What is Unit Economics
Unit economics (unit economics, unit economics) is an economic modeling method that helps determine the profitability of a business by calculating the profitability of a business unit (unit of goods or one customer). Effective for digital projects.
The growth and success of a business depend on the decisions the leader makes. To avoid making a mistake, you must think one step ahead (or, better, a few steps). Unit economics is one way to draw informed conclusions about possible success or failure. With the help of certain mathematical calculations, you can find out where your company is heading — going bankrupt or growing, and make the right management decisions.
The emergence of the methodology was provoked by the "dot-com bubble": new entrepreneurs — IT specialists — had little understanding of the monetization of projects. Then business accelerators proposed a simplified model for evaluating the business model at the initial stage — to calculate the marginal profit per unit of sale. Soon the popularity of the methodology began to grow — it began to be used by classic entrepreneurs who develop businesses on the Internet, and they started talking about it at thematic courses.
The impetus for developing the unit economy was the spread of Internet analytics — analyzing the effectiveness of communications and sales funnels became possible.
The essence of the method
The unit economy allows you to see how much you earn from a stream of customers — a stream consists of units, each of which brings a certain profit (or not). If you calculate how much each unit brings in and what costs the company incurs, you can calculate how much profit you will receive from a certain stream. According to the calculation results, it becomes clear whether it is worth scaling the business, attracting investors, and increasing the flow or margin of the transaction.
It is important that not only the client who paid can be called a unit (the client is the accepted definition of a unit primarily for SaaS projects). So, for example, in mobile applications and games, this will be a new user. And for an online publication or service — a subscriber (newsletters, demo versions of the product). Also, a unit of goods can be considered as a unit.
Why consider unit economics
- Determine the effectiveness of the main sales channels.
- Assess the prospects of the company, and understand where it is heading.
- To determine the profitability of a business at the idea stage.
- Find the breakeven point and calculate the return on investment.
- Understand how many customers you need to attract; find out how much each will cost.
- Objectively tell investors about business prospects.
With unit economics, you can calculate how many units of a product you need to sell to cover fixed costs.
When to count unit economics
- You want to attract investors.
- Are you planning to scale your business?
- You are starting a startup.
Promotion and advertising are the main costs of attracting clients and closing deals.
Fundamentals of Microeconomics
Unit economics is based on the principles of management accounting and microeconomics. The basic formula of microeconomics is the profit formula:
Profit = Marginal profit — Fixed costs
Marginal profit = Revenue — Variable costs
Profit = Revenue — Variable costs — Fixed costs
All further calculations in unit economics are based on these three formulas. If marginal profit is higher than fixed costs, the business is successful. In the simplest example, variable costs equal the cost of the product.
Marginal profit 1 product = Price — Cost
Then the total contribution margin is defined as the total number of goods sold multiplied by their price minus cost.
To estimate the profit or loss per item, the following formula is used:
Selling price — Expenses = Profit (Loss)
These are the roughest estimate, but it gives you an idea of how many sales it takes to make a business profitable. The following formula is used to calculate the breakeven point:
Fixed costs / (Profit from 1 sale) = Required number of sales
The formula has a certain limitation — it is suitable for a business where monetization occurs through selling single goods. For example, online stores.
What is COGS?
Gross profit (GP) is the amount left over from a company's earnings minus the cost of goods sold (COGS). So COGS includes all the "direct" labor and material costs needed to generate income. Costs can be presented in dollars or as a percentage (gross profit/revenue).
Let's say Amazon buys a book for $10 and spends another $5 to complete the order, resulting in a book cost of $15 (COGS). At the same time, the book's price for an Amazon buyer is $20. As a result, the company is up $5 in gross profit; after taxes, a $3 net profit remains.
Suppose Amazon decides to invest $5 in its development. As a result, the company is in the red by $2, right? Not really. The difference between this example and a bad unit economy calculation is that Amazon doesn't lose money on every transaction. Therefore, the business can become profitable again if the leaders slow the expansion.
Methodology development
In 2014–2015, cohort analysis became widespread in unit economics.
Cohort analysis is an analytics tool in which users are considered in groups related by a certain attribute.
Cohort analysis is needed to segment users in the calculations. That is, the unit economy is calculated separately for each group. For example, users who visited the site this month are combined into one cohort, users who came through contextual advertising, and so on into another.
An example of a cohort analysis.
Source: Google Analytics
The ability to simultaneously collect many metrics has led to using spreadsheets to calculate unit-economy models.
