Many businesses can predict whether they are going to make a profit or not. To do so we use a fundamental metric called the unit economics. With this blog, we uncover the mystery of how to scale a product around this one metric, and how to keep it at the forefront of metric discussions.
What is Unit economics?
Unit economics, in simple terms, is the profit earned per unit basis. Suppose, you earn $10 as profit by selling a unit of your product. Now, $10 can be considered as unit economics for your business model.
By keeping an eye on your unit economics from the very early stage of product development, you can track the profitability when you scale your business. By analyzing your profit from one user, you can expect the business to grow when it scales to a million users.
Are you going to make a profit from 1 particular user? If not, no matter how you scale, the businesses are destined to go in loss. Especially in the early stages, you must have a hypothesis to support your unit economics. The higher cost will only make sense if it is driving more users.
Some people argue that businesses like Lyft, Uber do not make sense. They lose millions for acquiring customers and subsidize their loss from venture capitalist’s fund. These are indeed risky businesses but they would balance out their losses when the number of users increases. The point is you need to track whether the unit economics is increasing or not. These businesses are operating on assumptions that the rate of per unit loss is diminishing and will turn out to be profitable in the future.
So should be the case in other businesses. In early stages your profit scale may be less, you might even be losing money for some time. What you must know is, the loss is diminishing and after a certain period, profit will increase at the unit level.
From day 1 if you don’t have positive unit economics, when you apply 1000 users, you won’t make the profit. Based on your metrics, you need to decide what value you can provide and prioritize on that. Look at it from an individual level. If your metric reflects a loss at an increasing rate period after period, it’s time for you to make changes. The changes can be at the product level or market level. Make a hypothesis, test it out and analyze your unit economics again. If you are losing money per unit, it’s the wrong business. Plus it says a lot about the market. You need to check if customers are willing to pay.
Is unit economics important for businesses?
Yes. Most people tend to measure the success or failure of their business by revenue. But revenues can be misleading. When we acquire more users, we will have more people paying which increases revenue. However, we are ignoring a crucial factor- COST.
While considering your unit economics, it is essential you consider both cost and revenue. By reducing costs, you can increase profit. The cost could include your customer acquisition cost, development cost, market research cost, etc.
A small number can tell you so much. You don’t require any fancy analysis if you know unit economics. Just track if it is diminishing or increasing. Furthermore, if unit economics makes sense, it will make sense to millions. If it doesn’t justify on day 1, you really have to look into the business. Make hypotheses around your customers’ will to pay, target market, product features, etc. Even after validating these hypotheses if your unit economics doesn’t improve, then something is definitely wrong with the business. If this fails, other metrics don’t really matter.
In a service company, cost, and revenue per employee could be used as a basis of unit economics. Either we increase revenue per employee or decrease cost per employee. You can also work on keeping the cost rate constant. The idea is to keep the ratio improving.
Hence, by making unit economics a part of your product growth strategy, you can run a profitable business. The profit per user will determine the profit when it scales to a million users. If your unit economics is not improving it’s time to rethink your business from the market, pricing, channels or customer segment perspective.