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Business

How to Calculate Unit Economics for Your Business

Written by MasterClass

Last updated: Oct 2, 2020 • 5 min read

Unit economics is a simple yet powerful tool that can help you better understand the success and long term sustainability of your business. Whether you’re the CFO of a powerful company or the businessperson trying to get an e-commerce startup off the ground, you should be using unit economics alongside overall cash flow and annual revenue to analyze your company’s performance and plan for its financial future.

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What Is Unit Economics?

Unit economics describes a specific business model's revenues and costs in relation to an individual unit. A unit refers to any basic, quantifiable item that creates value for a business. Thus, unit economics demonstrates how much value each item—or “unit”—generates for the business. For an airline, a unit might be single seat sold, whereas a rideshare app like Uber would define a unit as one ride in their vehicle. These units are then analyzed to determine how much profit or loss they individually produce. In the case of a retail store, for instance, its unit economics is the amount of revenue it’s able to generate every month from each single customer.

3 Reasons Unit Economics Is Important

The data produced through unit economics analysis can therefore be integral to the short-term and long-term financial planning of your company.

  1. Unit economics can help you forecast profits. Understanding unit economics can help you project how profitable your business is (or when it is expected to achieve profitability), since it produces a simple, granular picture of your company’s profitability on a per-unit basis.
  2. Unit economics can help you optimize your product. An understanding of unit economics is also helpful in determining the overall soundness of a product, providing evidence to suggest whether it’s overpriced or undervalued. Such information can help a company identify favorable strategies for product optimization, as well as determining whether marketing expenses are worth the cost.
  3. Unit economics can help you assess market sustainability. Unit economics is also particularly adept at analyzing a product’s future potential. For this reason, many startup founders and co-founders rely heavily on unit economics in the early stages of business development to measure their overall market sustainability.
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How to Calculate and Analyze Unit Economics

There are two ways to approach calculating unit economics, depending on how you choose to define a unit.

Method 1: Define Unit as “One Item Sold”

If a unit is defined as “one item sold,” then you can determine unit economics by calculating the contribution margin, which is a gauge of the revenue amount from one sale minus the variable costs associated with that sale. The equation is expressed as:

Contribution margin = price per unit – variable costs per sale.

Method 2: Define Unit as “One Customer"

If you choose to define a unit as “one customer,” then the unit economics is determined by a ratio of two different metrics:

  • Customer lifetime value (LTV): how much money a business receives from a given customer before the customer “churns” or stops doing business with the company
  • Customer acquisition cost (CAC): the cost of attracting a client

Therefore, the equation that produces your unit economics is: customer lifetime value divided by customer acquisition cost (UE = LTV/CAC)

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How to Model Customer Lifetime Value

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There are two ways to model customer lifetime value: predictive LTV and flexible LTV.

Method 1: Predictive LTV

Predictive LTV helps you forecast the average customer is likely to act in the future. The formula for measuring predictive LTV is:

Predictive LTV = (T x AOV x AGM x ALT) / number of customers for a given period

  • T (average number of transactions): The number of total transactions divided by a given time span, thus determining the average number of transactions in that period.
  • AOV (average value of an order): AOV is determined by dividing the total revenue by the number of orders, resulting in an average monetary value of each order.
  • AGM (average gross margin): AGM is calculated by deducting the cost of sales (CS) from the total revenue (TR) in order to determine actual profit. The equation to determine gross margin is: GM = ((TR-CS) / TR) x 100.
  • ALT (average lifetime of a customer). ALT is equal to the churn rate figure divided by 1. The churn rate is determined by taking the number of customers at the beginning of a given period (CB) and measuring it against the customers left at the end of the period (CE). That equation is expressed as: Churn rate = ((CB-CE)/CB) x 100.

Method 2: Flexible LTV

Flexible lifetime value helps you account for potential changes in revenue. This is particularly useful for new businesses and startups, which are likely to undergo changes as they grow and develop. The formula for measuring flexible LTV is:

Flexible LTV = GML x (R/(1 + D – R))

  • GML (average gross margin per customer lifespan): The amount of profit generated by your business from a given customer in an average lifespan. This is measured by the equation: Gross Margin x (Total Revenue / Number of Customers During the Period).
  • D (discount rate): Discount rate measures the rate of return on investment.
  • R (retention rate): Retention rate is determined by measuring the number of customers who repeatedly made purchases (Cb and Ce) against the number of new customers acquired (Cn), expressed in the equation: ((Ce - Cn) / Cb) x 100.

How to Analyze the Cost of Acquiring New Customers

Every new business encounters the hurdle of acquiring new customers. The cost of acquisition (CAC) is an essential metric for companies looking to accurately determine how much they are spending in order to obtain a new customer. The formula is:

CAC = (sales and marketing costs / number of acquired customers)

Your LTV to CAC ratio can help you determine whether the building blocks of your marketing efforts are strong or need to be adjusted. If your CAC is less than your LTV, it indicates that your business is strong. If the two metrics are equal, it likely highlights a stagnant business. If your CAC is greater than your LTV, you are looking at a financial loss.

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