I often think of myself as a storyteller. Perhaps a little (probably a lot) grandiose, but let me explain. I am not claiming to be the next JK Rowling or J.R.R Tolkien, a storybook written by me would probably be good for one thing, putting you to sleep. Instead, I tell the story of numbers.
To me, numbers on a page, particularly business finances, jump out and tell a story far better than words could. Over the years, I have learnt that this isn’t the case for everyone, who knew!
A significant part of my role working with business owners is to tell them the story of their numbers in language they can understand that will resonate with them and, most importantly, drive them to take action!
Looking at high-level P+Ls or management reports is great, but the true story is often buried deep in the data. This is where Unit Economics come into play.
What is Unit Economics?
Unit Economics refers to the finances of a business on a per-unit basis. That unit will often be a customer but could also be an individual product/service.
We look at the revenue and expenses associated with that unit, which allows us to provide a detailed look at what is driving your profit (hopefully not loss).
Unit Economics works incredibly well for E-commerce and SaaS businesses, hence I talk about them a lot, but really they work for any business.
I used them just this week in my Accountancy business to help decide how much I was willing to spend on Facebook ads to generate interest in a new, stand-alone service/product.
Why do we use Unit Economics?
They allow us to understand profitability at a granular level. Without segmentation, a P+L can mask hidden issues and opportunities.
Unit Economics allows us to make data-driven decisions
They are very powerful in helping us understand whether the business model you have now works and, importantly, how it might look as you scale.
When I first learnt to drive, I remember a conversation with a family friend who was a police officer trained in high-speed pursuits. He told me they always have their foot flat down on a pedal, either full-speed acceleration or hard braking. Running a scaling start-up can be a bit like that. Unit economics help us understand whether we should push that growth faster, usually by spending more on advertising or braking to readjust and make the figures work before moving forward again.
If you are looking for investment now or in the future, your unit economics will come under heavy scrutiny. What happens to your model if your Client Acquisition Cost (see below) doubles as you scale - are you still profitable?
What are the metrics?
Before we delve into these metrics, a little disclaimer/apology. I bang on about removing jargon from conversations and not talking like an accountant. This area is full of unavoidable acronyms, so bear with me, and I will explain as clearly as possible.
Revenue
Average Number of Transactions (T) - How many times will a customer buy from you over that period, i.e. if on a monthly subscription, then over a year, it’s 12
Average Order Value (AOV) - When they do buy from you, how much are they spending on average - used in Ecom
Average Revenue Per User (ARPU) - Same concept as AOV but used more in subscription, i.e. what is the average subscription price?
Average Lifetime (ALT) - How long does a customer stay with you before churning (leaving)?
Lifetime Revenue (LTR) - How much revenue does each customer bring you? Many people skip this and go straight to LTV, but splitting this out is important.
Life Time Revenue (LTR) = Average number of Transactions (T) x Average Order Value (AOV/ARPU) x Average Lifetime (ALT).
Increase your LTR by increasing your prices or getting customers to buy more. The real key here, though - especially for a SaaS business - is to reduce your churn, i.e. stop customers from leaving you. Reducing churn is always cheaper than acquiring new clients.
Gross Profit
Cost of Goods Sold (COGS) - The direct costs associated with producing the product/service
Gross Profit (GP) - Revenue minus COGS
Gross Profit Margin (GP%) - Gross Profit / Revenue (expressed as a %)
This tells us how much margin you have to cover your overheads and, hopefully, some left over for profit!
Calculating your COGS is where so many businesses go wrong. Only include costs directly related to providing your service (SAAS) or producing your product (E-Commerce). Do not include sales/marketing, product development or any other overheads.
Watch your margin like a hawk, especially in E-Commerce. As your business scales, you should see a reduction in COGS and an improved GP%. Economies of scale kick in for purchasing materials, for example.
Now we have calculated your margin, we can calculate one of the two key metrics, Lifetime Value (LTV).
Lifetime Value (LTV) = Lifetime Revenue (LTR) x Gross Profit % (GP%)
Marketing
Client Acquisition Cost (CAC) - How much does it cost to acquire one client
The second key metric is Customer Acquisition Costs (CAC). This shows how much it costs you to get each new customer. On the surface, this is a simple calculation:
Client Acquistion Cost (CAC) = Marketing Spend / number of new customers
In truth, CAC can be complex as it can vary for each industry. You could take a blended CAC over a period of months if that is more meaningful. You can break this down to show CAC through different marketing channels, although attribution can be very challenging.
In truth, CAC is the metric that I have seen manipulated the most (not always unfairly) and is one that falls under the most scrutiny during due diligence of a fundraise or exit.
Some businesses have pulled out fixed costs from their marketing before calculating CAC. The justification is that they want to show how CAC changes as they scale.
If accurately measuring your historical CAC can be tricky, you can imagine how hard it is to predict future CAC accurately. CAC can swing wildly as you experiment with channels & generally, over time, it will increase, especially as more competition enters the market.
Pulling it all together
Whilst you will still get value from looking at all the individual metrics above, the real power comes when you combine and compare your Lifetime Value (LTC) against Client Acquisition Cost (CAC).
We express this as a ratio:
Lifetime Value (LTV) : Client Acquisition Cost (CAC)
LTV:CAC = LTV/CAC
What’s a good ratio? That’s up to you. Common theory is 3:1 is the ideal ratio. Anything above shows that you could ramp up your advertising spend and grow quicker, anything below needs improving before scaling.
Like with all things, though, it depends on the business. Cashflow comes into play here as well. You could have good unit economics, encouraging you to grow quicker, but if you don’t have the cash to support this, then aiming for a higher ratio is sensible.
Payback Period shows us how long it will take you to recoup the cost of acquiring that customer.
Payback Period = Client Acquisition Cost (CAC) / Gross Profit
If your Gross profit per unit for one month is £100 and your CAC is £500, it will take five months to recover that CAC. Multiple that by 100 or 1,000, and you can start to see the strain it could have on your cash flow.
This is why Investors will look so closely at your unit economics. If they work at scale, but cash flow is holding you back, they will likely be very happy to invest.
The Dangers of Unit Economics
As with all areas of finance, relying on Unit Economics too heavily can also carry risks.
Don’t lose sight of the big picture at the expense of concentrating on the micro view. Use both together to nail your strategy moving forward.
The biggest issue with Unit Economics, though, lies in the data’s accuracy. Calculating LTV should be pretty straightforward and not too open to interpretation. However, as I mentioned above, COGS (and therefore GP) and CAC can be prone to errors or subjectivity in some people’s minds.
Make sure you have a solid financial reporting structure to accurately track these otherwise you will be making Data-driven decisions on crap data - the fastest route to failure!
Don’t forget we have the chancellor delivering the Budget in the UK on Wednesday 15th of March so keep an eye on my Twitter for relevant announcements. If there is a lot to discuss, it will most likely form the bulk of next week’s newsletter.
About the author
Luke Desmond
Fractional CFO for Tech, eCommerce & SaaS. CEO @Crisp_Acc provides virtual finance functions. Co-Founder @getvaulta SaaS Startup for accountants.