When it comes to start-ups it is all about top-line growth. Spend whatever you want, acquire as many customers as possible and as long as you’re achieving the “so-called” hockey stick curve then everything will be fine.. Right?
Unit economics is a term that is often floated around, however, it’s a key indicator when looking at how profitable a company will or won’t be. Unit economics looks at the direct revenues coming into the business and costs associated with selling the revenue generating item or service. This is often referred to as the business model
When looking into a businesses unit economics you need to understand the following terms:
CAC/ Customer acquisition cost
Customer acquisition cost is the cost that is occured when acquiring a new customer. To work this out, simply divide the TOTAL costs spent acquiring customers by the Total number of customers.
LTV/ Lifetime value
Lifetime value or customer lifetime value is the total that a customer will spend with you in their lifetime.
To work this out you need to understand:
AGM/ Average Gross Margin
This is the margin/profit you make from an order.
AOV/ Average Order Value
The total amount spent for an average transaction
ALT/ Average lifetime
How long will you customer continue to book
Although there are many variations of this calculation, the logic remains the same. Here is an example for a tutoring marketplace business
Step 1: Work out the total spend
From the above we can dissect the following
AOF: 6 (1 x 6 months)
To work out the customers total spend we can simply multiply our AOV by AOF to give us a total spend of £360.
Step 2: Work out the LTV
Being a marketplace business that takes a commission from each booking,we need to work out the companies profit margin For this example let’s say the AGM (Average Gross Margin) is 25%.
25% out of £360 = £90 << This is our LTV
To gain a deeper understanding into a company's unit economics we can look at their LTV:CAC ratio.This will display our lifetime value and customer acquisition costs as a ratio, highlighting whether the business model is sustainable.
LTV:CAC ratios are commonly used within marketing teams to identify how much they are spending to acquire customers and how this relates to customer retention. It can be a great way to identify profitable marketing channels and ones that need some work.
To work this out let’s again use our tutoring marketplace as an example:
We know the following:
Customer Acquisition cost = £100
Lifetime Value = £90
We now do the following
(£) LTV / (£) CAC = (#) LTV to (1) CAC Ratio
£90 / £100 = 0.9/1
We can see from the above this is not a sustainable model. In fact, this ratio shows that the company is burning cash and they will have to reduce the CAC or seek further capital in order to scale.
David Skok a leading Venture capitalist with Matrix partners stated that the ideal LTV: CAC ratio “should be at 3:1 - your customers are contributing three times more value than your cost to acquire them.”