How to Calculate Unit Economics:
Calculations for different business areas
Any investor is interested in accurately analyzing the business he invests in. Business people need it to evaluate the effectiveness of strategic decisions. Managers use it to develop different strategies and competently navigate the market. Although therefore, assessing the economic characteristics of production is necessary from the first stages of creating startups; it is needed even more than the first customers. In the early stages of startups, it is vital to understand the overall health and viability of the business. Unit economics provides such an opportunity.
Any business is a complex system. Factors, key indicators, and parameters must be considered to evaluate its effectiveness. Unit economics seeks to simplify the task by measuring profitability at the "unit" level. However, the approach to calculating the unit economy depends on what is taken for it.
Method 1: Unit as "One Item Sold"
If a unit is defined as "one item sold," then you can define a unit economy by calculating the contribution margin, which is the revenue from one sale minus the variable costs associated with that sale. The equation is expressed as:
Margin = (Average Price — COGS)/Average Price.
Let's assume that the cafeteria owner decided to calculate the indicator. Each dish he sold represents a unit or unit. Its value determines the products and the resources needed to prepare them. Then we use the formula above: Profit Margin = Revenue — Variable Costs.
Method 2: Unit as "Single Client"
A subscriber can act as a unit; then, they consider how much was spent on attracting a client and how much it costs to provide them with a service. In this case, revenue is the lifetime value (LTV) ratio to customer acquisition cost (CAC). Therefore, the equation that forms the unit economy, in this case, is:
UE = LTV / CAC.
Examples
Consider the example of a company specializing in mobile games (B2C sector). A company in this industry calculates its revenue in the following way. After collecting data on the number of average daily users (DAU), executives calculate the total amount of subscriptions acquired during this period. For example, let's say a company has 1,000 users and has raised $100. Thus, the unit revenue (average revenue per daily user — ARPDAU) is 10 cents per user per day.
The service provider now calculates its costs (fixed and variable). Variables include: server cost, bandwidth, and advertising spend to acquire users. Suppose your ad costs $2 per thousand impressions (CPM). How many impressions does a company pay for before it gets a client? Let's say 1000 impressions. Thus, the cost per install (CPI, i.e., cost of customer acquisition) is $2. The user must work for at least 20 days to bring profit to the company. (20 days * 10 cents / day = $2).
In the following analysis, we will take the number of subscribers as the unit of the Netflix economy.
- CLV (2) = (Monthly revenue per user * Gross margin %)/Monthly churn rate = $1
- CAC (1) = (Sales & marketing expenses /# New customers won) = $42
Netflix has a CLV to CAC ratio of 3.5. For every $1 invested in marketing, Netflix generates $3.5 in gross profit. Another interesting figure to calculate is the payback period, which is the number of months it takes for a company to recoup its marketing investment to acquire new customers.
- Customer Lifetime Months = 1 / Monthly User Churn % = 10.3 months
- Payback = CAC / (Monthly revenue per user * Gross margin %) = 3 months
According to neilpatel.com, Netflix has a monthly churn rate of 9.7%.
After subtracting the payback period from the number of months the customer lives, each subscriber makes a profit within 7.3 months.
Errors in calculations
Often business leaders need a more superficial understanding of unit economics. They analyze because they have to but need to realize its significance and purpose. This entails three main mistakes:
Confusion Between Real Fixed Costs and Variables
The biggest mistake entrepreneurs make when doing unit economics analysis. Whether you're just calculating your contribution margin or analyzing CLV/CAC, what costs are an important part of the equation?
The rule is simple: unit economics only considers variable costs, not fixed costs. But in practice, the distinction between fixed and variable costs often must be clarified.
The textbook defines variables as follows: variable costs are directly related to sales. Therefore, variable costs vary depending on the volume of production. Examples of variable costs are the cost of goods sold (COGS), shipping and packaging costs, and more.
Careful inclusion of all variable costs in the analysis of the economics of the unit is vital, as it is essential for correct calculations.
Absolute numbers matter!
The next common mistake is neglecting absolute values. Focusing solely on the percentage margin or the CLV to CAC ratio is often tempting. When in doubt, we suggest that you exercise caution. Include as many costs as possible in your unit economy calculations. So you will receive only positive surprises, and not vice versa.
Scaling a loss-making business = bankruptcy
The name speaks for itself, but for a better understanding, let's look at an example. Bento is a startup launched in 2015 that supplied adaptive "bento boxes" and raised $2 million in seed money in San Francisco. A few months after launch, Bento executives realized they were spending 30–40% more cash resources than originally thought. At the same time, the company grew at an incredible pace — 15% per week.
