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How to determine the profitability of a business idea? This does not really require a lot of complicated formulas and calculations. You just need to understand the basics of unit economics.
Many businesses fail in the first year because they run out of money. And the reason for this is the wrong decisions regarding their work and development. To act effectively, you need a tool that will help you understand how to act in a particular situation. Unit economics is such a tool.
A new concept in economics
This term is relatively new, so there are different definitions, which sometimes do not coincide.
The unit economy was first mentioned in the late 2000s in the book “Entrepreneurship: Starting and Running a Small Business”, written by Steve Mariotti and Carolyn Gluckin of the National Foundation for Entrepreneurship Education (NFTE). It was these authors who introduced the term “One Unit Economics” into business.
Two main points
Unit economics is an example, albeit a fairly new, financial model. It helps to calculate the profitability of a specific unit of a company’s product or service. This allows you to assess the scalability of the business – how much it really needs to grow.
So, what does unit economics do? First of all, it is a tool for assessing the profitability of a project. The bottom line is that your project will be effective only when its individual unit (unit) is profitable.
In fact, the unit-economy algorithm consists of only two points:
define the unit in your business;
calculate how much income and expenses this particular unit gives you.
It is important to understand that the definition of a unit primarily depends on the business area. For a manufacturer or seller of goods, a unit will be a unit of production. For those who provide consulting services – a contract. For outsourcing with the sale of resources on an hourly basis – a man-hour.
If an entrepreneur fully understands the economics of his business, it is easier to predict when the company will finally enter the black, – the expert explains – Units of measurement are several factors depending on the type of business. For example, in an online store, such a unit is a user, and for a tour operator – a sold tour of a charter flight. Always consider the specifics of your business.
In general, there are only two types of units:
item or product – more suitable for offline businesses;
customer – mainly an online category.
Each type has its own economic model:
transactional – for units-goods;
client, respectively, for client units.
So, we hope that you have decided on a unit for your company and have chosen a unit economy model. What is next?
How the tool works
First, you need to calculate all the income and expenses associated with your unit.
In general, any business can be represented as follows:
profit = average check x number of sales – expenses.
Your main goal is to choose such values so that the result is with a plus sign. If your calculations show unprofitability, you probably should not launch the project.
Still, the methodology for different models is somewhat different.
Economy for goods
This is a model for offline. Your unit is a unit of goods or a contract in the case of services. First of all, you need to calculate the marginal profit – the difference between the revenue from the sale of a unit of product and the cost of production / purchase and its sale. So we will understand whether we sell one unit profitably.
It is important to take into account the costs of all items:
cost price (production or purchase);
rent of premises and salaries to sellers (for offline business)
advertising, promotion;
delivery, packaging, etc.
Economy for the client
In this model, your unit is the customer. It is used when the business involves regular repeat purchases or subscription renewal (online services, info products).
Here, instead of marginal profit, new values appear:
Lifetime customer value (LTV) – the average gross profit per unit for the entire time of using your product or service. It is calculated for the period for which you need to make a business decision;
cost of customer acquisition (CAC) – sales and marketing costs divided by the number of new customers attracted during the study period.
It is necessary to calculate these indicators and compare them with each other. This way we will understand whether a unit customer brings more profit than we spend on his attraction. If LTV exceeds CPA, your business is real and promising.
