THE UNIT ECONOMICS OF THE BUSINESS MODEL

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Unit economics of a new company

Unit economics is the analysis of the revenues and costs associated with a product or service to determine its profitability at the individual level. In other words, it is about breaking down the costs and profits of each unit sold and assessing whether it is profitable or not. In a new venture, it is especially important to make a detailed analysis of unit economics to ensure that the business model is viable and profitable. Production costs, sales prices, contribution margin and sales volumes should be analysed. The analysis of unit economics allows company founders and managers to make more informed decisions on aspects such as sales price, production volume, advertising and marketing investment, and cost structure. It can also be useful in identifying opportunities for improvement and optimisation of the business model. It is important to bear in mind that the analysis of unit economics must be continuous and up-to-date, as costs and market conditions may change over time.

Summary of your company's unit economics

Unit economics are the basic building blocks used to construct any business model in the startup world. They are the direct margin and costs incurred per unit of measurement (customer, product, etc.) and act as the basic building blocks intrinsic to the business model. Unit economics are important because they help us understand and measure how the business is performing, what growth prospects it has or even whether it is investable by a VC.

To calculate the unit economics of any business model, some common steps must be followed:

1.  First, it is necessary to identify the base unit to be used to value the business.
2.  Secondly, it is important to calculate the customer acquisition cost (CAC), which is the cost of acquiring a customer (a paying customer, not a user). 
3. Finally, the customer life cycle value (LTV), which is the volume of revenue generated by the customer over its entire life cycle, net of the direct costs involved in providing the service or manufacturing the unit, must be calculated.

Understanding how the unit economics of a business model works is important because it will help you to analyse the potential of the business, predict evolution scenarios, predict the arrival of a new business model, and predict how the business model will evolve. break even (+) and decide whether it really makes sense to seek investment. Also can be used to compare the performance of companies with the same business models and in similar markets and to identify the growth levers acting on the unit economics of the model. In short, unit economics is a critical metric for any entrepreneur and can help make better business decisions.

Further explanation of UNIT economics

One of the most important concepts in the startup world, and perhaps the one that is least emphasised at the beginning, are the uni: economics. These are the basic blocks that we are going to use to build any business model, and they will help us to understand and measure how the business behaves, what growth prospects it has or even whether it is investable by a VC. It's a more financial topic, and absolutely critical for any entrepreneur... but don't panic, it's much simpler than it seems, and we'll try to explain it in a simple way. So first things first... What is unit economics and why is it such an important business model metric (another weird word?)?

"The unit economics is the direct margin and the costs we incur per unit of measurement (customer, product...), and they act as the basic building blocks intrinsic to the business model".

Its calculation is very important to understand the potential of the company: as long as the cost of acquiring customers does not exceed the margin that those customers leave in your company, you have a business (although as we will see, there are more things to take into account). For example, if we are operating a SaaS business model where the subscription is monthly, in a very basic way, the unit economics would be: 

• Expected revenue per customer (customer value): €10 (direct margin of monthly subscription cost) x Recurrence (6 = months you keep your subscription) = €60
• Cost of Acquisition: 20€ (money invested in acquiring the paying customer)
• This leaves a return per customer of 60-20=40€, or in other words, for every euro invested in customer acquisition, we get 3€.

HOW ARE THE UNIT ECONOMICS OF A BUSINESS MODEL BUILT?

To build the unit economics of a business model, the following steps can be followed:

1. Identify the base unit: This is the basic measure that will be used to value the business and depends on the type of company. Usually, the customer is used as a measure in service businesses, SaaS, etc., and in companies that manufacture or sell products, the unit produced is usually used (for example, for Coca Cola, the unit would be the can sold).
2. Calculate the acquisition cost: Customer acquisition cost (CAC) is logically the cost of acquiring a customer (if this is the unit being measured), and is calculated by dividing all the expenses involved in acquiring a customer (advertising, sales force, marketing salaries, etc.) by the number of customers acquired in a given month.
3. Calculate the customer lifetime value: LTV (Lifetime Value) is the volume of revenue generated by the customer (or the unit of choice) over its entire life cycle, discounting the direct costs involved in providing the service (or manufacturing the unit). This is a complicated element to measure, so you have to take into account the possible mistakes that can be made. The key here is really recurrence, which indicates how many times the customer repeats, something that can be misleading in many cases (either because there is no history or because the business has a lot of variation).

Taking these three elements into account, the direct margin per unit of measurement (customer, product, etc.) and the costs that have been incurred per unit can be calculated. It is important to remember that unit economics can evolve over time, so they should be regularly updated and the business model adjusted accordingly. Although it is extremely simple, there are a number of common steps that we have to follow in order to calculate the unit economics of any business model:

IDENTIFY BASE UNIT

This is the basic measure that we will use to value the business and it depends a lot on the type of company. Usually the customer is used as a measure in service businesses, SaaS, etc., and in companies that manufacture or sell products, the unit produced is usually used (for example, for Coca Cola, the unit would be the can sold).

