Unit economics analyses the costs and revenues of a single product unit to measure profitability and scalability. This topic explores key metrics like CAC and LTV, strategies to optimise performance, and the role of unit economics.
Approach
Product managers use unit economics as a tool to make informed, data-driven decisions, ensuring each unit's profitability and optimizing resources for sustainable growth.
Process
The key idea associated with unit economics calculation is tracking the flow from marketing channels through user acquisition, leading to sales, and resulting in transactions that generate gross profit.
Key Concepts
Unit economics uses a set of metrics to determine the profitability of a business, product, or feature.
Unit Definition
In unit economics, a 'unit' is the key entity used to evaluate profitability, such as a customer, service subscription, or product sale. The definition of a unit varies depending on the business model, reflecting what drives value and revenue for that specific business.
Estimation Process
Unit economics estimates involve analyzing costs, profits, and other indicators that each unit (e.g., user) generates.
Key Questions Answered
Do we profit from each unit?
How much did we spend on user acquisition?
How much did we earn per customer?
David Skok’s Model
This model helps assess the financial health of a business and guide strategic decisions. It determines if each unit (customer) is profitable. To answer the question, we need two metrics:
LTV – Lifetime Value of a typical customer
CAC – Cost to Acquire a typical customer
LTV:CAC ratio
The LTV:CAC ratio measures unit profitability, with a ratio above 1 indicating success. Strong models have CAC well below LTV, with top SaaS companies often achieving ratios of 3 to 8 or higher.
Basic Metrics
The basic unit economics model groups metrics into user acquisition, conversion, sales performance, and cost management. These metrics are essential for calculating contribution margin and determining if scaling units are profitable.
UA – User Acquisition
Defines a flow of acquired potential clients. Key metric of unit economics, determines scaling units flow.
E-commerce B2C
Number of unique visitors attracted to the website through advertising.
Corporate B2B
Number of new unique company records in CRM from direct sales.
B – Buyers
This metric quantifies how many potential clients become actual buyers, reflecting the effectiveness of the conversion process.
C1 – Conversion to First Sale
Percentage of attracted potential clients that make a purchase.
C1 = B / UA
This key product metric reflects product value and has a non-linear impact on profit margin and business growth.
AOV – Average Order Value
The average amount a client pays for goods or services.
AOV = AIV × IAQ
The e-commerce formula calculates sales metrics by multiplying Average Item Value (AIV) by Average Item Quantity (IAQ).
AOV = SUM(AIV × AIS)
The SaaS formula calculates Average Order Value (AOV) by summing the product of Average Item Value (AIV) and Average Item Share (AIS).
COGS – Cost of Goods Sold
Costs incurred by a business at the time of a transaction. Fixed costs remain unchanged regardless of the size of the average check, while variable costs vary based on it.
1sCOGS – First Purchase COGS
Additional costs incurred during the first transaction with a new customer are not classified as marketing expenses. Understanding 1sCOGS helps in assessing the initial variable expenses linked to acquiring new customers.
APC – Average Payment Count
This metric helps assess customer loyalty by measuring the average number of transactions per client.
APC = T / B
T – Total number of transactions.
B – Number of clients who made these transactions.
CPA – Cost Per Acquisition
Marketing cost per acquired scaling unit. Key metric in unit economics, determining if a business profits from acquired units.
Understanding CPA allows product managers to evaluate the profitability of marketing efforts and optimize resource allocation for maximum return.
CAC – Customer Acquisition Cost
Sum of all marketing expenses aimed to attract customers.
CLTC – Customer Lifetime Cost
Marketing spend on customer acquisition and retention over the customer's lifetime.
LTC = CLTC × C1
Marketing spend on scaling unit acquisition and retention over their lifetime. Lifetime Cost (LTC) assesses effectiveness of scaling unit acquisition and retention by comparing with LTV.
Calculations
Understanding and calculating CM, CLTV, and LTV helps product managers allocate resources efficiently and ensure profitability through effective unit economics.
CLTV – Customer Lifetime Value
Gross profit per customer.
CLTV = (AOV – COGS) × APC – 1sCOGS
Key metric showing how much a business earns from a customer over their lifetime.
LTV – Lifetime Value
Gross profit per scaling unit.
LTV = CLTV × C1
Helps in making marketing decisions to scale the number of potential customers. Lifetime (LT) refers to the duration a customer remains active with a product, measured as the time interval between their first and last recorded purchase.
CM – Contribution Margin
Measure of profit per unit after accounting for variable costs.
Determines the number of scaling units needed to cover fixed costs and achieve desired profit levels. Helps identify the optimal configuration of metrics to achieve a positive contribution margin.
CM = UA × (LTV – LTC) = UA × (CLTV × C1 – LTC)
The primary and expanded formulas for CM calculate profit by subtracting variable costs from revenue, with the expanded version adding metrics like CLTV and conversion rates.
CM = B × (CLTV – CLTC)
The client metrics formula assesses profit by subtracting customer lifetime costs (CLTC) from the revenue generated by buyers (B).
Break-even Point
Contribution margin must cover fixed costs. A positive contribution margin shows that unit economics are profitable, with the excess over fixed costs contributing to EBITDA.
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