Why Unit Economics Matter
Unit economics are a fundamental concept for businesses to evaluate profitability and make informed decisions. Focusing on units (products or services) rather than overall performance enables long-term growth. In this blog post we will explore the key metrics which drive unit economics and how you can measure them.
Customer Acquisition Cost (CAC)
CAC measures the direct cost of acquiring a new customer. It includes marketing expenses, sales efforts, and customer onboarding costs. For example, a SaaS business that spends $10,000 to acquire and onboard 100 new customers would have a CAC of $100. It is important that every business is pragmatic when analyzing CAC as they must understand what is driving the overall figure. By completing cohort analyses businesses can understand CAC on a per channel basis, allowing them to optimize their CAC spend and compress CAC with time.
Customer Lifetime Value (CLTV)
CLTV estimates the total value (gross profit) a customer will provide a business over their lifetime. To calculate CLTV you take the projected revenue over a period of time (month), multiply it by the gross margin, and then divide the figure (gross profit) by the projected churn rate for the same period of time. For instance, a subscription-based service with a monthly fee of $50, a gross margin of 80%, and a monthly churn rate of 4% would have a CLTV of $1,000 (($50 * 80%) / 4%).
Churn rates
Churn rates tell a business what percentage of customers are projected to leave or “churn” over a stated period of time. For example, if you acquire 100 new customers in month 1 and then in month to you 95 of the 100 remain as customers the monthly churn rate would be 5%. Using the example from above, if the churn rate were to expand by 2%, to 6%, the CLTV would compress by $333, to $667. This is critical to mention as CLTV is commonly used as a reference point for CAC so an unexpected expansion or contraction in CLTV can have a significant impact, to both the up and downside. This is why companies and obsessed with reducing churn.
Gross margin
Gross margin is equal to the gross profit of a product or service divided by the price of the product or service. Gross profit is the difference between the price and the direct cost of the product or service.
For example, a product that is sold for $100 and incurs $60 in production and distribution costs (COGS) would have a gross profit of $40. Dividing $40 by the $100 price results in a 40% gross margin.
CLTV / CAC
Understanding how CLTV and CAC are connected is crucial in evaluating any business, service, or product. The ratio is a key metric that compares the value (gross profit) a customer brings to the business over their expected lifetime to the cost of acquiring that customer. As a rule of thumb, to be deemed healthy the ratio should be at or above 3 and the higher the ratio the better as it indicates better profitability and efficiency in customer acquisition efforts. Moreover, the ratio should also be analyzed in the context of growth. For example, if Company 1 is growing at 10% per month and has a CLTV / CAC of 5 and Company 2 is growing as 40% per month but has a CLTV / CAC of 4 this does not mean Company 2 is less efficient as Company 2 is optimizing for growth and as you grow faster your return on capital usually compresses as you take on the next best channel, resulting in a lower blended CAC. If Company 2 were to reduce their growth they may have a CLTV / CAC which is on par or even higher than Company 1.
Payback Period
The payback period tells a business how long it will take for them to recover their CAC. Assessing the payback period helps determine the efficiency of customer acquisition. Achieving unit profitability and reaching the break-even point are essential milestones for sustainable business operations. For example, a subscription-based service with a monthly fee of $50, a gross margin of 80%, and a CAC $200 would have a payback period of 5 months, which is generally defined as strong. In general, businesses should aim to have their payback period be less than 12-months, but there are multiple factors that could result in an higher payback period being acceptable.
Conclusion
Unit economics are a powerful and necessary tool for evaluating the financial performance of individual products and services. Analyzing unit economics allows businesses to make informed decisions and optimize profitability. More importantly, investors will extensively review unit economics when analyzing an investment, especially for early-stage companies.
The above touches upon the basics of unit economics, if you would to learn more or have a professional analyze your unit economics, please contact us at contact@blackwellpartners.co or schedule a free consultation by clicking here.