Revenue growth does not necessarily indicate that a business is profitable all the time. There are many firms that experience explosive growth in revenue, but continue operating at a loss because their cost of customer acquisition and fulfillment is extremely high. That is why unit economics are so important for investors, company founders and financial executives.
By studying unit economics, a business can determine if each individual customer, product or deal adds value to the bottom line. By evaluating metrics such as CAC, LTV, and contribution margin, a business owner will be able to make better decisions regarding pricing, marketing and expansion. Let us understand these metrics and see how outsourcing accounting services can help you master these concepts and implement them in your business.
What Are Unit Economics?
Unit economics is a concept related to the actual revenues and costs that pertain to an individual business unit. Unit economics will vary based on what type of company you have and might be one of the following:
- Customer
- Subscription
- Product
- Project
- Transaction
The objective of unit economics is to evaluate if a unit is making money for you and helping your business grow.
Good unit economics show that scaling the business should be successful while poor unit economics usually means that scaling could create bigger issues.
Why Unit Economics Matter
Revenue is one metric many companies care about; however, revenue by itself tells you nothing about profitability.
Unit economics can be used to answer the following questions:
- Is customer acquisition profitable?
- Are there any returns on marketing campaigns?
- Is scaling affordable?
- Are prices right?
- Which product generates maximum profit?
Unit economics is one thing investors look at before investing in startups as they give insights into whether the business will be sustainable.
Understanding Customer Acquisition Cost (CAC)
Customer Acquisition Cost (CAC) is a way for companies to understand their costs of acquiring a new customer.
Some examples of things CAC encompasses are:
- Advertising costs
- Marketing campaigns
- Cost of the sales team
- Subscriptions to software
- Costs of lead generation
- Costs of working with agencies
Customer Acquisition Cost (CAC) Formula
CAC = Total Sales & Marketing Costs ÷ Number of New Customers Acquired
Example
In case a company spends $40,000 on its sales and marketing and acquires 200 new customers:
CAC = $40,000 ÷ 200 = $200
Each customer costs $200 to acquire.
Why CAC Is Important
CAC helps businesses to analyze the effectiveness of marketing efforts.
If CAC is high, then this may be due to the following reasons:
- Unproductive advertising
- Low conversion rate
- Increasing competition
- Poor sales process
Measuring the CAC will help businesses to optimize their marketing budget and increase profitability.
Understanding Lifetime Value (LTV)
Lifetime Value (LTV) measures the total income or profit made by a client during his/her entire cooperation with a company.
LTV helps businesses to see the value of their client relationships.
LTV formula
LTV = Average Income Per Client × Client Lifetime
For example:
Annual income per customer = $1,500
Client lifetime = 4 years
LTV = $1,500 × 4 = $6,000
It means that an average client generates for the business $6,000 worth of income during his/her lifetime.
Why LTV Matters
LTV helps businesses not to think in short-term terms.
Higher LTV usually means:
- Good customer retention
- Customer satisfaction
- Upselling
- Business sustainability
Companies that have good LTV numbers can safely invest in customer acquisition.
Understanding the CAC LTV Ratio
Calculation of CAC LTV Ratio involves comparing the revenue generated through the customers and the cost incurred for acquiring them.
It is one of the most critical metrics of business success.
Formula For Calculating CAC LTV Ratio
CAC LTV Ratio = Lifetime Value/Customer Acquisition Cost
Example
LTV = $6,000
CAC = $200
Therefore, the CAC LTV Ratio = $6,000 / $200 = 30:1
This means every dollar used to acquire customers results in thirty dollars' worth of customer revenue.
How Much Is a Good CAC LTV Ratio?
Although different industries have different benchmarks, some common guidelines are:
Under 1:1
The company spends more in acquiring customers than what the customers generate.
The model tends to be unsustainable.
3:1
It is common for many investors to find 3:1 to be a good CAC LTV ratio since the customers' value greatly exceeds their cost of acquisition.
