Under The Hood Of The Unit Economy: How To Create A Successful Startup

Introduction: Why Startups Fail

According to Startups Success and Failure data, compiled in 2022, 9 out of 10 startups fail. Those are grim numbers influenced by these most reasons for failure:

Lack Of Finance

Startups may allocate expenses in a way that does not serve the business purpose or choose the wrong investors and run out of money before the product starts to generate revenue. Startups may also miss the mark on hiring the right teams of driven individuals that work toward a common goal.

Pricing

Some startups also fail to strike the delicate balance between the product generating consistent and healthy revenue and it being accessible to the customer. Startups may be tempted to price their offerings too high or too low depending on the industry, and may even fail to adjust pricing in the course of running the startup or suggest a price the market is not yet ready for if we’re talking about a novelty product or service.

Poor Business Modeling

If a startup lacks a cohesive vision and a roadmap to deliver its unique value proposition, it may be doomed to fail. Monetization has been left out of the business model or only involves a single channel that simply cannot balance out the expenses that a young startup is seemingly drowning in. Other pitfalls in this category may include ignoring customer feedback, overestimating the size of the market, and frankly, even scaling too fast and burning bright for a short time.

Whatever the reason for failure is, we can usually find a common denominator: a poorly planned unit economy. And it is our, very important, job to get it right the first time.

What Is the Unit Economy?

Unit Economy is an analysis method that is used to zero in on the profitability of a singular product or service. This method allows companies to determine the level of sales necessary to cover production costs and ensure consistent revenue while helping to understand where the business may be losing money.

A unit can be anything. It could be users, clients, sales of goods and services, or deals. The key to choosing the proper unit is to determine the area of your company. Digital businesses would be more comfortable estimating the profitability of each individual user or subscriber, whereas taxi company owners would be looking at the cost of a single ride.

Calculating Units

Let’s consider the example of COGS, the Cost of Goods Sold. It is the manufacturing cost of goods that consists of the sum of all expenses incurred during the production or delivery of goods and services. It includes direct expenses related directly to manufacturing, and indirect expenses that reflect overall enterprise costs.

To calculate the revenue of the project, take one unit cost and multiply it by the number of units, and then subtract the manufacturing cost of all units. Revenue per unit means the difference between the average revenue for one unit and its manufacturing cost. Let’s see it in action.

Sample Bagel Business

You decided to open your own bagel shop. Let’s say that it takes $1.50 worth of sourdough, sugar, and eggs worth to make a single bagel. Our constant expenses will include the cook’s wage, the acquisition of inventory, and renting out a kitchen: $1500 per month.

We’ve priced our hypothetical bagel at $2.50, and need to sell 1,500 bagels to hit critical mass. Therefore, the revenue of the project after selling 2,000 bagels would be:

2000*2.50 - 1500-1.50*2000 = $6500.

Customer Acquisition Cost

CAC is the cost of attracting new clients. Their LTV (Lifetime Value) is the indicator used to forecast the revenue which the company will derive from the customer over their lifecycle or continued collaboration. You definitely want your LTV to be higher than your CAC to derive tangible profit per customer.

ARPU, or the Average Revenue Per User, is the average revenue from one customer over a specific period of time. Keep in mind that the ratio of ARPU over CAC should be 3:1. You can use your ARPU to compare your business to competitors in the same industry, set a sensible price strategy and put it to work to boost customer loyalty.

The Bagel Funnel

Now that we are armed with the ARPU and the CAC, let’s get back to our bagels. If we suppose that 100 people see the advertisement about our bagel, 10 of them visited the website and considered the offer, three lucky individuals ordered our bagels, and one of them paid for it in full, we need to seriously consider our chosen CAC.

At a CAC of $2.50, our intermittent expenses will quickly dwarf the unit prices and the model will not be sufficient. On the other hand, if we target a CAC of $0.50, we will hit steady revenue at 4000 bagels.

To further help us work our unit economics out, we can introduce CR - the Conversion Rate, also known as the percentage of customers who performed a certain action. They may respond to sales and promotions. For example, we can offer one bagel for free after buying two. Conversion rates can be useful to see how well your marketing campaigns are reaching their target audience and how well your ROI (Return on investment) stacks up against your expectations. Conversion rate measurements and other types of estimates can be done on groups of people called cohorts.

Cohorts

Cohorts are groups of people or objects that share a common characteristic or have gone through a specific event cycle at a particular time, like following the same link from a mass email campaign or using a specific feature in the product.

In the business and marketing context, cohorts are often used to analyze and segment client databases. Cohort analysis is a method of research of groups of clients that studies the behavior and metrics of those groups and compares them over time. You can resort to cohort analysis to study how long customers stay engaged with your business after going through the initial funnel and how they react to changes in your offerings.

Timelines

You launch the business to hit the critical sales volume in the shortest possible time. Here is what you need to know:

● Break-even is the point of zero-loss, also known as the minimal amount of goods at which profit completely overshadows manufacturing expenses.

●       Payback is the point at which your overall project expenses hit zero.

●       BE-PP is the possibility to scale the business before investing

●       PP+ is the scaling and searching for new niches

The Credit Card Example

Let’s summarize everything we’ve learned so far by doing a case study of a credit card product.

Our major expenses will include issuing the physical card, supplying the welcome pack, and operational expenses like delivery, cashback, transactional costs, cash withdrawals, SMS service costs, transfers, overdraft, funding, and risk management.

On the flip side, we will be receiving turnover shares, transactional income, and charges for SMS messages and transfers. We will also be able to upsell cross products and collect insurance fees on cards, APR, and overdraft fees.

After our funnel, we will need to consider the number of existing cards, active cards, turnover, card lifetime, and overdraft risks and limits.

Conclusion

Unit economics will help empower better decisions for your business from investment to product pricing and service availability, customer retention, and market share growth. If you properly track and optimize your unit economy, your profitability and scalability will improve and make your business resilient. You will gain a better understanding of your cash flow at a granular level and better communicate your value proposition to stakeholders and investors.

Do not be afraid to use the method of trial and error and build and prove hypotheses for each metric before you hit your stride.