What is unit economy in simple words
Unit-economy is a calculation method, which allows you to understand if a unit (unit) is profitable or unprofitable. The unit can be a product, a service, a customer – it depends on your business model. The key is that this unit must generate income for the company.
The conclusions are simple: if the business makes money on a particular unit, then the business model is working. You either need to keep moving in the chosen direction, or improve the promotion strategy (or the product itself) to make even more money, or scale up (e.g. open another store). If the business is losing on a unit, then you need to understand why and take action. If you try to scale on a loss-making unit, you will increase not profits, but losses.
History of the unit economy
Opinions vary as to who invented the unit economy. According to one version, the method was invented by David Skok, an American investor who invested in startups. The investors demanded a clear business plan and calculations from the startups. But since the inventions included completely new products and services, there was little to rely on. Then startups started “drawing” numbers, and this did not allow for an adequate assessment of risks. Investors needed answers to the questions in order to make a decision:
- how much money is spent on creating and selling one unit of a product;
- how much profit the sale of one unit makes;
- how much does it cost to attract a customer.
Unit Economics helps to understand these things
According to another version, the term appeared in the period from 1995 to 2010 when the U.S. was experiencing a boom in entrepreneurial activity, including in the IT sector. Programmers, designers and other professionals were burning with ideas, but had no understanding of the numbers. And consequently, they could not determine how profitable or unprofitable their idea or selected business model was. In the noughties in the textbook for entrepreneurs “Entrepreneurship: Starting and Operating a Small Business” there was a separate chapter “Business Decisions & the Economics of One Unit”. It is true that at that time it was not yet considered a separate method of calculation – all calculations were made by standard formulas, but it was possible to attract attention to the fact that in addition to total income and profit there is a profit for individual units. Only later, new terms and ways of calculations began to appear, and the model was called uniteconomics.
What we have here is a relatively new term, so there are discrepancies in the interpretations, formulas and generally the expediency of using this method.
Why do we need unit-economics?
Unit-economy is not about figures, but about decision making and understanding if the company is moving in the right direction.
The method allows you to find out
- how profitable or unprofitable the unit is;
- Whether the business model is the right one;
- whether the business can be scaled up or if we are scaling up losses;
- how to manage unit costs more effectively;
- how to organize pricing in a profitable way;
- how you can increase the profit from a particular unit;
- whether it is worth changing the assortment, and if so, which specific items are more profitable and which are less.
A simple example. You sell cacti, orchids and daisies. You invest in advertising and, in general, at the end of the reporting period is in the black. And you decide to double the cost of advertising, thinking that it will increase profits. But the effect is not what was expected.
What is meant by a unit here – the fact that the product was sold. But for a more detailed analysis, we take apart the sale of each group: separately cacti, daisies and orchids. We preliminarily count the costs for each.
If you start counting units, it turns out that
- cacti make the most profit at the lowest cost;
- Orchids are bought more often than cacti, but the final cost of them is more, and the total profit is less;
- Daisies in general are taken most often, but the profit does not cover the costs and in this position you go into deficit.
In fact, the conclusions can be drawn as follows:
– Leave the advertising to the cacti;
– Orchids, either lower your costs or raise your price so you can increase your profits relative to your costs. You can also optimize the cost of the advertising campaign or try a different distribution channel. For example, so that orchids are bought more often, but advertising costs are reduced or remain the same;
– Daisies must either be removed from the range, or to reduce costs for them, or again, raise the price (but the price increase must be justified). Or modify the product – for example, include chamomiles in a bouquet, the profits on which will exceed the cost of daisies.
These are very tentative examples, but the essence, we think, is clear.
The trick is that the company may be profitable as a whole, but the unit economy for individual units do not add up. And then the scaling or lack of strategy changes in a changing market can lead to unnecessary costs. After all, if you take a typical small business, such as a clothing outlet in a market, most often the profits there are counted at the end of the day. “We earned this much today, and yesterday we didn’t earn at all, but at the end of the month we are on the plus side. They go to buy the same items, and history repeats itself.
