We look at the unit economics of a business -- comparing the cost to acquire a customer with the customer's lifetime value. Once you understand how that works, you can achieve success over 10 to 15 years.
In any business, medium or small; understanding and implementing unit economics is very important. It is the fundamental concept regarding the financial aspects of any business. It might sound complicated and overwhelming to study unit economics, but in order to analyze the performance and growth of your business or company, one has to go through this fundamental aspect of finances.
Any company’s financial performance is measured in terms of unit economics. All business stakeholders, analysts, investors and management have to understand and have to go through the financial aspects of the business, regularly.
All businesses have to work around a unit economics model, and all the key resources are utilized to keep track of the financial model, so that it helps in determining the return of investment ROI in the business.
So, what is the meaning of unit in this business model? Unit in a business model depends and varies according to the type of business. For example, for any retail company or e-commerce store, customer is the ultimate unit, and this unit is used to measure the finances of a business. For example, if it is a clothing store, the customer that buys the clothes, is the unit. This unit refers to the unit economics in business.
Once a unit of any business has been identified, it is time to measure the unit economics of that business. While studying this key aspect of a business, we have to go through certain technical financial terms, in order to understand this, fully. One such important key term is Cost per acquisition CPA, which is the cost company spends to acquire one user, or unit.
This cost depends and varies with different businesses, for example, for an internet service provider, or a telecommunication company, acquiring a user may involve different factors for acquisition, and the costs would be different for another type of business. The amount company spends to get that one user is, “cost per acquisition or acquisition cost”.
Acquiring a customer involves many factors, and a company will have to oversee the marketing and selling expenses; it involves both search engine marketing and social media marketing (which is most successful in today’s time). Therefore, CPA measures all the factors that were utilized to acquire a new customer.
Now the user has been acquired, next the measurement of unit economics, involves determining customer lifetime value LTV. The revenue a company or business generates after acquisition of that one user until the user keeps using the services of the company, is known as “customer lifetime value”. Companies also take into consideration, the average of monthly and weekly revenues generated by a customer. For example, a retail or e-commerce store, takes into consideration how active a user/customer was during a particular week, or a month, and how much revenue was generated. Check our article and learn how Customer Lifetime Value is calculated.
Therefore, it’s easier to see that customers make or break your business, the number of a costumers a business has, the number of long-term and re-occurring customers a business has, determines the success of a business – whether small or medium. Having loyal, customers that keep coming back, establishes trust and reliability of a business, and it is set to thrive more. Long-term customers provide the most revenues to a business, and in a business financial model, it has two key aspects.
Input revenue of a business is determined by the number of customers you have, the number of orders placed, and purchases made by a customer and the size of the transaction. The output expenditure is determined by the expenditures company has to make to run its business. It also has two types; one is the capital investment which involves setting up a company office or a warehouse, the other type is payment of salaries and dues to the employees of a company. Therefore, output expenditure should not exceed input revenue.
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Especially the companies who grow exponentially during the last few years were keeping track of their unit economics. To give you an idea of different industries, products and business models, we researched for some of them.
| Company | CAC * | LTV * | CAC/LTV |
|---|---|---|---|
| Wework | 250 | 2,249 | 1/9 |
| Netflix | 67 | 291.25 | 1/4 |
| Starbucks | 1,400 | 14,099 | 1/10 |
The whole business and its success revolve around the unit economics that is why it is very important to nail it and understand it fully to be able to run a successful business model. Financial analysis is the key for any business, understanding the capital investment and the return of investment in the form of revenues, generated by your customers, is what businesses thrive on.
Having a solid unit economics model in place, will help you determine the key financial aspects of your business, and you can’t take your business all the way if you don’t have a unit economics model in place.
If you are just starting up a business, it is needless to say that you can’t underestimate the value of unit economics, nailing it will help you go a long way. In the turbulent economic times of today, unit economics model for any business keeps fluctuating, which in layman’s term is a profit/loss calculation per customer, and the calculation of overall costs and revenues generated from a business. For a startup, the measurement of the initial setup cost and the revenue generated from a unit, such as a customer determines the success of a business.
It’s imperative to note that in the initial stages of any business, revenues and profits are very marginal. The whole management of the company needs to understand the unit economics model of that particular business and not just the financial team, as we mentioned before, the unit is the customer that is different for every business. Once you have figured out the unit, it is easier to calculate the CPA and customer lifetime value LTV. Check our article how Customer Acquisition Costs are calculated.
Commonly used term for CPA is CAC (cost to acquire a customer), therefore, it is common business knowledge that CAC value should not exceed the monthly revenue generated from the customer, or customer lifetime value LTV. In simpler terms, LTV: CAC ratio should be 3:1, meaning the customers bring 3 times more value/profitability to your business than the cost you spent on acquiring them.
A “run rate” in unit economics is the forecast of all the financial aspects of a business in the long run. For example, companies calculate an annual run rate that gives them an approximate value of the revenue generated in a particular year. A company or a startup might also lose money, which is calculated as the “burn rate”. The burn rate is calculated by tracking the amount of Money Company is spending every month. So, when burn rate starts to exceed revenues, companies have to cut down on their expenses.
Keeping a track of all these important values, helps you determine the efficiency of your business’s sales and marketing team; how much they are contributing and how much your company’s sales and marketing plan is working. It helps you narrow down, how efficient the marketing is, and what can be done to improve it. Thus, unit economics helps you determine the overall cash flow in your business model; how efficient the business model is and how much is it delivering. This is the key to success of any business.
This goes without saying, that unit economics is the fundamental key to the success of your business, nailing it right from the beginning of your business will help you stay longer in your business, as you will be able to measure finances properly, and the profit or loss ratio accurately. Another important aspect is to look at the time frame of acquiring a customer and the payback from the customer, if it’s taking too much time to acquire a customer than to begin generating profit from that particular customer, you need to up your game, and understand what you need to do to shorten the “payback period”.
Therefore, if you want to understand your own business better and be efficient at what you do, unit economics is the key, the basics you need to master, so overtime you can increase the LTV of a user and decrease the CAC. Overtime, it does shorten, once a business is established, but initially, CAC (cost to acquire a customer) is high and is very time consuming. Therefore, with a model in place to calculate and determine and analyze the finances, a company’s management and the financial team can keep track of expenses, revenues and losses.
Unit economics helps determine the success of your business, and this process cannot and should never be overlooked by any business, whether it’s a start up, or a small or a medium-sized business. Unit economics model exposes the problems you are having in your marketing campaigns; what you are lacking, and what you need to do to stay ahead of competition – and what you can do to minimize losses. Finances are like backbone for any company, if a company can master its finances – it is bound to do well in the long run.
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