People say that economics is boring. So unit economics must be really boring. And yet it’s a leading cause of startup death.
Unit Economics form the underpinning of any venture’s financial model: You have something that you can make for X, and you can sell it for Y. If you’re a bakery then your unit economics are pretty simple — every loaf of bread costs you X to make and you can sell that loaf for Y. If you’re a consulting firm every hour of time costs you X and a client is willing to pay Y for that hour. If you are Facebook then each targeted page-view costs you X to create, and an advertiser is willing to pay Y for that targeted page-view. For airlines, it’s seat-miles. Every venture distills down to unit economics.
For most companies, unit economics improve with scale. As your factory grows, your cost of producing one unit goes down, and the price you can sell that unit for goes up (as your marketing and customer retention improve).
But if your unit economics are fundamentally upside down (your cost of making a unit is hopelessly higher than you’ll ever be able to sell a unit for) then scale just makes you go broke faster (which is not usually a desired outcome).
And unit economics are the key inputs for the most important metric of all: Customer Acquisition Cost has to be less than the Lifetime Value of a Customer (CAC < LTV). Every business has to have a way of getting customers at a cost less than what it can make from them. Every one. (see my separate article on this).
How do you calculate Unit Economics for your venture?
The first step is to figure out what “one unit” is for your business. For a taco shop, a unit is one taco sold. For a consulting firm, it’s one billable hour. For a SaaS company it’s one subscriber-month.
Now we need to make a distinction between fixed costs and variable costs. Fixed costs are the factory overhead, the variable costs are the labor and materials to make one widget. So for our taco shop, our fixed costs are the “overhead” of rent, utilities, etc. These are called fixed costs because they are the same over month no matter how many tacos we sell — so we don’t put those into our unit economics.
Each taco we make has some ingredients, so let’s say those are $1.20 per taco, on average. And we have some labor to assemble the taco ($1.50), some packaging (.83), and we pay a revenue share to DoorDash to deliver the order (.73). So for our taco shop our Unit Economics are represented in the graphic at the top of this post — we sell each unit (taco) for $5.00, our costs of making that taco was $4.26, yielding a gross profit per unit of .74, or about 14%. Nice, easy unit economics (and I love tacos).
Now let’s say the fixed costs for our taco shop are $2,000/month. This is the rent, the utilities, the insurance, etc. Since our unit economics are that we make .74 per unit sold, we need to sell 2,700 tacos in a month to cover the overhead. Each additional unit sold that month puts us “in the money”, and the gross profit on each unit is pure net profit for our taco shop.
The concept of Unit Economics is pretty simple, but of course it gets more complicated in real life. What if we have several different taco types, with different prices for each taco type? In this case, the easiest approach is to think of one unit as being an “average order”. What are our costs on one average order, and what do we sell one average order for?
The concept of unit economics even applies to nonprofits and social enterprises. You have fixed costs (overhead) for your nonprofit organization and then maybe you run programs that help kids to read, and your costs for that work out to $5/month/kid, and the school district reimburses you at $6/month/kid. So there’s your unit economics. Funders and donors will want to understand the unit economics of your social venture. And so should you. It’s the key to creating sustainable impact.
The reality, of course, is that most ventures are more complicated than just “we make tacos for $4 and sell them for $5”. And so many entrepreneurs just wave their hands and say “Well, unit economics doesn’t really apply to what we do, because what we do is new and different”.
History says otherwise. Many startups have died because they didn’t really understand the concept of unit economics. So avoid a leading cause of startup death by taking the time to understand the unit economics for your venture. Once you understand the Unit Economics for your venture then you can build a full economic model for your venture, and go on to great success.
This article was merged into my new book, The Launch Path, now available on Amazon.
Some additional reading:
Sam Altman (CEO of Y-combinator) on the topic.
Masterclass on Unit Economics.
Andreessen Horowitz on CAC < LTV.
Building a Successful Social Venture, by Eric Carlson and Jim Koch, pages 161–162