Unit economics are the direct revenues and costs associated with a business on a per-unit basis. The unit economics of a shirt, for a fashion company, for example, relate to the all the costs of making it, the costs of shipping it to the retail store, and ultimately the price it’s bought for by the store.
This gets more complicated with software-based startups, where a company’s long-term vision is often more valued than its present profitability. It’s ok to lose money today so long as you can eventually monopolize the market.
The recent spotlight on Uber, Lyft and WeWork’s weak unit economics might signal a shift in investor preference towards companies whose grand visions are accompanied by healthy profit margins. This puts pressure on startups to find a working business model with strong unit economics. By unit economics, I mean how profitable each transaction with each customer is.
This includes knowing the customer acquisition cost (blended, fully loaded), average purchase value, average purchase frequency, average customer value, average customer lifespan, life-time value per customer, and churn. See this handy presentation for how to calculate this stuff.
Ride sharing as an example
Ride sharing companies typically have really bad unit economics, making ride sharing a risky investment. Margins are tight because the driver takes a big cut, so much is spent on getting new customers, and almost every company fights off competition with discounted rides. When they’re not losing money, these companies often make just pennies on each transaction.
Low-margin businesses are hard to grow
A valuable business with low-margins must operate at massive scale. Operating at scale implies excellent execution; something you can do only if you have and retain great people and build great technology. To do these things you usually need lots of money, which implies several rounds of fundraising. Hiring, retaining, building, and fundraising are hard enough, but they get even harder with competition, because competitors will shrink each other’s margins and try to hire away talent.
Low-margin businesses are especially hard in developing markets
In much of the developing world, especially Pakistan, Myanmar, Bangladesh and Vietnam, businesses see low margins because the local population doesn’t have a lot of money to begin with. Add to this the challenge of keeping good managers (who would rather work in Canada or at a multinational), the relative dearth of international investors funding startups in developing markets, and the few options for exits, and low margin businesses in developing markets start to seem especially scary.
If your business is low margin or has weak unit economics, you need a plan
You’re on the hunt for margin. That means offering products and services yourself rather than just providing a marketplace. Or it can mean expanding the offering to include customers who will pay more. Certainly it means knowing what your unit economics are today and where they can potentially go in the future.
This article was originally published on arshadgc.com.
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