Unit economics plays a vital role in any successful team’s business metrics, and chances are that you’ve barely ever heard about it.
Unlike the hundreds of jargon terms and buzzwords that mire business analysis, by examining your unit economics you can get a solid sense of your business’s current potential for profitability, be able to predict it in the near future, and even see which products and services you should be focusing on in order to maximize your performance.
Yes, they’re heady claims, but read on and let us show you how to bring new context to your analytics.
- What is unit economics?
- What is unit economics in SaaS?
- What unit economics shows you
- How to calculate unit economics
- Improving your unit economics
Let’s get started.
What is unit economics?
Unit economics is the method of measuring your costs and revenue in relation to a specific unit relative to your business goals and value offering. This allows you to get a sense of how your business is performing in relation to the units that you’re selling.
To simplify it a little, unit economics is a measure of how large the difference is between the money you make per unit sold and the cost to produce it.
The “unit” that you’re measuring performance by will vary from business to business, just as the costs that you stack against the profits from those units will too. It all depends on the nature of your business, what it provides to customers, and how it provides those items or services.
We’ll go into more specific examples later in this post, but let’s cover the basics here to give you a solid foundation on the topic before continuing.
The whole point of unit economics is to measure your business’ performance in relation to the goods and/or services being provided. Hence why you need to define what “unit” you’re measuring before you start judging performance.
Your “unit” should be fairly self-explanatory, as you should already be tracking many of the elements used to calculate it to keep an eye on the overall health of your company. The key is to always keep in mind the costs of delivering that unit alongside the revenue generated by that unit.
In this sense unit economics can also be seen as a measure of how profitable a specific unit is, and thus an indicator of how much profits from that unit can be increased. For example, if your business is a taxi service and your unit is “one customer”, you could see what the average profit per customer (minus costs) is, and whether you need to think about either raising prices or cutting costs somehow.
What is unit economics in SaaS?
As with many other business metrics, SaaS organizations have a different interaction with unit economics due to their nature and practices. You’re not selling a product once and then washing your hands of it, you’re providing an ever-evolving product as an ongoing service to customers over a long period of time. Hence why the “unit” in your unit economics can’t be the profit from a single sale - it’s just not compatible with SaaS.
Instead, SaaS businesses need to focus on the value of one customer as their unit, over a specific period of time. In fact, the concept of unit economics for SaaS allows a business to examine the margin made in the average client relationship over time, and not just the cost to acquire a customer.
This means that your entire focus shifts when calculating your unit. In addition to including the costs of creating, providing, and maintaining your product (Cost of Goods Sold, or COGS) as you would with, say, a retail store, you’re also looking at your customer acquisition cost (CAC) and customer lifetime value (LTV). Then, you’re factoring in a specific timeframe for analysis.
It might seem like a simple change, but this fundamentally changes what you need to look at when calculating your unit, and thus what your unit tells you about your current performance.
SaaS unit economics measures your performance through gross margin on a customer-by-customer scale, and can be used to help forecast growth potential. Through your unit you can see how much you’re earning on average from each customer and how much said customer will cost to service over the duration of their relationship with you, which can trigger some immediate red flags if you show yourself to be in the red.
With that knowledge, you can then go on to focus on increasing the amount you earn from your customers (their LTV) and/or reducing how much it costs to acquire them (CAC) and the cost to service them (per-customer COGS).
For example, let’s say that your unit economics shows that you’re performing well per unit (customer sold to). This means that, on average, you’re making money on each of your customer relationships. This means you will have the extra cash to be able to invest in business-growth opportunities and, perhaps, to drive profit back to your business owners.
In other words, it’s a business whose future looks bright.
However, SaaS businesses’ unit economics are unique in another way. Unlike a consulting business where all costs are centered around serving a particular customer or job, a SaaS business spends a lot of money investing in building and expanding the current product set. This means that your unit economics could show a wonderfully profitable customer relationship, but the actual business could be losing a lot of money.
Traditionally, this kind of investment in the future isn’t a bad thing, but it’s important to keep in mind that a positive unit economic calculation isn’t a guarantee for a profitable SaaS business.
What unit economics shows you
As we’ve touched on earlier in this post, unit economics is a fantastic calculation that can teach you a lot about the current performance of your business in relation to its “units”. Namely, it can:
- Let you predict your margins
- Show the future potential of your ventures
- Provide insight for your primary business focuses
- Help to evaluate recent changes
The primary use for unit economics is to allow your team to see and predict the margins of your product and/or services, which can drive profitability. As in, you can find out what your revenues are per unit of what you’re selling versus the costs of achieving that revenue. Further, you can segment these units by meaningful business categories, like products sold or customer profiles.
By using this you can see the sustainability of your individual units, whether those are the customer value versus costs to deliver each of your products individually (or of separate pricing plans) or the value of each physical product you sell. This not only allows you to see what endeavors are the most advantageous for you as they currently stand, but also predict which customer segments or product lines will be the best to focus on expanding due to their relative profitability.
