How to Calculate Unit Economics for Your Business
Unit economics is a key concept that every business owner needs to understand if they want to have a profitable business. It refers to the profitability economics associated with acquiring and serving each individual customer.
In simple terms, unit economics allows you to analyze how much money you make from each customer versus how much you spend to acquire and serve that customer. This provides you with fundamental insights into the health and potential scalability of your business.
To be successful in the long run, you need to have positive unit economics. This means the lifetime value of a customer should exceed the costs involved in acquiring and serving that customer. Not familiar with Customer Lifetime Value (CLV) or Customer Acquisition Cost (CAC)? Don’t worry, we will cover both key metrics in a simple and easy-to-understand way in this post.
- Strategic Advantage of Knowing the Unit Economics of Your Business
- Key Unit Economic Metrics
- Customer Lifetime Value (CLV but also referred to as CLTV or LTV)
- Customer Acquisition Cost (CAC)
- LTV to CAC Ratio
- Ways to Improve CLV to CAC Ratio
Strategic Advantage of Knowing the Unit Economics of Your Business
Understanding your unit economics provides strategic advantages. It will enable you to make smarter decisions across many aspects of your business.
Some key strategic benefits include:
- Ensures profitability – Analyzing customer lifetime value in relation to acquisition costs helps ensure the profitability of your business model and pricing. This allows you to course correct early if needed.
- Informs growth planning – Knowing your unit economics helps you model growth scenarios practically. You can set targets for how many new customers you need to acquire to scale sustainably.
- Enables forecasting – With data on your key unit metrics over time, you can forecast future revenue and profitability more accurately.
- Drives decision-making – Every key business decision can be evaluated through the lens of how it will impact your unit economics. This prevents bad calls that erode profitability.
- Attracts investors – Demonstrating solid unit economics shows potential investors that you have a viable, scalable business model. This makes it easier to raise capital.
- Benchmarks progress – Tracking unit metrics provides an ongoing benchmark to measure your business performance over time. You can catch negative trends early.
Key Unit Economic Metrics
Calculating unit economics can become quite complex depending on your business model and data availability. For simplicity, we’ll use basic examples to help understand how unit economics are calculated and the main benefits they provide.
Customer Lifetime Value (CLV)
Let’s break down Customer Lifetime Value (CLV), which can differ depending on your business model. If your business only involves one-time sales (no subscriptions or repeat purchases), then CLV is simply the average order value minus the cost to serve that customer or minus the cost of the product you deliver (commonly referred to as cost of goods sold).
For example, if the average customer spends $100 on a single purchase and it cost you $50 to service that customer, then your CLV is $50.
However, when you have customers making multiple purchases over time, CLV calculation involves two additional metrics: how long they stay as customers and how many purchases they make during that time.
The calculation looks like this:
If your average order is $100 (minus $50 to service the client), and customers purchase on average 5 times per year, and stay for 3 years, your CLV is:
$50 x 5 x 3 years = $750
This gives you a benchmark for how much revenue you can expect per customer. A key metric to factor in here is that the company would have to wait 3 years to collect the $750.
Why is CLV so important? Consider a scenario where you hire a marketing agency and agree to a $60,000 budget for six months. After six months, the agency successfully brought in 100 new sales.
Well, that depends on what a sale is worth to you.
If a sale is worth $100 to you then you just lost $50,000 (100 sales x $100 CLV = $10,000 made from marketing efforts but you paid the agency $60,000).
Now, on the other hand, if each sale is worth $1,000 then you just made $40,000 (100 sales x $1,000 = $100,000 – $60,000 = $40,000).
This is why understanding your Customer’s Lifetime Value is so important, it can be the difference between being in the red or in the green.
Customer Acquisition Cost (CAC)
Next up is the cost to acquire customers. This metric becomes important once you have established your Customer Lifetime Value. This is because once you understand your CLV you now know how much you can afford to pay to acquire new customers.
For example, if your CLV is $100 and in order to have a profitable business you need to maintain a 50% profit margin on the $100 then you now know the maximum amount you can afford to pay to acquire customers is $50. You can use this number as a target for all of your marketing efforts.
To calculate CAC (assuming no sales team is needed), simply take your total marketing costs for a set period of time and divide by the number of new customers gained.
For example, if you spent $10,000 last month on marketing and acquired 100 new customers, your CAC is $10,000 / 100 = $100. In that month it cost you $100 to acquire each new customer. How does that match up to your CLV? Can you continue at this rate and be profitable? In the next section we will talk about the ratio between CLV and CAC you should aim for.
LTV to CAC Ratio
Lastly, let’s talk about the ratio of customer lifetime value (CLV) to customer acquisition cost (CAC). This ratio shows how much revenue a customer will generate for your business compared to how much it costs you to acquire that customer.
A good target CLV to CAC ratio is 3:1 or higher. This means that over the lifetime of the average customer, they will generate at least 3 times more revenue than it costs to acquire them.
For example, if it costs $100 on average to acquire a new customer, you want that customer to generate at least $300 in revenue over their lifetime. Something to keep in mind here, that I just want to touch on briefly, is the time it takes to recoup the money spent to acquire each customer. This is known as the CAC Payback Period and you want it to be as short as possible. Having a shorter payback period really goes a long way in creating positive cash flow which can lead to faster growth.
The 3:1 target ratio is a general rule of thumb that provides a buffer between your CLV and CAC to account for additional operating expenses not factored into the CLV calculation. Costs like rent, salaries, insurance, etc. still need to be covered even if they are not directly tied to serving each customer.
The buffer that a 3:1 or higher ratio provides, allows you to pay for these other operating expenses, while still recovering the CAC within a reasonable timeframe. A ratio below 3:1 is generally considered less favorable because the CLV may not be high enough to cover both the CAC and additional overhead. In this scenario, you’ll want to consider slowing investment in growth.
Conversely, if your ratio climbs above 4:1, that indicates there is room to invest more aggressively in growth initiatives to acquire more customers. The higher lifetime value relative to CAC provides confidence that the additional spending will pay off. The ultimate goal is finding the optimal balance between business growth and sustainable unit economics.
Ways To Improve CLV to CAC Ratio:
- Increase customer loyalty – The longer you can retain customers, the more revenue they will generate over their lifetime. Look for ways to improve the customer experience to keep them coming back. It never hurts to have a loyalty program.
- Upsell/cross-sell – Selling additional products or services to existing customers is easier and cheaper than acquiring brand new customers. Develop ongoing nurture campaigns.
- Reduce CAC – Lowering your customer acquisition costs through more efficient marketing and promotions will automatically boost your ratio. Closely track performance by channel.
- Increase purchase frequency – The more often customers buy, the quicker you recoup CAC and the higher the CLV. Leverage recurring purchases like subscriptions.
- Raise prices/improve margins – Increasing prices or margins on products widens the gap between CLV and CAC. Be sure to retain perceived value.
Tracking CLV to CAC ratios over time and by acquisition channel provides great insight into the overall efficiency of your customer acquisition strategies. Focus on incremental improvements to push that ratio higher.
It’s important to recognize that the business world is more complex than our simplified examples here. I purposely left out or just briefly touched on topics like CAC payback period, cohort analysis, churn rate etc.
My hope is that this has been simple and easily digestible for someone new to the subject. If you are looking for a more detailed breakdown I found this article to be useful.
By continually working on your understanding of these metrics and staying attuned to the specific needs of your business, you’ll be better equipped to make informed decisions and optimize your strategies.