In the early phases of a startup, decision making guided by data is the key to securing the necessary information in order to understand the general situation of your company when you navigate it in the market.
Taking an approach of unit economics assists you to assure you are navigating your company in the right direction, and when the financial aspects of your product are aimed for profit and growth.
In this article, we will comprehensively examine the unit economics and its broad effects on a sustainable business.
What is unit economics?
Businesses are complex systems and measuring their success can feel like a difficult and challenging process. With a massive amount of different strategies that need to be taken into consideration and an endless list of KPIs to track, being an early phase startup owner can be crucial. Unit economics aims to simplify this complexity by measuring profit on a single unit basis.
Estimating the income and expenses directly by your business model and by a single unit basis (per client), you can answer one of the most important questions: does your income from clients surpass the client acquisition costs?
This method of analysis allows you to make predictions about the speed at which you can launch your business and its profitability. It helps early stage startups to acquire better understanding of the growth potential. For instance, is it worthwhile to allocate higher budget for client acquisition?
All companies are driven by growth and profitability, but startups in early stages must pay close attention to this index.
More: A Business plan guide
How to approach unit economics in the business plan?
You can approach a unit economics from 2 lanes: look at the ratio between value of customer life (LTV) and customer acquisition costs (CAC), or the payback period on CAC.
Ratio between LTV and CAC:
As part of your unit economics analysis, you will closely look at value of your customer life- LTV, and the client acquisition indexes (CAC), and how they correlate.
An ideal ratio is considered 1:3, when you get 3 times the value of a new client acquired.
If this ratio is lower (1:1 for example), it means that acquiring a client will cost the same amount as this client spends on your product. If this is the case, you must consider new ways to improve your revenue, purchasing, and pricing models.
If your ratio is higher (1:6 for example), it signifies a valuable opportunity. When each client worth more to your startup than what you spend to acquire him, you can afford to allocate higher resources to marketing and sales. The money you spend at this point, will be returned during the life cycle of each client.
Return period in CAC:
Takes into account the time a company needs to cover its client acquisition cost. To the average startup, the CAC return period will take 15 months on the basis of gross profit.
Shorter return periods are an advantage because they require lower working capital, which gives companies the ability to grow faster.
Why is it worthwhile to monitor unit economics at an early stage?
The earlier you start tracking your unit economics, the better the chances you have to establish yourself in the market and gain an exponential growth curve.
Founders can often be too optimistic about the idea behind their business. Many startup companies are founded without investing enough though in adapting to the product market, pricing strategy, cost structure related to its business model and customer acquisition. If all of the aforesaid factors, which should be analyzed in the business model, are being disregarded, the liquidity issues will rise and the startup dream will become less realistic. The understanding of unit economics in an early stage allows you to perform long term financial forecasts which provide higher accuracy of your revenue model. At an early stage, you need a healthy growth rate, but also be profitable (on a unit economics level).
Even in a perfect execution, growth acceleration can be accompanied with reduced profit margins. By closely examining the key indexed, you can measure, improving and aligning the marketing, product, or service.
Regularly evaluate your direct income and costs:
Being aware to the income and direct costs of your business model is an essential and continuous priority for startup companies.
By taking a unit economics approach to businesses, startups at an early stage are able to gain a better understanding of their operations as they evolve, expand, and grow.