This article is part of the newsletter OpenBooks crafted by LiquidCFO and was originally posted in Substack. You can access the original content here.
Not such an obvious answer in your financials. Let’s understand why….
A lot of startups and businesses hide behind the concept of economies of scale. This concept helps them justify short term losses – since you can argue that the business will become profitable once you reach higher sales volume, with the same cost structure.
The concern is that sometimes their financials could be so messed up that it’s hard to know what are fixed and variable costs, or what are the specific costs directly linked to the sale of their products or services.
There is a concept called unit economics that is quite helpful to verify the profitability of your business, by removing the effect of investments in growth (marketing, technology, people development, etc.).
This metric became quite popular in the startup industry for this reason, since investors use it to understand if the losses that a business may be making are related to investments or if the business is selling at a loss (the famous selling for 95 cents what you acquire for 1 dollar – or close to that).
Grab your pen and paper now – I’ll explain the two ways to calculate Unit Economics:
Unit is one product sold
For companies that sell goods and products, this is the ‘to-go’ metric. You just have to calculate the total revenue minus the variable costs associated with that revenue. The equation is expressed as:
Unit Economic:
Contribution margin = (Total Revenue – Total variable costs) / Total items sold
Unit is one customer
If you choose to define a unit as ‘one customer’ then the unit economics is determined by a ratio of two different metrics:
Customer lifetime value (LTV): how much money a business receives from a given customer before the customer stops buying your services
Customer acquisition cost (CAC): the cost of acquiring that client (marketing, sales, any incentives or fees you have to pay for a partner, etc.)
The unit economics will then be calculated as:
Unit economics = LTV / CAC
Once you’ve identified the Unit Economics for your business, you can assess if you are profitable and aim for investment on growth in volume. If your Unite Economics are positive, good job. Carry on and make investments or go for a fundraising round.
If you are not…. well, then we have to apply a few strategies – which probably deserve an article alone, so I’ll just list 3 actions (since OpenBooks is all about quick and actionable wins 😊 )
- Start by reviewing all agreements and terms with vendors and suppliers. Are there other suppliers with better commercial terms out there? Or can you renegotiate the pricing for the existing ones?
- Review your staffing strategy – maybe replacing expensive headcount to a contractor that is paid based on performance? This era of remote work has enabled a global workforce and a tremendous opportunity for how we think and manage labor + the overhead cost that comes along with full time employees.
- Review your pricing strategy: maybe it’s time to increase price, or offer alternative packages and promotions that will drive your client decision towards a pricing that makes your business profitable. Here is a great article listing a few strategies for pricing.
Unit economics is a powerful tool to remove ‘noise’ from your financials and assess the real profitability of your business model. It not only helps you to identify the costs that you can’t move away from but it also gives you information about actions you can take to improve your margins.
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