Unit Economics: Amortization
Once you have a strong understanding of your unit economics, the next step is to understand how changes to your business will affect them going forward. Many companies will start off with profitable unit economics, only to make business decisions that unexpectedly cause their unit economics to become unprofitable and eventually harming the business!
A simple example is in manufacturing: Let’s say we have a company that produces fidget spinners (and is appropriately named “Spidget”). As part of the manufacturing process, there is a metal stamping machine that stamps out a part for the spinners. The current stamping machine is broken and a new one would cost $100k, so we replace it with a much smaller and cheaper version for only $10k, congratulating ourselves on saving money on our fixed costs! Unfortunately, this new machine can only produce 100k parts before breaking down and requiring us to buy a new one. No fear, we can buy another machine since they are so cheap.
It might sound like we are saving money, but we’re actually changing our unit economics. Since the machine can only product 100k parts, we need to spread the cost of the machine ($10k) across those parts, adding $0.10 of cost to every fidget spinner we create. If we had been producing spinners for $5.25 and selling them for $5.30, we are now losing money because they cost $5.35 to make.
Spreading a cost out like this is known as amortization and it is an important tool for understanding your unit economics. When making a change to your business, think about how it amortizes across your units and if it does change your unit economics. You might think you are saving money and in reality losing it on every product.
In Review: Unit economics are an important tool for evaluating high growth businesses (and business units) that are not yet profitable. The better you understand the unit economics for such a business, the easier it will be to predict when and if that business will become profitable.
Quote of the Day: “The glass isn’t half-empty or half-full. What you’re looking at is half a pint of depreciable assets sitting in a pint of capital infrastructure that can be amortized over two accounting periods.” ― Charles Stross, Halting State