Detailed analysis solved the mystery: Bento sold his boxes for $12, even though each box cost $32 to make. Including costs for kitchen staff, equipment, ingredients, and so on, Bento lost $20 on every sale. Even after cutting costs, raising additional funds, and changing the business model, the company achieved minimal profitability.
Don't scale a losing business. Instead, examine the economics of your division, make sure your contribution margin is positive, and keep a close eye on variable costs.
Unit economics metrics
To make it easier to understand further calculations, here is a list of metrics that can be used and the formulas by which they can be obtained.
Metrics Definition Formula user: The user, the base entity, refers to the person who has read the advertisement. — UA (User Acquisition)The number of attracted users. That is the number of those we introduced to our product through marketing channels, such as contextual advertising. — marketing costs Marketing costs. — COGS (Cost of Good Sold)The cost of each sale, its cost. These are variable costs that increase in proportion to sales volumes. For example, this includes delivery. — Is COGS (First sale COGS)Additional costs incurred to make the first sale? — Fix COGSFixed business expenses. Costs are to be borne in any case. This includes the wage fund, office rent, etc. — C1 (Conversion to first purchase)Conversion to the first purchase is the percentage of those who, for the first time from the user, became a buyer. — B (buyer), Buyer, client. The formula determines the number of clients from the total user flow.
Buyer = User Acquisition × C1AvP (Average Price)
Average check the amount that users pay on average for our purchase. It is determined by the ratio of income to the number of orders.
Average Price = Revenue/OrdersAPC (Average Payment Count)
The number of repeat purchases is the average number per paying user for a certain period (by default, it is considered for the entire lifetime). The ratio of the total number of orders to the number of customers determines it.
APC = Orders/BuyersARPC (Average Revenue per Customer)
The average revenue per client. This indicates how much we earn from sales for the selected period, excluding marketing costs.
ARPC = (AvP − COGS) x APC − 1sCOGSARPU (Average Revenue per User)
The average revenue per user, excluding marketing costs.ARPU = ARPC x C1ARPPU (Average Revenue Per Paying User)
Revenue per paying user minus costs, i.e., revenue per paying user. Defined as the average revenue per user, excluding marketing spend, divided by the first conversion rate. You can also determine by multiplying the number of repeat purchases by the average bill.
ARPPU = ARPU/C1
or
ARPPU = APC × Average PriceCAC (Customer Acquisition Cost)Customer Acquisition Cost.
The metric takes into account all costs until the client is received. Then, it is calculated as the ratio of marketing costs to the number of customers.
CAC = Marketing Costs/BuyersCPA (Cost per Acquisition)
The cost of one attracted users to the beginning of the funnel, that is, to the landing page. It is calculated as the ratio of marketing costs to all users.
CPA = Marketing Costs/UAmarginProfit.
It is determined by subtracting the cost of the product from the average check and dividing by it.
Margin = (Average Price — COGS)/Average Price Profit Net streaming income excluding fixed costs.
Profit = UA × (−CPA + ARPU × Margin)Profit finalNet streaming income minus fixed costs.Profit = User Acquisition × (−CPA + ARPU × Margin) − fix COGS
In recent years, more and more people have been talking about the unit economy. People get acquainted with the method and begin to use it: someone for themselves, someone for reporting to investors. However, most entrepreneurs make a common mistake — they do the calculations irregularly. As a result, there is no constant data collection — there is no clear understanding of whether there are problems in the business or whether everything is going according to plan. This means that there is simply nothing to make effective management decisions.
Calculation example
There are many ways to calculate the unit economy: manually using formulas, in spreadsheet templates, or an online calculator. The last way is the most convenient.
First, it's the easiest — you need to enter the data. Secondly, in the calculator, you can change the number of indicators and immediately see how the unit economy changes. Finally, this allows you to test hypotheses on the go: for example, what will happen if you double the conversion, increase the average check, or increase the number of repeat sales?
The answers to these questions allow you to understand where it is better to move and what decisions should be made to increase profits.
For example, let's calculate the unit economy for a small business. Suppose our company sells test equipment for industry. We have a landing page where we attracted 600 users from Google. Direct at 3 dollars per click and received six applications, of which only one became a buyer. We also know the price and cost of the product; on average, we have one repeat sale.
We are interested in how much profit each client brings; that is, the unit, in our case, is the paying user. Therefore, for calculations, we will use the following formula:
UA — (CPC / CR1 / CR2) + (AVP — COGS) x APC = Profit Per Paying User
CR1 is the conversion rate from user to lead, that is, the percentage of those attracted to the landing page.