CALCULATE ACQUISITION COST

The customer acquisition cost (CAC) is logically the cost of acquiring a customer (if this is the unit we measure - note: a paying customer, not a user), and is therefore calculated as the result of dividing all the expenses involved in acquiring a customer (advertising, sales team, marketing salaries...) by the number of customers acquired in a given month (note, or often and in the first few months as Samuel Gil said, including fixed costs such as marketing salaries skews the number).

CALCULATING CUSTOMER LIFETIME VALUE

Perhaps one of the most complicated points to measure, LTV (Lifetime Value) is the volume of revenue generated by the customer (or whatever unit has been chosen) throughout its life cycle, discounting the direct costs involved in providing the service (or manufacturing the unit). This is a complicated element to measure, so you have to be aware of the possible mistakes you can make. The key here is really recurrence, which indicates how many times the customer repeats, something that can be misleading in many cases (either because we have no history or because the business has a lot of variation)... but undoubtedly the best way to calculate it (if we have history) is with cohort models. One of the consequences of the importance of this factor is that, unless our business has embedded recurrence, it is a good idea to design our business model so that CAC recovery happens after the first sale.

WHAT IS THE PURPOSE OF UNIT ECONOMICS?

Unit economics is important for an entrepreneur for several reasons:

1. They help to understand the profitability of the business: Unit economics allows entrepreneurs to understand whether their business model is profitable and sustainable, and whether it is possible to achieve a positive margin with each customer.
2. They help to analyse the potential of the business: Unit economics can provide insight into the potential performance of a startup from the early stages and the sustainability of the business model, which is important to consider along with the market and competition.
3. They allow the prediction of different development scenarios: Unit economics can be used to make predictions and different scenarios in the financial models of any company. They can also predict how growth will affect unit economics, which can help entrepreneurs make informed decisions about the scalability of the business.
4. They help to identify the levers of growth: Identifying and understanding the levers of growth that act on the unit economics of the model is key to designing differential advantages in the company and to making strategic decisions.
5. They help in deciding whether to seek investment: Well-designed unit economics with a growth model on top of them can help entrepreneurs understand the potential of the business and assess whether the unit economics will not be able to degrade with growth, which is a key requirement to be able to seek investment from a VC or business angel fund.

Understanding the unit economics of a business model is important for any entrepreneur because it helps them to understand the profitability of the business, analyse its potential, predict different evolution scenarios, identify growth levers and decide whether to seek investment. Understanding how the unit economics of your business model works is more important than it seems, as it will help you to

ANALYSE THE BUSINESS POTENTIAL

Although unit economics can and usually do evolve over time (ideally for the better), they are a good indicator from the very beginning of any startup's potential performance and the sustainability of the business model, something we must consider in addition to the market, competitors, etc.

PREDICT DEVELOPMENT SCENARIOS

Assuming unit economics as a business hypothesis, it is possible to make predictions and different scenarios in the financial models of any company. In this sense, one of the most important aspects when deciding to start a business, or if you will, when deciding whether it makes sense to continue a business, is to assess how growth affects unit economics. That is, it is critical to understand what happens if we grow up:

1. Unit economics improve, as there are synergies with network effects / economies of scale, which makes a seemingly unprofitable business become profitable (what happens with companies like Uber/Cabify/Instacart...). These are businesses where the key is then to grow as fast as possible to get to the point where unit economics are expected to be positive (in my opinion many businesses base the belief of this momentum shift on untested assumptions). 
2. Unit economics worsens, either because the complexity of operations increases, because it becomes more expensive to attract customers, or because our margin deteriorates. In this case, it is better not to finance the business with investment or to control the :amelo of the business in order not to exceed this limit, and not to fall into the disease of the mas.

PREDICT ARRIVAL AT BREAK EVEN

If we have been attentive, one of the things that stands out is that in all this calculation we have not included indirect costs (management and support staff, for example) or CAPEX (Capital Expenditures). This means that, even with positive unit economics, many companies lose money... but this is usually only a temporary problem: the interesting thing about these indirect costs and CAPEX is that they are decoupled (at least partially) from revenue, so that if we continue to grow in units sold there will come a point at which we will start to make a profit -> this number is calculated to find out how many units we have to sell to reach the famous break even or break-even point.

DECIDE WHETHER IT (REALLY) MAKES SENSE TO SEEK INVESTMENT

Having well-designed unit economics and a growth model for these unit economics is key to the story that any investor needs to hear, as it helps them to understand the potential of the business, and above all, to assess whether they believe that the unit economics will not degrade with growth... a key requirement for seeking investment from a VC fund or business angels. However, in most cases (including many where the choice is made to finance the enterprise with external investment), it is critical to design sustainable business models with units economics in which the value obtained from each customer is positive (ideally from the first purchase)... so that there is no need to rely on external investment.

COMPARE

Since unit economics are business model specific, they can be used to compare the performance of companies with the same business models and in similar markets (to some extent).

IDENTIFYING THE LEVERS OF GROWTH

Identifying and understanding the 'levers of growth that act on the economics of the model (inherent to the business growth engine) is key, as they will help us to design differential advantages in our company. 

As you can see, identifying, calculating and understanding the improvement levers of the :mil economics is absolutely key for any company, startup or not, and will help us make better decisions about when and how to grow, whether it makes sense to seek external investment or how we should cut back on the business.