How to Calculate the Unit Economy + Terminology
This is where the fun part begins. The unit economics manuals are full of complicated formulas with acronyms, but not every formula will fit your business model specifically.
How to simplify it all?
We’ll take two types of units as the basis:
A unit is a product or service.
Or rather, a sale of a good or service. That is one transaction. In this case the margin is calculated. From the income received from the sale of goods we deduct all the costs related to the production and sale of goods. If the amount is greater than 0 – we are in the plus, but there is still the question of how much this amount is greater than zero.
The bottom line is that at all costs remain in profit on the sale of a unit of goods. If we want to change something, for example, to change the supplier, or increase spending on advertising in the calculation, we must still remain in the plus. If we know in advance how the figures will change due to a change of supplier, and when calculating the unit economy we go to the minus, then the change of supplier may be the wrong decision. The calculation will help you avoid it. This is why we say that unit economics is more about decision-making.
Wait, isn’t this just regular margin analysis?
There’s a difference. In marginal analysis, all costs are considered, both fixed and variable. Constant is, for example, the cost of renting a bicycle sales office – no matter how many bicycles are sold, rent has to be paid and its cost is fixed. In unit economics, only variable costs are counted, and only those costs that are directly related to the unit. For example, if you produce a unit on a machine, you count the electricity spent to produce the unit + roughly the wear and tear on the machine when you sell it. If there were no orders, the machine stands shut down, so there is no extra cost.
Important: In unit-economy we count only the fact of sale in the reporting period. That is, if you bought 50 bicycles, but sold 30 in the reporting month, we count 30.
This point also confuses many people. “I spent money on 20 more bikes, but they are not sold, so I’m in the minus, not the plus!” That’s not true. You can sell those bikes next month, and then you have to count the unit economy for those 20 bikes and the new reporting period. But here the cost per item will be different, because you have to pay for a second month of rent for the unsold bicycles (if the rent price depends on the number of items). If at the additional cost you are still in the plus, then the unit economy has converged.
Of course, there are always items that don’t sell. And returns. If they are few – we take them to the costs. If there are a lot of them, we look into the specific reasons for the lack of sales and eliminate them. Maybe it’s because of marriage, lack of demand, out of season, and so on.
But we only count the actual sales, but what about the example with a theoretical change of supplier?
In that example, we can count the unit economy even before the supplier changes, only if we already know the exact cost figures from that supplier (for example, they are in his commercial proposal). That is, we take the actual number of sales in the reporting month, but substitute figures not from the current supplier, and the new. And we go into deficit. The same would be the case with a real change of supplier, but the pre-calculation helped avoid making the wrong decision. If we do not know the exact figures, then it is a prediction, and this has nothing to do with unit economics.
Important: When calculating unit economics, costs are considered literally per unit. How much is spent on production, advertising, storage, packaging, delivery of ONE item. There can be confusion with this, too. For example, how do we calculate the cost of shipping one item to the warehouse if we pay for shipping a batch? We take the amount of delivery and divide by the number of units, we get the cost of delivery of one unit. If each month we order a different number of units, the cost of delivery of the same unit will be different.
2. unit is a customer
This model is more suited to an online business or an offline subscription model. Or your business model involves repeat sales. For example, you offer hosting rentals or send a box of socks to customers each month in a subscription model. That is, one customer makes multiple sales and generates revenue for you. If we are talking about SaaS services or mobile applications, you don’t need to produce a service for each sale, it’s already there.
Here we calculate by another formula:
1. Calculating the profit of the clients. Gross profit is divided by the number of clients, you get the profit per client. Gross profit is calculated as the difference between revenues and the cost of services (again excluding fixed costs).
2. Calculate the cost of attracting customers. All client costs divided by the number of clients.
3. Compare the two figures. The average profit from one client should be more than the cost of this client.
You can also find the following formula:
LTV > CAC.
