Sometimes in a business, sales are growing, the number of clients is increasing, but the marginal or net profit is not increasing or is at a minimum level. In such a situation, it is important to analyze the business processes and quickly identify the problem.
This may be due to an excessively wide range of products or different effective audience acquisition channels. Some products are profitable, while others are unprofitable due to too high variable costs or unjustified costs of attracting one client.
What is unit economics
Unit economics is a calculation method that helps to evaluate the profit of a business and its overall efficiency. Its peculiarity is that profit, income and expenses are estimated per unit of goods or, for example, services.
In fact, it is a way of calculating the financial performance of a business that demonstrates how much a company earns from the sale of one product, customer, or other “unit” that will generate income.
A “unit” is the basic unit of a product or service that a company sells. All calculations within the method are made in units. Each type of business can have its own unit:
- for a clothing store, this is, for example, one T-shirt;
- for a restaurant – one dish;
- for a law firm – one concluded contract;
- For a streaming service, there is one customer who pays for a subscription.
Tasks of Unit Economics
The peculiarity of unit economics is that it is necessary to consider not the entire range of goods or services at the same time, but to correctly research and focus on one group of market products. For example, unit economics for dry washing powders is calculated separately from liquid capsule ones.
1. Checking and confirming the profitability of a business idea. When launching a new type of business or product in an existing company, it is important to calculate in advance whether it makes sense to sell such a product or service.
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Unit economics shows how much revenue per user or specific unit of a product exceeds the average for all products in a business.
2. Cost optimization. Helps to identify all costs associated with the production and sale of a specific unit. Knowing the cost structure will allow the company to identify its weak points, reduce costs and significantly increase the profitability of the product.
Unit Economics Models
Within the framework of Unit-economics, two different models are usually considered. The choice of one of them will determine the logic of actions and the formulas used to calculate unit-economics. Experts distinguish:
- Client model. Suitable for both online and offline businesses. In this model, units are regular customers of the company, users of the product or service. Average revenue per user is how much money he or she brought in over a period. Let’s say a person who buys a monthly subscription to an online cinema for six months.
- Transactional model. Used mostly for offline business. Here, services or goods act as a unit. One sale and the income from it is one unit. For example, an hour of lessons with a history tutor or one table for furniture production can be called a unit.
How to calculate unit economics
In order to correctly calculate unit economics, first, you need to understand which model you want to choose:
- Transactional, where a unit is a single element and the subject of a transaction.
- Client, where the unit is your client.
Further, depending on the chosen model, a specific algorithm of actions and a set of formulas are used within the framework of unit economics.
Unit Economics Calculations: Main StagesThe easiest way to do the calculations is if the unit is a best headphones for iphone product. If you want to calculate the profit, the average income from selling a TV, you need to know the selling price and all the variable costs . These are costs that change with the increase in production volume. For example, raw materials, materials, delivery, acquiring commission, and so on.
Calculating the ARPU metric
Let us clarify that ARPU shows how much money one person spends on average on purchasing a service or product over a set period of time – a day, a month, or, for example, a quarter.
The user in the ARPU formula is a person who is simply aware of the existence of your product or company. For example, he may have visited your office, website or social networks, but has not yet made a purchase.
Disadvantages of unit economics
Unit economics, like any other method, has its drawbacks. Before using unit economics, it is worth getting acquainted with the nuances of the model and possible difficulties.
1. Exceptional precision is important
Even the smallest error in data or calculations can distort the sales picture, leading to incorrect decisions.
2. A large amount of data is required
In order to calculate some unit economics metrics, you may need a lot of additional data that is not always easy to obtain. For example, the total “lifetime” of a customer for any given product, the exact cost of acquiring one, and so on.
3. Difficulty of learning
The method itself is quite complex in terms of calculations and formulas. To successfully apply unit economics in large companies, you can hire a specialist in this field.
4. Lack of clear rules and calculation systems
Each company will calculate and analyze unit economics numbers lists in its own way. Everything will depend on the business area and the specifics of attracting customers. Therefore, it is not recommended to compare data from different companies with each other, either to compare efficiency or to use someone else’s calculation “template”.
5. Distortion of results due to seasonality and fluctuations in demand
Unit economics may not always correctly account for seasonal fluctuations in demand and other variables. This is especially important for companies that are dependent on certain seasons or events. For example, ice cream sellers, bicycle sellers, ski sellers. The price of their goods and services may vary greatly before and after the main season.
6. No consideration of intangible factors
Unit economics focuses on quantitative data and financial indicators: new products sold, number of purchases, orders. It does not take into account such intangible factors as brand reputation, customer satisfaction and product innovation. These elements can significantly affect the success of a business, but they are difficult to include in calculations and take into account in the analysis.
Common Mistakes When Working with Unit Economics
Calculating unit economics is a fairly complex process, during which entrepreneurs make mistakes. They can distort the results of the analysis, which leads to incorrect business decisions. Let’s consider several typical and common mistakes:
1. Advertising costs are not included in the calculations.
Advertising costs are often underestimated when calculating unit economics. However, they are a significant part of the overall cost of customer acquisition and can significantly affect future profits in the first place. If you do not take into account the costs of advertising campaigns, it may turn out that the revenue per unit of goods exceeds the costs, although in fact the business will go into the red.
2. Carrying out calculations for the entire business at once
The basics of unit economics include provisions that calculations should be made for individual products, goods, services, clients for each user acquisition channel. Therefore, calculating indicators immediately for the entire company as a whole is a mistake that will lead to distortion of the overall information and results.
3. Insufficient detailing of costs
Consider absolutely all of the organization’s expenses. Sometimes companies simplify calculations by excluding small, seemingly insignificant costs. However, even small key expenses can significantly affect the overall situation. Insufficient detail can lead to distorted results and, as a result, to making incorrect decisions.
Let’s sum it up
Unit economics is not just a formal set of calculations. It is a comprehensive approach that leads to an understanding of the essence of business. Unit economics allows you to consider each product, service or unit individually.
