What are unit economics and how do you work them out?
The purpose of working out your unit economics is to understand the revenue behaviour of your business on a ‘per unit’ basis. This means we want to understand what every transaction looks like with regard to revenue and cost. It’s a basic measure of how you propose to make revenue out of the thing (aka unit) you’re planning on selling. It’s worth remembering that units vary wildly for different businesses, so let’s consider these web-based examples:
Example 1 is an e-shop selling T-shirts.
This one is pretty straightforward. In this example a T-shirt costs £10 to manufacture, £2 to package and £3 to ship. All the T-shirts on the website cost £35. In this case the unit economics work out to be:
- (sale price) - (manufacture cost + packaging cost + postage cost)
- (£35) - (£10 + £2 + £3) = £20
So for every T-shirt sold in this example we’re taking £35 of revenue which breaks down into £15 of cost and £20 of profit. That means that on a per unit (in this case a T-shirt) basis we’re making £20.
Example 2 is an affiliate website directing traffic at the T-shirt e-shop.
This example is a bit more complicated. To understand the unit economics of this business we need to understand how the affiliate website makes money. This affiliate sends traffic to the T-shirt website and then receives a commission from every successful transaction of 15% of the total revenue. So for every T-shirt sold the affiliate would receive:
- (£35 x 15%) = £5.25 of commission
However this doesn’t tell the whole story. The affiliate is directing a lot of traffic to the T-shirt website and only a percentage of the traffic will buy a T-shirt. So although the T-shirt shop has units of T-shirts, the affiliate website is actually dealing in different units. In this case the units for the affiliate are unique visitors (UV). This is then how it breaks down: The affiliate spends £100 on advertising which attracts 1000 UVs to the T-shirt site. Only 5% of the visitors convert to purchase:
- 1000 UVs x 5% = 50 purchasers
We have already learnt that the affiliate takes £5.25 per purchase. So:
- (50 x £5.25) = £262.50 of revenue
The affiliate had £100 of cost, so that leaves us with:
- (£262.50 - £100) = £162.50 of profit
We then need to divide this profit number by the number of units involved here, which is the UV number. Therefore, on a per unit basis the affiliate is making:
- (£162.50 / 1000) = £0.1625 or 16p
As you can see, unit economics are very different for different businesses.
Unit Economics vs Customer Economics?
We talked about unit economics, but in some cases this doesn’t tell the full picture of how your business is going to shape up. Let’s look at Example 1 again to really understand why this is sometimes the case and why we need to go a step further and understand the customer economics of the T-shirt e-shop.
In theory, the T-shirt shop is making £20 of profit per sale. This is a pretty rosy outlook, however, we’ve forgotten to include any costs involved in acquiring the customer in the first place. Let’s consider that the T-shirt e-shop only gets customers through its affiliate partner in example 2. In example 2, we found out that the affiliate is taking £5.25 for every successfully transacting customer. So although the T-shirt e-shop is making £20 per unit, it’s actually only making £20 - £5.25 = £14.75 per customer. It’s a slight nuance, but an important one to appreciate. When you look at working out your unit and customer economics, you may find that your unit economics work out to be positive, however your customer economics work out to be negative (i.e. you have lost money after the customer has transacted).
Don’t panic. Whilst not perfect, this can be ok as long as you can estimate some sort of lifetime value effect for your acquired customers.
What if I don’t know how much it’s going to cost me to acquire customers?
In this scenario, you will need to estimate to your best ability using what data you have available. Some things to think about are:
- Have you asked someone who works in a competitive or similar industry?
- Have you used the Google Keyword Planning tool to understand the typical bids required to get clicks using paid search?
- Have you used Facebook Power Editor’s bid estimates to understand how much you may need to pay for a click for a certain audience on Facebook?
This will give you some idea of the costs to acquire users to your product. However, you’ll have to then estimate some conversion rates on your (maybe unbuilt) website. Some sort of benchmarking should be used to estimate conversion rates. Typical web ecommerce visitor to purchase conversion rates usually vary from 1% to 3%, and up to 5% for deal or offer led sites (but be aware that this will vary by vertical). A bullish landing page sign-up conversion rate would be around 30%, but will decrease with the number of form fields required. With all of these benchmarks, you should probably underestimate the conversion rates of your product against these as your product will probably be at the minimal viable product (MVP) stage and as a result not fully conversion optimised.