LTV – lifetime value, i.e. how much profit he brought us for the whole time of cooperation.
CAC – customer acquisition cost.
Attentive reader will notice that this chain does not include the cost of customer support, and after all, these costs are often present in online services. For example, if the number of hosting clients grows, the cost of servers, tech support grows. These costs are added to CAC.
And what is ARPPU, COGS, APC?
These are abbreviations, which are used in more complex formulas for calculations. These formulas provide refined information, but they don’t fit every business. Each formula usually has an explanation of what each abbreviation means.
For example, there is a formula:
CM = UA * (ARPU – CPA).
It looks unclear. Let’s break down the abbreviation:
CM – marginal profit (Contribution Margin);
UA – number of users (User Acquisition);
ARPU – Average Revenue Per User;
CPA – Cost Per Acquisition.
If ARPU is higher than CPA, business is profitable, if not – unprofitable. This is essentially the same as in the beginning of this paragraph. Only there we separated the calculation into 3 steps, and here everything is packed into a formula with incomprehensible letters.
The plus side of formulas is that they tell us what else we should consider in the calculations. For example, when we consider a client as a unit, we can miss the point that there are users who come in through advertising, but do not make a purchase, but the cost is there. Accordingly, to calculate ARPU with this in mind, an additional formula is introduced:
ARPU = ARPPU * S₁
ARPPU – Average Revenue Per Paying User (Average Revenue Per Paying User).
С₁ – the percentage of users who became clients.
Then you specify what ARPPU is made up of and the formula becomes even longer and more incomprehensible.
The complexity of the formula depends on your objectives. For example, you can calculate the unit-commodity as a whole using the simplest formula – income minus unit costs. And get a figure on the fact of sale. For example, 500 rubles. But if you follow the client’s further actions, it will turn out that he can buy the same product for the second time or buy several other products in the accounting period, and then the unit-unit amount will be higher.
All formulas with abbreviations can be found in unit economics handbooks.
To summarize: the key in unit economics is to correctly identify a unit and then calculate income, expenses, and profit for that unit. The important thing is not what specific formula to use for the calculations – it is important to consider all the factors that affect income and expenses. The following is trivial – from income subtract the amount of expenses and get the final figure.
What you should keep in mind when counting unit economy (some points have already been pointed out in the article):
Don’t count fixed or one-time costs. Only variable costs. And also consider revenues and expenses related only to that unit. For example, you hired programmers to make a mobile app. The unit is a paying user who downloads the app and generates revenue. You don’t include the cost of these programmers in the costs because they don’t re-create the game, it’s already made. That is, the cost of each copy is 0 rubles. But you need to count the cost of advertising the application. For example, you spent 1,000 rubles and got 20 downloads. This means that the cost of attracting one user is 50 rubles (and if you take into account that not everyone is monetized, it’s higher). Then we look at how much money this user brought in.
Determine the reporting period. And count only for this period. Recall the example of bicycles. If we take a month period as the basis, then count sales only for that month.
Unit economy may differ by customer acquisition channels, audience segments, product categories, cohorts. Therefore, for more accurate data it is better to divide products or customers into groups and count each one separately. And then analyze. This takes time, but gives more information. For example, if we have a seasonal business, the unit economy may add up in the season, but not in the off-season. That’s fine. It’s the same for customer acquisition channels. This way, in conjunction with analytics services, you can get more information to see if, for example, it’s worth investing in advertising on Facebook or if it’s a black hole where the budget goes.
Why the unit economy causes so much trouble
The main reasons:
- Many entrepreneurs or economists think it doesn’t make sense to count profitability by units. Why this is wrong has already been pointed out in the article (no complete picture). But if you’re not going to scale or change your development strategy or bring new products to market, you can do without it if the bottom line suits you. And there are no “black holes” in the budget. If you want to increase profits or cut expenses, but don’t know how to do it, unit-economics can help you.
