To run a successful business, it’s imperative to know and understand unit economics. Although many entrepreneurs and investors have heard of the term, taking the time to understand it and how it works will help a business grow and thrive. The basic definition of unit economics is gathered data that looks at the direct revenues and costs associated with the most basic element of a company’s business model. This defines unit economics in a nutshell, but understanding the concept goes far beyond this:
The most important factor unit economics can project is profitability. How profitable a business is can be is the main decider of whether or not it is successful. In order to measure this, a company must first identify its basic unit. The basic unit is the one part of the business they can measure. This reflects how the business operates. Businesses are then able to use that basic unit to calculate how much revenue is being brought in by that unit and the costs to achieve that revenue. From items sold to the number of customer accounts, the basic unit will be unique for every business.
When calculating and measuring, it’s important to identify the recurring revenue. This is the portion of the revenue that it recurring. Once it has been identified, it’s important for a business to determine how often it must be calculated. Typically, it can be measured on a monthly basis. Companies can also measure it on a yearly or quarterly basis. Whatever will work best for the analysis will depend on what the recurring revenue will be.
Another important factor that defines unit economics is customer lifetime value (CLV). When finding new customers, a business should know how long they’re going to stay, which is the CLV. The CLV calculates the initial revenue from gaining the new customer and future revenues the customer will be worth. This should also factor in the churn rate of customers. The churn rate is the percentage of customers who have returned a product or cancelled a service or subscription. The churn rate can be calculated either monthly, quarterly, or yearly depending on what works best for the company.
When presenting to prospective investors, they will look closely into the company’s unit economics. Investors will break it down until they are certain a company is profitable and worth the investment. It’s important for companies to understand their unit economics and how they work in order to be successful.