2024-05-07 17:39 For CFOs

Are your Unit Economics OKAY?

Why Do Unit Economics Matter?

Unit economics refers to the fundamental elements of a company's business model, specifically its costs and revenues related to each individual unit. A unit can be any distinct, countable component that brings value to a company.

Broadly, unit economics helps understand how and when the costs of one client or unit are recuperated. This is crucial as it provides insights into the profitability of individual units, aiding in determining the scalability, sustainability, and future growth of the business. It helps businesses strategize their resources effectively and ensure a return on investment.

For instance, for a restaurant, a unit could be one meal served, while for a SaaS company, a unit could be one subscription. The goal is to understand how much value each unit brings to the business and whether it generates profit or loss. In an e-commerce context, the unit economics could be seen as the monthly revenue generated from each individual customer.

The Importance of Unit Economics

Regardless of the business type, understanding unit economics is crucial. The idea is simple: you need to know the cost to acquire a client (customer acquisition cost or CAC) and the revenue you make from one client (lifetime value or LTV).

Unit economics is key in both short-term and long-term financial planning for your business. It helps you:

Forecast profits: You get a clear, detailed view of your company's profitability on a per-unit basis, helping you predict business profits or when you can expect to achieve profitability.
Optimize your product: It can help ascertain if a product is overpriced or undervalued, guiding you towards strategies for product optimization and assessing if marketing costs are justified.
Assess market sustainability: Unit economics is an effective tool for analyzing a product's future potential, which is why many startup founders rely on it in early business development stages to evaluate their market sustainability.

How to Calculate Unit Economics

Let's break down an example step by step:

Defining the unit: In our case, the unit is “one customer.” This means that we will be assessing the revenue and costs associated with each individual customer. Our goal is to find out how much it costs us to acquire each new customer (CAC) and how much profit we can get from each customer over their "lifetime" with us (LTV).
Calculating LTV (Customer Lifetime Value): Let's assume that the average purchase size is $5, the customer makes purchases 20 times a year, typically stays for 1 year, and the customer churn rate is 10% per year. Then, the LTV would be $5 * 20 * 1 * (1 - 0.1) = $90.
Calculating CAC (Customer Acquisition Cost): Suppose you have spent $2,000 on marketing and attracted 100 customers through various channels. Your CAC would be $2,000 / 100 = $20.
Calculating unit economics: We substitute the values obtained into the formula UE = LTV/CAC. In our case, UE = $90 / $20 = 4.5.

Conclusion: If UE is significantly greater than 1, in our case 4.5, this indicates that the unit economics of the business are in good shape. You are getting more money from each customer than you are spending to acquire them.

How to Determine if Your Unit Economics is Sound

It's important to remember that the ratio of LTV to CAC should be at least 1, meaning it covers your marketing expenses.

However, a good traditional value is more than 3!
1) is to cover current marketing costs,
2) is to cover current operational expenses,
3) is to attract one more user.

Remember that LTV can be considered in different ways and it's normal if your product moves to good economics over time. It's better to look at expanded economics, taking into account other costs, the amount of traffic, and user retention.

Surface Instant Insights About Your Startup’s Unit Economics

As a startup founder, it’s clear that understanding how unit economics applies to your business is essential. Essential for making smart business decisions, and essential for the VCs you’re pitching (especially in today’s market where we are all under scrutiny!).

At the same time, startup founders can’t and shouldn’t be expected to become financial experts overnight –– or at all!

Before investing in a CFO, consider exploring Octopus AI — an innovative FP&A tool that automatically provides analytics and financial predictions for startups that don’t yet have a CFO. Based on conversational AI, the platform can help you gain real-time insights into your startup’s current and projected financial health. With Octopus AI, you can find out your runway, cash burn, and cashflow and much more — all in real time with complete accuracy.

Octopus AI alleviates the hassle of manually calculating financial KPIs and lengthy “what if” scenarios. Instead, it simplifies founders’ FP&A (financial planning and analysis) with a fast, convenient, and easy-to-understand conversational AI dashboard.

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