- People get scared of incomprehensible formulas and can’t figure out how to do the math. If the formula takes into account all the nuances of your business, you can just substitute figures and count by these formulas. If it doesn’t – it’s better to count by the simple version (income minus expenses by unit). No one but you will be able to tell exactly what to include in the expenses and what not.
Answers to questions
The things that most often confuse newbies at the stage of getting acquainted with unit economy, so let’s make it clear:
How can a startup calculate unit economics at the development stage, because there is no data?
We need to get at least primary data. For example, release a batch of 100 to 1,000 products and try to sell them. If it’s a service – run a beta version. Fix the first data and analyze. This is better than immediately seeking an investor, and then realizing by experience that the idea is unprofitable.
Can you use numbers from forecasts in your calculations? For example, count potential buyers based on market analysis?
No, because potential buyers may never become real buyers. Market potential tells you nothing about the real costs and revenues per unit. Forecasting as well as market research can be done in parallel to get more information.
Where do we get the numbers to calculate costs?
The figures are taken from the financial department and services: from the advertising office, CRM, analytical services, stock-keeping services.
Are the figures obtained as a result of the calculations objective?
There may be an error in the calculations. The important thing here is not the specific figure, but the one that allows you to make the right decision.
What is the calculation period of the unit-economy?
You choose the period of calculation. Usually it is a week, a month, a quarter, half a year, or a year. You also need to look at the number of sales per month. If they are a lot, it makes sense to count every month. Also, if you calculate the rest of the metrics on a monthly basis, so as not to get confused, take a month as well.
How do you calculate the profit of a unit with several channels of customer attraction?
Divide into groups, segments, cohorts and count. Again, there may be uncertainties here. For example we can think that the client was brought to us by advertising, and before that he found us in a search, and before the search he was told about the company by a friend. Here it is important to understand – either the unit openly goes to the minus, or to the plus. If there are doubts, it means that some additional calculations are necessary.
Can unit economy be considered a separate direction or a replacement for the standard economy?
No! And this is the main reason for arguments among beginners. Like – “Why do we need your unit economics when we have standard economics and marginal analysis? That’s the thing, the term is only called “unit economics”, but in essence it’s just a calculation method that provides additional information for analysis and decision making. It’s like counting ROI or conversion rates. We’re not saying that calculating ROI means abandoning standard economic calculations, are we? Or that we have to choose between ROI and CTR – both are important to us.
Are unit economics and marginal analysis the same thing?
No, but in the unit-economy calculation method, we consider marginal profits. Excluding fixed costs and as applied to the unit. This is described in the article in the calculations section.
Can there be more than one unit?
Yes. For example, a large retail chain may have a sale and a customer as a unit. However, a large business usually does not calculate all of these in much detail; otherwise, if you divide them into all groups, cohorts, and channels of attraction, you will end up with thousands of reports. They use a number of factors in addition to unit economics to make a decision. But for product managers, startups, and small and medium-sized businesses, when they bring out a new product or want to scale, this is important.
Is it worth using unit economy calculators?
This is where you need to look at whether the calculator takes everything into account for your business? If yes, you can, but if not, the calculations will be inaccurate. A universal calculator may not have an important cost item for you. Or, for example, the calculator is designed for SaaS services, but you sell paintings and it is not suitable for you. It’s more efficient to put all your income and expense data into an Excel spreadsheet and calculate it yourself.
I still have questions – who should I read on the subject of unit economy?
In Runet, Daniil Khanin, Ilya Krasinsky and Andrey Fedorov give detailed accounts on this subject. In the original, you can read or listen to lectures by David Skok.
In spite of the incomprehensible abbreviations and formulas, uniteconomics comes down to simple mathematics. The first thing to do is to figure out if your business needs this method of calculation, and if so, what is the goal? Next, determine what counts as a unit. Then carefully write out what to count as income and expenses per unit. Calculate, analyze, and draw conclusions.