Every Unit Counts: Assessing Profitability

Unit economics is a term for metrics that represent your business in per-unit terms. This group of metrics, while challenging to calculate, can help you determine the profitability of your business.

It may seem strange to evaluate a company by transaction instead of using total revenue and cost, since each product may only cost a few dollars and the business generates many millions of dollars in revenue a year. For most businesses this is true, but for high-growth businesses that are losing money, the unit economics can tell you whether the business has the potential to become profitable in the future.

For example, if a company that is losing money is selling a product for $5 when it costs $2 to make, they might become profitable as their volume grows. However, if that same company is selling a product for $5 when it costs $10 to make, then they may not be able to become profitable on any scale. It seems obvious when I frame it this way, but in reality it can be hard to calculate and evaluate unit economics.

“Unit economics” is actually a broad term for a number of different metrics you can use to evaluate individual transactions. We’ll cover some of them including:

• Part 2 — Contribution Margin
• Part 3 — Examples of Unit Economics
• Part 4 — Amortization

What is a Contribution Margin?

Contribution margin is a measure of your per-unit profit. This is done by subtracting the variable cost per unit from the sale price of the product or service. It is very similar to the Net Margin (See Gross vs Net Margins) but harder to determine, because it is calculated at the individual sale level. For example, if you sell basketballs for $25 each and it costs you $10 to make each ball, your contribution margin per basketball is $15 or 60%.

The benefit of tracking your contribution margin is that, you can easily do a break-even analysis. This shows you how many units you need to sell to break even on your costs. For example, if your annual fixed costs (office space, administration, etc.) are $100k and the contribution margin for each item you sell is $5, you break even when you sell 20,000 units a year.

Contribution margin is most often used for businesses that sell physical goods, since it can help take into account returns and defects, which other metrics may exclude. It can be hard to determine the contribution margin for subscription businesses since the sale is not a single transaction, but can be estimated if you know the customers’ average subscription length.

Of course, few businesses have a single product with a single price and a fixed cost. Most businesses have many products or services each with their own margins.

Examples of Unit Economics

Unit Economics is a measure of how profitable your business is for each unit sold. To understand them you need to understand the cost in producing a unit and how much the unit is sold for, right? Wait, what in the world is a ‘unit’?

Let’s review unit economics, aka contribution margin, for a few different types of businesses.

Restaurants

Each meal you serve is a unit, so the costs include the food you purchase and the time it takes to prepare the meal. The revenue is how much you charge for the meal, so your per unit contribution margin becomes:

Contribution Margin (Restaurant) = Meal Fee-[Cost of Food + (Prep Time x Hourly Wage)]

You would not include the cost of the location or the cost of your furniture; those are fixed costs that stay the same, regardless of the number of meals served.

Subscription Software (SaaS)

Each subscriber is a unit, so the costs include how much you spend to acquire a customer (Customer Acquisition Cost) and how much it costs to provide the service to them (likely $0). The revenue for a customer is their Lifetime Value (LTV), which you can either estimate or calculate depending on your customer tenure (see Customer Lifetime Value for more details).

Contribution Margin (SaaS) = LTV-CAC

You would not include the costs of your servers, unless you need to add new servers for every customer. Similarly, assuming each customer uses the same software you would not include the cost of developing the software.

Delivery Service

Each delivery is a unit, so the cost is primarily the payment you make to the courier who makes the delivery. More complex is the revenue you make from a given delivery, which may either be a separate fee or an increase in the value of the product being delivered.

Contribution Margin (Delivery) = Delivery Fee-Wages for Courier

Note that many high-profile delivery services have failed in recent years because their delivery fees were lower than the wages paid out to couriers.

As you can see, the challenge lies in separating your fixed costs from your variable costs and mapping those to your individual unit of business.

Amortization

Once you have a strong understanding of your unit economics, the next step understanding how changes to your business will affect them going forward. Many companies will start off with profitable unit economics, only to make business decisions that unexpectedly cause their unit economics to become unprofitable and eventually harming the business!

A simple example is in manufacturing. Let’s say we have a company that produces fidget spinners (and is appropriately named “Spidget”). As part of the manufacturing process, there is a metal stamping machine that stamps out a part for the spinners. The current stamping machine broke and a new one costs $100k, so we replaced it with a much smaller and cheaper version for only $10k, congratulating ourselves on saving money on our fixed costs! Unfortunately, this new machine can only produce 100k parts before breaking down; which forces us to buy a new one. No fear, we can buy another machine, since they are so cheap.

It might sound like we are saving money, but we’re actually changing our unit economics. Since the machine can only product 100k parts, we need to spread the cost of the machine ($10k) across those parts by adding $0.10 of cost to every fidget spinner we create. If we had been producing spinners for $5.25 and selling them for $5.30, we are now losing money because they cost $5.35 to make.

Spreading a cost out like this is called amortization, and is an important tool for understanding your unit economics. When making a change to your business, think about how it amortizes across your units and if it affects your unit economics. You might think you are saving money, but in reality you may be losing it on every product.

In Review: Unit economics are an important tool for evaluating high-growth businesses (and business units) that are not yet profitable. The better you understand the unit economics for such a business, the easier it will be to predict if and when that business will become profitable.