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Growth
To us, numbers on a page, particularly business finances, jump out and tell a story far better than words could. Over the years, we have learnt that this isn’t the case for everyone.
A significant part of our role working with business owners is to tell them the story of their numbers in a language they can understand that will resonate with them and, most importantly, drive them to take action!
Looking at high-level P+Ls or management reports is great, but the true story is often buried deep in the data. This is where Unit Economics come into play.
Unit Economics is the analysis of financials on a per-unit basis in your business. Here, a "unit" can be a customer, product, or service. By evaluating the revenue and costs associated with each unit, we can uncover what's driving profit or loss.
Unit Economics is crucial for understanding profitability at a granular level. It allows us to make informed, data-driven decisions about our business model's effectiveness and scalability.
Consider it like this: when you're scaling a start-up, it's similar to driving at high speed – you're either accelerating or braking hard. Unit Economics helps you decide whether to push for faster growth or pause to adjust your strategy.
If you're seeking investment, your unit economics will be scrutinised. Investors will want to know if your model remains profitable as costs, like Client Acquisition Cost (CAC), increase with scale.
Average Number of Transactions (T) - How many times will a customer buy from you over that period, i.e. if on a monthly subscription, then over a year, it’s 12
Average Order Value (AOV) - When they do buy from you, how much are they spending on average - used in Ecom
Average Revenue Per User (ARPU) - Same concept as AOV but used more in subscription, i.e. what is the average subscription price?
Average Lifetime (ALT) - How long does a customer stay with you before churning (leaving)?
Lifetime Revenue (LTR) - How much revenue does each customer bring you? Many people skip this and go straight to LTV, but splitting this out is important.
Life Time Revenue (LTR) = Average number of Transactions (T) x Average Order Value (AOV/ARPU) x Average Lifetime (ALT).
Increase your LTR by increasing your prices or getting customers to buy more. The real key here, though - especially for a SaaS business - is to reduce your churn, i.e. stop customers from leaving you. Reducing churn is always cheaper than acquiring new clients.
Cost of Goods Sold (COGS) - The direct costs associated with producing the product/service
Gross Profit (GP) - Revenue minus COGS
Gross Profit Margin (GP%) - Gross Profit / Revenue (expressed as a %)
This tells us how much margin you have to cover your overheads and, hopefully, some left over for profit!
Calculating your COGS is where so many businesses go wrong. Only include costs directly related to providing your service (SAAS) or producing your product (E-Commerce). Do not include sales/marketing, product development or any other overheads.
Watch your margin like a hawk, especially in E-Commerce. As your business scales, you should see a reduction in COGS and an improved GP%. Economies of scale kick in for purchasing materials, for example.
Now we have calculated your margin, we can calculate one of the two key metrics, Lifetime Value (LTV).
Lifetime Value (LTV) = Lifetime Revenue (LTR) x Gross Profit % (GP%)
Client Acquisition Cost (CAC) - How much does it cost to acquire one client
The second key metric is Customer Acquisition Costs (CAC).
This shows how much it costs you to get each new customer. On the surface, this is a simple calculation:
Client Acquisition Cost (CAC) = Marketing Spend/number of new customers
In truth, CAC can be complex as it can vary for each industry. You could take a blended CAC over a period of months if that is more meaningful. You can break this down to show CAC through different marketing channels, although attribution can be very challenging.
In truth, CAC is the metric that I have seen manipulated the most (not always unfairly) and is one that falls under the most scrutiny during due diligence of fundraising or exit.
Some businesses have pulled out fixed costs from their marketing before calculating CAC. The justification is that they want to show how CAC changes as they scale.
If accurately measuring your historical CAC can be tricky, you can imagine how hard it is to predict future CAC accurately. CAC can swing wildly as you experiment with channels & generally, over time, it will increase, especially as more competition enters the market.
Whilst you will still get value from looking at all the individual metrics above, the real power comes when you combine and compare your Lifetime Value (LTC) against Client Acquisition Cost (CAC).
We express this as a ratio:
Lifetime Value (LTV) : Client Acquisition Cost (CAC)
LTV:CAC = LTV/CAC
What’s a good ratio? That’s up to you. Common theory is 3:1 is the ideal ratio. Anything above shows that you could ramp up your advertising spend and grow quicker, anything below needs improving before scaling.
Like with all things, though, it depends on the business. Cash flow comes into play here as well. You could have good unit economics, encouraging you to grow quicker, but if you don’t have the cash to support this, then aiming for a higher ratio is sensible.
The payback period shows us how long it will take you to recoup the cost of acquiring that customer.
Payback Period = Client Acquisition Cost (CAC) / Gross Profit
If your Gross profit per unit for one month is £100 and your CAC is £500, it will take five months to recover that CAC. Multiple that by 100 or 1,000, and you can start to see the strain it could have on your cash flow.
This is why Investors will look so closely at your unit economics. If they work at scale, but cash flow is holding you back, they will likely be very happy to invest.
As with all areas of finance, relying on Unit Economics too heavily can also carry risks.
Don’t lose sight of the big picture at the expense of concentrating on the micro view. Use both together to nail your strategy moving forward.
The biggest issue with Unit Economics, though, lies in the data’s accuracy. Calculating LTV should be pretty straightforward and not too open to interpretation. However, as we mentioned above, COGS (and therefore GP) and CAC can be prone to errors or subjectivity in some people’s minds.
Make sure you have a solid financial reporting structure to accurately track these otherwise you will be making Data-driven decisions on crap data - the fastest route to failure!
Understanding and applying Unit Economics can transform how you view and grow your business. By focusing on these metrics, you can make informed decisions that drive profitability and sustainable growth.
If you need help analysing your unit economics or want to discuss how these concepts apply to your business, feel free to reach out to us at Crisp Accountancy. We're here to help you make the numbers work in your favour!