losing more money. Here the owners need to determine how they need to adjust their business model to improve unit economics.
Unit economics is value to other stakeholders including potential investors.
Unit economics is a standard measure of basic profitability that can be used to evaluate different kinds of businesses. It’s a simple way to determine which businesses offer the most profitable products. Higher profit margins mean lower risk for investors, as it allows the business to absorb the cost of mistakes and market place changes. With certain types of business models, it’s difficult to assess at an early stage if the company will be able to make a profit at scale. Even worse companies that appear to be doing well by growing quickly could simply be masking a fatal flaw in their ability to generate long-term profits. By analyzing unit economics it’s possible to make an informed decision in this regard.
All things being equal investors will select companies with the most attractive unit economics. Businesses looking for capital should include unit economics in their investment teasers and pitches.
Unit economics doesn’t replace traditional methods of measuring business performance; it should be added as another way to maximize a company’s potential for long-term success.