Venture Capital

How to calculate unit economics

In the article I wrote a couple of days ago, we discussed how increasingly more scale-ups are fundamentally unprofitable and don’t have any perspective on a change since their companies are build on unhealthy unit economics. Their future is highly uncertain, because if your growth is artificially subsidized by VC’s how can you ever be confident in the consumer’s willingness-to-pay for your product or service?

Unit economics matter more than most people -even in tech- realize, and for reasons other than simply determining whether your business model and pricing is sustainable in the long run. It helps you to make better judgements regarding what products or services you should be offering and for what segments over which channels. Every decision you make can be evaluated with regards to how it impacts your unit economics. Measuring and keeping track of unit economics is a good way to estimate your profits. Additionally, it’s a great feedback loop regarding your value proposition. You might be able to capture a substantial chunk of your serviceable attainable market. However, if it’s at prices below the total cost of service or costs of goods sold, you are building an empire on quicksand and you didn’t really test the market.

There are two ways to work with unit economics and in my opinion, both are strategic exercises you should continuously conduct in your startup. The difference is in the way you define a “unit”. You can either define it as “one extra unit sold” or as “one customer”. In the previous article, we were mainly talking about one extra unit. If you calculate unit economics based on extra units sold, you will learn if your business model is sustainable. You simply calculate this by subtracting the variable cost of one sold item from the price you charge for this. Important to note is that this doesn’t include overhead costs such as marketing. It’s okay to operate at a loss as a fast-growing startup. The entire point of venture capital is to facilitate fast and aggressive customer acquisition. The problem arises when you’re losing money on every item you sell. In theory, your startup decreases in value for every customer you acquire. The case that you could simply increase your price should never be made without having tested this assumption thoroughly.

The second way of measuring unit economics is by assessing the total net value an extra customer contributes. It’s important to segment your customers here. The value is derived by subtracting the customer lifetime value (LTV) from you customer acquisition costs (CAC). Both the LTV and the CAC differ between customer segments. Conducting this exercise requires some assumptions regarding the churn rate. You might find out there are customer segments that will never be profitable. You need to fire these customers. If the costs of servicing them is more expensive than what they generate in revenue, you should stop the contract and refocus your marketing efforts on segments that are profitable.

Unlike unit economics with regards to extra units sold, unhealthy unit economics with regards to customers can keep under the radar for a long time. The reason is that problematic unit economics for certain customer segments don’t necessarily surface because costs are often not accounted for on a ‘per customer’ basis and the losses made on these segments are made up by profitable segments.

With what’s going on in the world right now, I expect VC’s and angels to care more and more about your unit economics. Making your case and showing you at least have a roadmap towards healthy unit economics will make all the difference.

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