- CPC — cost per click in contextual advertising or attracting one user from search engines.
- UA — the number of unique users who visited the site
- CR2 is the conversion rate to the buyer, the percentage of those who turned from a lead into a client.
- AVP is the average check that the user pays in one purchase.
- COGS — variable sales costs excluding marketing costs (shipping costs, etc.)
- APC is the average number of repeat sales over the life cycle of a customer (LT).
In this formula, costs consist of advertising costs + sales costs. And the income is calculated as the profit from one transaction multiplied by repeated sales.
The formula can be conditionally divided into several semantic blocks:
Attracted users the cost of selling a unit of goods revenue per paying userProfit per paying user UA (User Acquisition)– (CPC / CR1 / CR2)+ (AVP — COGS) x APC= Profit Per Paying UserTotal number of users– (cost per click/conversion to lead / conversion to customer)+ (Average Check — Cost per Sale) x Average Number of Sales per Period= profit or loss per customer
Now let's plug in the data:
Attracted user's cost of selling a unit of goods revenue per paying user Profit per paying user 600– (3 dollars/ 1% / 20%)+ (35,000–28,000) x 1= — 8,000 dollars.
We work at a loss and lose about 8,000 dollars; all profits are "eaten up" by advertising costs.
Now let's see what we can do with it. For example, if we double the first conversion to 2%, we will get 12 requests instead of 6 and reduce the loss by more than ten times — up to 500 dollars.
Attracted user's cost of selling a unit of goods revenue per paying userProfit per paying user 600– (30 dollars/ 2% / 20%)+ (35,000–28,000) x 1= — 500 dollars.
If we reduce the cost per click to 25 dollars, we get an average profit of 750 dollars per client. That is, we will already go to a small plus.
Attracted user's cost of selling a unit of goods revenue per paying userProfit per paying user600– (25 dollars/ 2% / 20%)+ (35,000–28,000) x 1= 750 dollars.
If we leave the cost per click the same but increase the number of repeat sales to at least three (we will get a regular customer, which is not difficult to do in the field of measuring equipment), then we will get a solid profit — 13,500 dollars per client.
Attracted users Cost of selling a unit of goods revenue per paying user Profit per paying user 600– (30 dollars/ 2% / 20%)+ (35,000–28,000) x 3= 13,500 dollars.
But if, for example, we leave the initial indicators but increase the traffic by ten times — up to 6,000 visitors, we will see that we remain at a loss. So it turns out that a thoughtless increase in traffic does not give us anything but only scales the losses.
Attracted usersCost of selling a unit of goods revenue per paying userProfit per paying user 6000– (30 dollars/ 1% / 20%)+ (35,000–28,000) x 1= — 8,000 dollars.
By experimenting in this way, you can test hypotheses and make predictions.
Unit economics is very effective and useful, but you should not reduce it to financial accounting — this is incorrect and complicated. First, a technique is a tool for making the right decisions. Don't complicate it.
Calculators for calculations:
Online calculators
A more convenient tool for calculations is a paid online calculator. However, before you start using it, see an example of calculating the unit economy for an online store.
If you are not ready to pay yet, there is an alternative — a free Retail Engineering calculator.
Retail Engineering Free Calculator Interface
FAQ
— What is the easiest way to calculate unit economics?
The easiest way to do this is with a calculator; you can also use spreadsheets.
— How to correctly evaluate the results?
Evaluate the results separately for each advertising channel or cohort.
— What if I have a lot of products?
It is desirable to evaluate each product separately, but in extreme cases, it can be divided into groups.
— What should I do if I have a loss-making unit economy?
Try changing one of the indicators. For example, increase the conversion, the average check, or the number of repeat purchases. This way, you can see how much your profit can increase if you improve one of the parameters.
- Materials to help you understand the unit economics
Video lectures
Publications
Guide to Unit Economics (detailed Ultimate guide)
Business Decisions & the Economics of One Unit (presentation)
My product management toolkit (25): understanding the "unit economics "of your product
Unit Economics: A "Must Have" at All Stages of a Startup (interviews with startups who use unit economics)
Must-do Unit Economics Analysis for a Startup — Part 2 (an article about startup analytics)
Unit Economics in Practice (article "Unit Economics in Practice")
Books
Unit economics is indispensable for determining and forecasting the profitability of a business. Even though the technique is quite young — only 10–15 years old, the terminology and calculation formulas continue to develop. If it is still new to you, be sure to understand: the future belongs to companies that know about unit economics, can objectively assess successes, risks, and failures, and make informed management decisions. Be among them! And we will help.