5:1 and above
A very high CAC LTV ratio might mean that the company is extremely profitable, but it could also mean that the company does not spend sufficiently on growth.
What Is Contribution Margin?
Whereas CAC and LTV have their focus on customer economics, contribution margin has its focus on profitability, taking the product or service under consideration.
Contribution margin represents revenue left over when all variable costs have been subtracted.
Contribution Margin Formula
Contribution Margin = Revenue - Variable Costs
Variable costs could be such as:
- Product costs
- Shipping costs
- Transaction costs
- Direct labor costs
- Sales commissions
The rest contributes towards fixed costs and profit.
Importance of Contribution Margin
Good contribution margin assists companies in deciding whether their sales are making any profits.
Contribution margin indicates:
- Profitability of products
- Effectiveness of pricing
- Efficiency of costs
- Opportunities for growth
Sometimes even those companies that make good sales may face troubles because of poor contribution margins.
Example of Contribution Margin
Assume the price of a product sold by the company is $120.
The following variable costs:
- Manufacturing cost: $50
- Shipping cost: $15
- Payment transaction cost: $5
- Total variable costs = $70
Contribution Margin = $120 - $70 = $50
With each sale, $50 will contribute towards fixed costs and profit.
How CAC, LTV, and Contribution Margin Work Together
Most successful firms take these metrics together.
CAC Measures Efficiency of Customer Acquisition
CAC demonstrates how expensive it is to acquire customers.
LTV Measures Value of Customers
LTV helps to calculate revenue potential.
Contribution Margin Measures Profitability
It demonstrates what amount of money stays after direct costs.
All these metrics paint a whole picture of firm performance and scalability.
How Virtual CFO Services Help to Improve Unit Economics
Quite many growing companies do not have internal expertise to constantly analyze and improve their unit economics. Here the virtual CFO services come to help.
Virtual CFO can help businesses:
- To analyze profitability of customers
- To improve pricing policy
- To lower costs of acquisition
- To track the cash flow
- To optimize contribution margins
- To develop growth scenarios
- To create financial dashboards
Not only do virtual CFO services deal with bookkeeping and accounting, but they also use financial data for strategic purposes.
Companies that use virtual CFO services usually have a better understanding of profitability factors and drivers of their growth.
Common Unit Economics Mistakes
Most companies do not understand their financial state because they do not pay attention to certain expenses.
Not Accounting for Variable Expenses
Incomplete calculations might be misleading when it comes to financial performance.
Overlooking Customer Acquisition Costs
Companies might not account for software, sales salaries, or agencies.
Calculating Based on Income
Calculations done using revenue might overstate the value of the customer.
Growth is All that Matters
Growth at any cost leads to future financial problems.
Correct calculations are crucial when making business decisions.
Ways to Enhance Unit Economics
There are many ways companies can enhance their unit economics.
Cut Customer Acquisition Costs
- Better conversions
- Optimization of ad campaigns
- Getting more referrals
- Sales optimization
Boosting Lifetime Value
- Increasing customer retention
- Introducing additional services
- Upselling customers
- Improving customer support
Boosting Contribution Margin
- Raising prices effectively
- Lowering supplier costs
- Increased operational effectiveness
- Automation of processes
Any improvement in those areas will have a significant effect.
Why Investors Focus on Unit Economics
Unit economics are an important consideration when making investments as they help to determine whether the growth is sustainable.
- Unit economics that are sound will include:
- Efficiency
- Scalability
- Good relationship with customers
- Potential for profitability
Firms with a good CAC LTV ratio and sound contribution margin are considered to be low-risk investments.
The ability to comprehend unit economics is vital for any firm that wants to experience growth that is sustainable. Unit economics metrics such as CAC, LTV, CAC LTV ratio, and contribution margin provide insights about profitability, efficiency, and scalability.
Instead of only being concerned with revenue, good firms consider how much each individual customer is worth. In addition, many firms can take the advantage of using outsourced accounting services from The Fino Partners in order to monitor these metrics.
