Building a business is often romanticized as a grand vision of the future. However, the survival of that vision depends on the cold, hard math of the present. This math is best summarized by a concept called Unit Economics.
Unit Economics refers to the direct revenues and costs associated with a particular business model, expressed on a per-unit basis. It is the fundamental financial building block of your company. It answers a simple question. Do you make money or lose money on every single transaction?
If the math does not work at the unit level, it will never work at the company level. No amount of volume can fix a business that loses money on every sale.
Defining Your Unit
#Before you can calculate the economics, you must define the unit. This varies depending on your business model.
For an e-commerce company selling shoes, the unit is one pair of shoes. For a SaaS (Software as a Service) company, the unit is usually one customer subscription. For a ride-sharing app, the unit is a single ride.
Once the unit is defined, you calculate the direct inflows and outflows attached to that specific unit. You ignore fixed costs like office rent or executive salaries for a moment. You focus strictly on what it costs to produce, sell, and support that single item.
The two most important acronyms in unit economics are CAC and LTV.
CAC (Customer Acquisition Cost): This is the total cost of sales and marketing required to acquire one new customer.
LTV (Lifetime Value): This is the total profit you expect to earn from that customer over the entire duration of their relationship with you.
In a healthy business, LTV must be significantly higher than CAC. A common benchmark for investable startups is a ratio of 3 to 1. This means for every dollar you spend finding a customer, you make three dollars back over time.
The Trap of Scaling Prematurely
#Many founders make the fatal mistake of trying to scale before their unit economics are positive. They believe that if they just get big enough, the economies of scale will kick in and they will become profitable.
This is rarely true. If you are selling a product for less than it costs to make and market it, scaling just means you are losing money faster. You are effectively selling dollar bills for ninety cents. The more you sell, the broke you become.
Investors look at unit economics to distinguish between “good burn” and “bad burn.” Good burn is spending money to acquire customers who will be profitable later. Bad burn is subsidizing a product that has no path to profitability.
Unit Economics vs. Gross Margin
#It is helpful to compare unit economics to gross margin. They are related but distinct. Gross margin looks at revenue minus the Cost of Goods Sold (COGS).
Unit economics goes deeper. It includes the COGS, but it also factors in the marketing spend to get the customer (CAC) and the churn rate. It provides a more holistic view of the viability of the business model.
Founders need to be obsessed with these numbers. You must know your contribution margin, which is the selling price per unit minus the variable cost per unit. If this number is negative, you do not have a business yet. You have a hobby that costs money.