Unit economics

Unit economics analyses the profitability of a business at the level of a single customer or transaction. Because the financial results of a firm are the aggregate of its individual transactions, a business whose unit economics are unprofitable cannot become profitable through scale; expansion increases the magnitude of its losses.

The principal variables

The analysis rests on four variables:

1. Revenue per customer, per period or per transaction
2. Direct cost to serve, excluding fixed overhead
3. Customer lifetime, the expected duration of the relationship
4. Customer acquisition cost (CAC), the total sales and marketing expense incurred to acquire one customer

The first two variables determine gross profit per customer per period. The product of that figure and the customer lifetime gives lifetime value (LTV) on a gross profit basis. The ratio of LTV to CAC indicates whether customer acquisition creates or consumes value.

Illustration

A subscription business charges $50 per month and incurs direct costs of $10 per month per customer, producing monthly gross profit of $40. The average customer remains for 30 months, giving an LTV of $1,200. CAC is $400. The LTV/CAC ratio of 3.0x indicates that expenditure on customer acquisition generates a return and may reasonably be regarded as an investment.

Suppose instead that the average customer lifetime is 10 months. LTV falls to $400, equal to CAC. Each additional customer now contributes nothing towards fixed overhead. Price, margin and acquisition cost are unchanged, but the business is no longer economically viable.

Customer retention is frequently the variable that determines the viability of a growth business. It is also among the metrics least consistently disclosed in public reporting.

Payback period

The CAC payback period measures the number of periods required for gross profit from a customer to recover the cost of acquisition. In the base case, $400 of CAC recovered at $40 per month implies a payback of ten months. A payback period under twelve months is generally regarded as healthy. A payback period exceeding twenty-four months implies that the company must finance its own growth for an extended period, and therefore depends on patient capital or on a high degree of confidence in retention.

Definitional inconsistency

These metrics are not defined under generally accepted accounting principles, and companies calculate them in ways that favour their own presentation. Common practices include computing LTV on revenue rather than gross profit, excluding sales personnel compensation from CAC, and omitting underperforming cohorts from cohort analyses. Where a company does not disclose its definitions, the analyst should assume the most favourable definition has been used and adjust accordingly.