Unit economics is an easy and powerful tool that will help you to understand the success & sustainability of the business. No matter whether you are a CFO of a powerful company or a businessperson who is trying hard to get your e-commerce to start from the ground, it is important to use unit economics for e-commerce alongside the overall cash flow & yearly revenue to analyze the company’s performance & plan for the financial future.
The strength of unit economics is an important benefit in the venture capital market, which most predict may toughen as a cost of this can toughen considerably for the founders over the next five to ten years. One question that may immediately follow is, ‘What is the annual growth rate?’ and what is the unit economics?’ Such change in the investor mentality will be catalyzed by an increasing cost of the startup capital.
Looking at the Importance of the Unit Economics
Understanding of unit economics for e-commerce helps to:
- Predict profitability. It is based on the per-unit analysis, the unit economics shows you how profitable the business is and how soon it can achieve profitability over some time.
- Get the right and clearer picture of the business processes. Using unit economics is the first step for your company’s management, investors, as well as other stakeholders that will help to analyze the financial performance.
- Evaluate the product’s future potential. By relying on unit economics, the businesses will be able to analyze what customers like more and keeping up to the sustainability standards.
- Develop the right strategies for product optimization. The unit economics allows the companies to know if the product is undervalued or overpriced. This will help them to know what & how must get optimized.
How Can You Analyze the Cost of Getting New Customers?
Each new business will encounter the hurdle of getting new customers. Cost of acquisition or CAC is one very important metric for the companies who are looking to decide how much they can spend to get the new customer. This formula is:
CAC equals to (marketing and sales costs or number of the acquired customers)
Your customer lifetime value and CAC ratio will help you to decide if the building blocks of the marketing attempts are strong and want to get adjusted. Suppose your CAC will be less than the LTV, then it indicates your business will be strong. Moreover, suppose both the metrics are equal, then it highlights the stagnant business. Suppose your CAC is higher than the LTV, you’re looking at the financial loss.
It will not get cheaper to run the startup and raise any serious capital for keeping things going. If you are making low margins or face huge competition as well as are looking on the short runway, then your financials will not inspire confidence in the investors. Alternatively, suppose you have any racking up of short-term losses over customer acquisition, however, will demonstrate your client payback time and lifetime value, and you will be the most attractive target for the investment.
Examples of Unit Economics
Let’s look at an example of using unit economics in marketing to regulate the most effective channel for unit promotion in an online store. The reference data is as follows:
Contextual advertising brought in $70,000, generating 420 contacts with 250 orders.
$30,000 has been spent on targeted advertising, resulting in 280 leads generated by targeting. A total of 100 orders have been place.
To briefly calculate the use of each channel, we do the following
Contextual advertising efficiency = $70,000 / 420. That’s $166.6. Of the 420, only 250 became actual buyers. So we calculate the subsequent: 250 / 420 * 100 = 59.5%. In this case, the cost of attracting a unit is analyzed as 166 / 59.5% = $279.
Targeted advertising effectiveness = $30,000 / 280, which equals $107.1. Out of 280, 100 became customers, so the method is as follows: 100 / 280 * 100 = 35.7%. The price per unit is calculated like this: 107.1 * 35.7% = $300.
Based on these calculations, contextual advertising appears to be this store’s most advantageous promotional option, as its conversion rate is 55.5% (higher than targeting). This calculation disproved the misconception of store owners, as it showed that advertising spend is not what should be considered when choosing a channel. Yes, leads from targeting are cheaper, but leads are more affordable from context, so this channel wins.
You can learn the basics of unit economics with proper training. Today, you can also find books or a particular course, one of which, for example, is offered by Lectera.
Improving the relationship between the CAC & LTV
An ideal ratio between both LTV: CAC needs to be 3:1. It means that every customer generates 3 times in its profit of money that you want to acquire them. Hence, proving such a ratio will be the green light for the investors who are looking for low risk and long term growth opportunities.
People with a lower ratio like 2:1 will naturally want to improve the unit economics. In the early startup’s stage lacking cash flow, this will be very challenging to optimise the unit economics since there will be a lack of historical data, customers, and lack of resources for conducting research. However, it must not be impossible (in the early stage) since these are some key fundamental metrics that will track down before you look at the financing options.
If you are looking to improve your unit economics for eCommerce, you have to either:
- Decrease the Customer Acquisition Cost
- Increase the Customer Lifetime Value
For increasing your LTV, you have to increase the customer retention rate, average order value, and frequency of orders, just by:
- Taking a closer look at the analytics and track your user sentiment.
- Including any special offers and add-ons at a checkout area