Unit economics are the direct revenues and costs associated with a particular business model expressed on a per unit basis.
If you fully and thoroughly understand the unit economics of your business, it becomes easier for you to project how profitable your company may be (or not), and when it can expect to reach profitability.
The unit can mean several things depending on the type of business the company operates. For instance, in a consumer internet company, the unit is a user, while an airline might look at seats sold as its units.
The next thing after knowing what your unit is will be to calculate how much revenue you derive from that unit and what it costs to achieve that revenue.
There are two things to consider when doing the calculation which are the following:
- Lifetime value (LTV): the amount of revenue a single user generates during the entire duration of their usage of your service.
- Cost per acquisition (CPA): How much it costs to acquire a user.
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A major point to note is that if the LTV exceeds CPA, you have a business.
One of the major jobs of an entrepreneur is to understand the factors that impact those unit economics, and figure out ways to create structural advantages that shift them in your favor.
In calculating the lifetime value of a customer, it is important to know your gross margin, your monthly churn percentage and how much each customer spends on average each month.
The cost per acquisition or customer acquisition cost on the other hand includes things like the total sales and marketing costs, salaries, campaigns, programmes and everything required to acquire a single customer.
Cost per acquisition = Sales and Marketing Costs/New Customers Won.
It is also important to express both values as a ratio – LTV:CPA
According to some entrepreneurs, the ideal ratio should be 3:1, which means your customers are contributing three times more value than your cost to acquire them.
If the ratio is lean, then the business owner must find ways to improve the efficiency of his sales and marketing, or the value and staying power of the product.
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