Unit economics is the foundation of financial success for any business, and therefore essential for startups too.
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What is Unit Economics?
Unit economics refers to a business's revenues and costs associated with an individual customer. Calculating unit economics means breaking down your financial metrics on a per-customer basis. Think of it as a mini income statement that shows your entire relationship with one single customer over months and years. For most investors, the first thing they do is a deep dive into the unit economics.
Why Unit Economics is Important for Startups (and all businesses)?
Businesses that are struggling almost always have poor unit economics, and successful businesses always have strong unit economics. And once you can see them clearly, you can improve them.
Positive unit economics means your business is making more money per customer than the costs to acquire one. For e.g. if you sell your product for $10, it only costs you $7 to you, which indicates positive unit economics, and that your business model is working.
Most startups start with negative unit economics i.e. they tend to spend more on acquiring their early customers while earning little revenue from them.
More than 8 out of 10 well-funded startups/unicorns grew aggressively for a long time with negative unit economics, with the spend ratio being as high as 10:1 (Spent ₹10 to Earn ₹1).
As a result, they bleed money, despite being funded at various rounds.
Why Should Startups Focus on Positive Unit Economics?
At some point, all startups must achieve positive unit economics, this gives businesses the ability:
To Scale and Grow Profitably
Outgrow the Competitors, and
Dominate the Market
How to Calculate Unit Economics?
There are 2 approaches when calculating unit economics depending upon the type of unit that a business considers important:
Approach 1. Units sold
The formula for unit economics is pretty simple:
Contribution Margin = (Selling) Price per unit - Costs (Fixed+Variable) per unit
Using the above example:
Contribution Margin (per unit) = $100 - $58 ($30+$20+$8) = $42
Approach 2. Customer as a unit
The unit economics formula in this case is pretty straight forward:
Unit Economics = Customer Lifetime Value (CLV) / Customer Acquisition Costs (CAC)
Where
Customer Lifetime Value (CLV) indicates the total revenue that can be reasonably expected from a single customer.
Customer Acquisition Costs (CAC) measure how much (average) it costs to get a customer.
Thus, if your LTV is bigger than your CAC i.e. you are making more money from your customers than it costs to acquire them. It fairly indicates that you’ve achieved positive unit economics.
Investors prefer the ideal LTV:CAC ratio of a fundable startup to be 3:1 or above.
Review: The Ultimate SaaS Unit Economics Tutorial by Eric Andrews
Summary
Positive unit economics proves the viability of your business model and lays the foundation for the financial success of any business, startups included.
Build a viable business model to profitably grow your business and dominate the market while your competitors (and most unicorns) continue to struggle with unit economics.
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