Knowing which sections of your business are performing the best (and will likely continue to perform well given no changes occur) is incredibly helpful for knowing which parts of your business to expand and double down on. This can be instrumental in shaping the future of your company as a whole, and it all can largely stem from your unit economics calculations.
When you make any changes to your formulas or business practices, keeping track of your units and their performance over time is an easy way to plot their performance due to those changes too. This will let you keep those changes in the context of how they’ve affected not only their primary fields, but the performance of your company in regard to its units overall.
However, it’s vital to remember both what is and isn’t included in these unit calculations, especially when it comes to SaaS.
As a SaaS business, your unit economics isn’t a measure of overall business performance and profitability. It’s certainly a part of that, and can be demonstrative in showing issues that play into the wider whole (such as profitability per unit), but there is vital context that unit economics does not cover. Specifically, unit economics includes the costs to acquire customers and the cost to service customers, but not the costs to grow your business offerings.
You completely ignore the cost of things such as your dev team and UI designers, but you do need to include the hosting costs of your production environment and those related to keeping your product up and running effectively. Additionally, your unit economics do account for many key elements to your company’s growth, such as your marketing and sales costs per customer gained, and how much an average customer spends in their lifetime as a customer. As such it’s not the end of the world if these metrics aren’t given as the extra context for your units, but it’s worth remembering to do so to avoid any nasty surprises down the line.
Speaking of the metrics used to calculate and contextualize your unit economics…
How to calculate unit economics
There are two ways to calculate your unit economics, with different interpretations as to what your “unit” should be measured as. The right one to pick will largely depend on your business and what it sells:
- Units as items sold
- Units as customer value
Unit economics as items sold
The first method is for companies that have a definitive end to their item sale, such as a retail store. This requires your “unit” to be measured in terms of the profits from selling an item, usually by examining their “contribution margin”.
To calculate this, you need to take what you earn from each sale of a specific product and subtract the variable sales costs of that item on average.
These variable costs are the only difficult part of this equation, as they require you to go through all of the costs which can change from item to item and account for how these costs have changed over time. Incidentally, this is also why the variable costs figure is an average - so that it can give a better overview of what these costs look like over time.
Variable costs are calculated by adding together costs including raw materials, direct labor, commissions, utilities, and shipping and/or freight costs. Be particularly careful when summarizing or predicting commission costs, as these not only differ based on the rate you’re giving, but also the number of products sold to which the commission applies. You then need to divide the overall lump sum by the number of products made in that batch.
Once your variable costs are calculated and subtracted from the revenues earned from selling each product, you have your gross margin for that specific product over the time you’ve examined those costs for.
In other words, you can compare products both with how much raw revenue they earn, how much they cost to produce, and the difference between the two (gross margin). This will let you see which items could be better to focus on and which could stand to be optimized through higher sale prices or by lowering costs.
Unit economics as customer value
The second method is to take your unit to be that of your customer’s value. This method is particularly useful in subscription-based models such as SaaS companies, as your customers are continually generating stable revenues for as long as they are customers rather than with traditional one-and-done product sales.
First, you’ll need to determine whether you’re calculating unit economics over customer lifetime, or only for a snapshot in time. We’ll cover customer lifetime first.
For this calculation you’ll need to divide your customer’s lifetime value (LTV - the total revenue they generate in their lifetime as your customer) by your customer acquisition cost (CAC) and the monthly cost of goods sold (COGS) multiplied by the duration of your average customer’s relationship with you, in months.
This method of unit calculation is a little more complicated, given the extra work that goes into calculating your LTV and CAC. For reference, your customer LTV is your total revenue divided by your total number of customers (both over a set period), and your CAC is the total cost of sales and marketing divided by the number of customers you acquired during that same time.
An easier, and just as helpful approach to unit economics in SaaS, is for a snapshot in time. For this calculation, you’ll need to take the monthly revenue from the average customer and divide it by your monthly cost of goods sold.
To further enhance this approach, you can divide your customers by a specific characteristic that makes either their revenue or their costs different, such as average number of users or frequency of product usage. The challenge with this approach is that you’ll need to be able to associate the costs of goods sold properly by each segment.
No matter the approach you take, it’s well worth the benefits as this unit will show you how profitable your current efforts are (aside from the costs of developing and maintaining your product).
Improving your unit economics
We’ve already highlighted how your unit economics calculations can help you to see which products or customer segments are performing well, which you should focus on more, and whether your current business model is reasonably sustainable should no sudden changes occur.
But what happens if your units show that you need to make changes, and fast?
In that case, you can use your calculations to see where your efforts need to be focused and even get ideas on how to go about fixing your situation.
Is your LTV bringing down your score? Look into decreasing your churn or optimizing your pricing plans to increase customer spending without affecting churn. Is COGS draining your pockets? Analyze your costs to deliver your products or services. If you’re a SaaS company, it might be time to optimize that AWS bill (Aimably offers an AWS Cost Reduction Assessment that could really help!)..
The specific calculations and what they tell you might change, but unit economics are and will remain a vital aspect of modern businesses.
What are you waiting for?