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Unit Economics

Unit Economics

This is part 1 of a 4 part series on Unit Economics.

With the failure of high profile hardware companies like Jawbone, there is a renewed focus on the unit economics of fast-growing businesses. Unlike most financial metrics of a business (see Money Metrics) that look at the business as a whole, unit economics focus on each product sale individually.

It might seem strange to evaluate a company by each transaction instead of using overall revenue and cost, since each product might only cost a few dollars but the business generates many millions of dollars in revenue a year. For most businesses this is true, but for high growth businesses that are losing money, the unit economics can tell you whether the business has the potential to become profitable in the future.

For example, if a company that is losing money is selling a product for $5 when it costs $2 to make, they might become profitable as their volume grows. However, if that same company is selling a product for $5 when it costs $10 to make then they may not be able to become profitable at any scale. It seems obvious when I frame it this way, but in reality it can be hard to calculate and evaluate unit economics.

“Unit economics” is actually a broad term for a number of different metrics you can use to evaluate individual transactions. We’ll cover some of them this week.

Tomorrow we’ll get started with some examples of unit economics, across a few different industries, to highlight how challenging they can be to calculate.

“There are 10¹¹ stars in the galaxy. That used to be a huge number. But it’s only a hundred billion. It’s less than the national deficit! We used to call them astronomical numbers. Now we should call them economical numbers.” 

Unit Economics: What is a Contribution Margin?

This is part 2 of a 4 part series on Unit Economics.

“Unit Economics” is a term that generally refers to examining the profit and loss associated with each product your company sells. Most discussions of unit economics focus on a specific metric called the contribution margin.

Contribution margin is a measure of your per unit profit, by subtracting the variable cost per unit from the sale price of the product or service. It is very similar to the Net Margin (See Gross vs Net Margins), but is calculated at the individual sale level which makes it more difficult to determine. For example, if you sell basketballs for $25 each and it costs you $10 to make each ball, your contribution margin per basketball is $15 or 60%.

The benefit of tracking your contribution margin is that you can easily do a break-even analysis, which shows how many units you need to sell to break even on your costs. For example, if your annual fixed costs (office space, administration, etc.) are $100k and the contribution margin for each item you sell is $5, you break even when you sell 20,000 units a year.

Contribution margin is most often used for businesses that sell physical goods, since it can help take into account returns and defects, which other metrics may exclude. It can be hard to determine the contribution margin for subscription businesses since the sale is not a single transaction, but you can estimate it if you know how long customers maintain their subscriptions on average.

Of course, very few businesses have a single product with a single price and a fixed cost. Most businesses have many products or services each with their own margins.

Tomorrow we’ll discuss a variety of different businesses and how you can calculate their unit economics (contribution margin).

“If everyone had something to contribute, there would be enough.” 

Unit Economics: Examples of Unit Economics

This is part 3 of a 4 part series on Unit Economics.

Unit Economics are simply a measure of how profitable your business is for each unit you sell. To understand them you simply need to understand the cost in producing a unit and how much the unit is bought for, right? Wait, what in the world is a ‘unit’?

Let’s review unit economics, aka contribution margin, for a few different types of businesses.

Restaurants

Each meal you serve is a unit, so the costs include the food you purchase and the time it takes to prepare the meal. The revenue is how much you charge for the meal, so your per unit contribution margin becomes:

You would not include the cost of the location or the cost of your furniture, as those are fixed costs that stay the same regardless of the number of meals you serve.

Subscription Software (SaaS)

Each subscriber is a unit, so the costs include how much you spend to acquire a customer (Customer Acquisition Cost) and how much it costs to provide the service to them (likely $0). The revenue for a customer is their Lifetime Value (LTV), which you can either estimate or calculate depending on your customer tenure (see Customer Lifetime Value for more details).

You would not include the costs of your servers, unless you need to add new servers for every customer. Similarly, assuming each customer uses the same software you would not include the cost of developing the software.

Delivery Service

Each delivery is a unit, so the cost is primarily the payment you make to the courier who makes the delivery. More complex is the revenue you make from a given delivery, which may either be a separate fee or an increase in the value of the product being delivered.

Note that many high profile delivery services have failed in recent years because their delivery fees were always lower than the wages they had to pay for delivery.

As you can see, the challenge lies in separating your fixed costs from your variable costs and mapping those to your individual unit of business. Tomorrow we’ll talk about that mapping and how it can help you understand changes in your unit economics over time when we discuss Amortization.

“Most writers regard the truth as their most valuable possession, and therefore are economical in its use.” 

Unit Economics: Amortization

This is part 4 of a 4 part series on Unit Economics.

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.

“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.” 

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