Why Unit Economics Matter: Optimizing for Profitable Growth!
- Jasaro.in
- Jan 20, 2023
- 4 min read
Updated: Jan 10
When building a business, it's easy to get caught up in the big picture - expanding markets, increasing revenue, and acquiring customers. But how do you know if your business is truly sustainable? That’s where unit economics comes into play. This concept dives deep into the profitability of your product or service, breaking it down to its most basic unit.
By mastering unit economics, you can evaluate whether your business model is working, identify areas for improvement, and ultimately build a thriving company. Let’s unpack what unit economics is, why it’s so important, and how you can leverage it for long-term success.
What Are Unit Economics?
Unit economics refers to the revenues and costs associated with a single unit of your product or service. Think of it as a financial snapshot of one customer or one product/service - whatever “unit” matters most to your business. In simple terms:
Unit Economics = Revenue per Unit - Costs per Unit
This formula helps you understand whether you’re making a profit or incurring a loss on each unit. It’s a critical measure for assessing the scalability and sustainability of your business, and it’s a key metric that investors use when evaluating companies.
Breaking Down Unit Economics
Revenue Components has 2 main sources:
Per Unit Revenue: The price you charge for one unit.
Additional Revenue: Earnings from upsells, subscriptions, or repeat purchases.
Cost Components includes
Cost of Goods Sold (COGS): Direct materials and labor needed to produce 1 unit.
Customer Acquisition Cost (CAC): Marketing and sales expenses to acquire 1 customer.
Overhead Costs: Expenses like rent, utilities, and insurance allocated per unit.
Why Unit Economics Matter
Investors and entrepreneurs alike use unit economics to predict profitability, estimate break-even points, and plan for sustainable growth.
Negative Unit Economics
Many startups begin with negative unit economics, meaning they spend more to acquire customers than they earn from them. For example, in FY-2024, 17 out of 47 startups reported losses, with some spending as high as $2 to earn $1. This is a common scenario for early-stage companies, but it requires adjustments to pricing, costs, or the overall business model to achieve sustainability. [33,000 Startups, ₹22,000+ Crore Losses]
Positive Unit Economics
Positive unit economics means you’re earning more per unit than it costs to produce or acquire i.e., make a profit on each sale. For instance, if you sell a product for $10 and it costs $7, you have positive unit economics, indicating your business model is viable.
Businesses that are struggling almost always have a poor (negative) unit economics, while successful businesses have positive unit economics.
How to Calculate Unit Economics?
There are 2 main approaches depending on your business’s focus:
1. Units Sold as the Basis
Use this formula:
Net Profit per Unit = Average Selling Price - (Fixed Costs + Variable Costs per Unit)
Example: Selling Price - $100 ; Fixed Cost - $50 ; Variable Cost - $8
Net Profit per unit = $100 - ($50+$8) = $42
2. Customers as the Basis
Typically used for service-based or subscription models, use this formula:
Unit Economics = Customer Lifetime Value (CLV) ÷ Customer Acquisition Costs (CAC)
Definitions:
Customer Lifetime Value (CLV) indicates the total revenue expected from a single customer over their lifetime.
Customer Acquisition Costs (CAC) reflects the average cost to acquire a customer.
Example (earlier): Selling Price (per unit) - $100 ; Net Income (per unit) - $42
Average Customer Lifetime: 5 years (calculated as 1 ÷ Churn Rate presumed as 20%)
Customer Lifetime Value (CLV) = $42 x 5 = $210
Customer Acquisition Costs (CAC) = Total Sales & Marketing Costs ÷ Number of New Customers Acquired
Say, if you spent total of $35,000 on sales and marketing in a month and acquired 500 new customers, your CAC would be: 30,000 ÷ 500 = $70.
Therefore, Customer Acquisition Costs (CAC) = $70
Unit Economics = CLV ÷ CAC = $210 ÷ $70 = 3.0X
If your LTV is bigger than your CAC (making more money from your customers than it costs to acquire them) it fairly indicates that you’ve achieved positive unit economics. Investors look for a CLV:CAC ratio of 3:1 or higher as a benchmark of profitability.
Payback Period: Calculate how quickly you recover the CAC (Economic Sustainability)?
Payback Period = CAC ÷ Net Income = $70 ÷ $42 = 1.67 x 12 months = ~20 months.
Why to Focus on Positive Unit Economics?
Positive unit economics is the foundation of a scalable, profitable business. It ensures businesses have the ability:
To Grow Profitably & Sustainably: Profitable growth allows you to scale without constant funding injections.
To Outpace Competitors: With a healthier financial model, you can invest in better products and services.
To Dominate the Market: Businesses with strong unit economics win customer trust and loyalty while others struggle.
Conclusion
Understanding and optimizing unit economics is crucial for any business aiming for long-term success. By focusing on unit economics, you gain valuable insights into profitability, pricing strategies, and growth potential. While many startups start with negative unit economics, achieving positive unit economics is non-negotiable for sustainability. It’s a clear indicator that your business model works and is ready to scale up.
By continuously analyzing and improving unit economics, you’ll lay a strong foundation for a thriving, profitable enterprise—leaving competitors with weak unit economics far behind. Start optimizing your unit economics today and unlock the key to financial success!
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