Unit economics is a powerful tool that can help you better understand your product and business. In particular, it helps you answer one of the key questions when you want to scale your product: are you making or losing money on a particular user?
Calculating unit economics might look like a complex task that requires knowledge of various formulas and terms. However, in reality, unit economics is simple and intuitive.
I will explain it to you in less than 40 words. Read and count.
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Unit economics made easy
Unit economics answers a simple question: Do we make money on a particular user (unit) or not.
To answer this question, you need calculate the following:
- How much money do we spend to acquire one user?
- How much money do we earn from one user?
Calculating unit economics for your business
To calculate how much you spend on acquiring a user, divide the cost of acquiring a cohort of users by the number of users in the cohort. The resulting value is the cost of acquiring one user in the given cohort, also referred to as Cost per Acquisition (CPA).
To calculate how much we earned per user, take the same cohort of users and calculate how much profit it will generate. For this, you need to calculate the contribution margin (not revenue) of the cohort in the future. By dividing the contribution margin by the number of users, you’ll obtain the lifetime value (LTV) of a user in the cohort.
The final step is to compare the CPA to the LTV.
Pitfalls of calculating unit economics
LTV (Lifetime Value) should be calculated based on contribution margin, not income or revenue
LTV (Lifetime Value) should be calculated based on contribution margin.
Contribution margin is the difference between revenue and all variable costs that are directly associated with the product or service sold.
Different companies might calculate LTV in different ways. So make sure to figure out how this metric is calculated in your company before using it. However, in the context of unit economics, we should calculate LTV based on contribution margin, since it represents what will happen when we scale the business.
Many online guides will state that LTV should be calculated based on Gross Margin (or gross profit). It depends on how these terms are used and interpreted in different companies and industries. In classic accounting, gross profit is the difference between revenue and cost of goods (COGS or Cost of Goods Sold). But when calculating gross profit in the IT world, they often take into account not only the COGS (which is often zero since it costs nothing to make another copy of a software) but also other variable costs associated with it. In this case we are basically looking at contribution margin.
To avoid the complicated maze of financial and accounting terms, focus on the main question: are you making or losing money on a particular user? To answer this question you should calculate the contribution margin that the company will receive from the sale of a specific service or product. Therefore, all variable costs that are directly related to it must be deducted from the revenue.
Variable and fixed costs
The key for calculating LTV is to understand which costs are fixed and which costs are variable.
If you sell a mobile game through the App Store, then the cost of a specific copy of the game is zero. The salary of the developer team is a fixed cost. It doesn’t scale with the sales of the game.
Now consider a company that develops and sells complex, expensive B2B software. For every customer, the company’s engineers must work on the integration of the software into the customers business and workflows. In this case, the costs of integration should be accounted for when calculating LTV (these are variable costs). But the costs of developing the software itself do not need to be taken into account because they are fixed and are not directly related to a specific transaction.
If you sell gloves through an online store, then the variable costs for a particular transaction will consist of the purchase price of the gloves, shipping, payment system fees, and other related costs.
LTV is usually calculated for a specific moment in time
In the classical sense, LTV (Lifetime Value) is the contribution margin (revenue minus variable costs) of an average user over the entire period of using the product. This is a nice definition, but it is hard to apply it in practice.
A more practical application is to estimate the LTV for some month from the moment the user arrives.
For which month to calculate LTV
The projection period of the LTV strongly depends on the product and the problem being solved.
For example, venture-backed companies often aim to recoup the money spent on acquisition in 12-18 months (sometimes even longer).
If the company is bootstrapped and is spending its own money, then it can rarely afford to wait more than 2-6 months for returns on the investment in user acquisition.
For some products, LTV plateaus quickly. In these cases, it makes sense to calculate LTV for a month, when the curve almost becomes parallel to the X axis.
LTV must be predicted early
Usually, you can’t wait 6 or 12 months to gather enough data to calculate the LTV of your users. Therefore, you must be able to predict LTV based on one or two weeks of data.
Forecasting LTV is difficult, but not impossible.
Segment users when calculating unit economics
Unit economics may be positive for some acquisition channels or countries and negative for others. Therefore, unit economics must be calculated separately for different acquisition channels, platforms, regions, etc.
One of the challenges of this case is attributing users to a specific acquisition channel. But that is a separate topic of discussion.
A unit can be anything
The “unit” in unit economics is what you plan to scale. It can be a new user, a user converted into a paying user, or a user who has subscribed to the trial. You must choose a target unit and calculate both CPA and LTV for it.
However, there are some well-established conventions that are worth mentioning. In mobile games and applications, a unit is a new user. In SaaS, it is the paying customer.
ROI/ROMI vs Unit Economy
ROI (Return on Investment) or ROMI (Return on marketing investment) is an excellent metric that helps apply unit economics to marketing and product growth. ROI = (LTV – CPA) / CPA
ROI shows how much return you get on your investment in a specific distribution channel. To calculate ROI for a channel, take the contribution margin of customers attracted from this channel, subtract the money spent to get these customers, and divide the result by the acquisition costs.
Unit economics is better introduced and explained in simple words, without using complicated terminology. Otherwise, everything becomes more complicated than it really is.
“The supreme goal of all theory is to make the irreducible basic elements as simple and as few as possible without having to surrender the adequate representation of a simple datum of experience.”