Understanding Unit Economics

Before we begin. I wanted to apologise for a delayed post. I was in middle of moving to the other side of the world - Chicago. That being said..

👋 to all of you from the windy and beautiful city of Chicago

Today, I will talk about unit economics. You must have heard this buzz word many, many times and I am sure we all can use a refresher on what does it really mean, and why do we bother about is so much.

Recall that startups are about acquiring customers ahead of time or in a more technical way, ahead of cashflow cycles. They are about creating markets (read, consumer behaviour) ahead of time. In doing so, they burn cash in various aspects of the business - more importantly, in acquiring and servicing customers. Thus, it becomes imperative to understand…

(A) what is current economics at unit level - for example, selling $10 product online may not make sense because the cost of shipping is more than $10. And,

(B) will it ever make sense - say at steady state, cost of shopping may go down to $8 and thus, one can make money by selling a $10 product online.

Investors, founders, and growth finance professionals are essentially trying to answer the above two questions through unit economics. These two questions may look different for different business, for example, a content business, a lending business, and, a telemedicine business. But the crux remains the same - what is today and what can it be in the future. Additionally for us investors, this kind of analysis helps compare or benchmark different companies.

How to build insights from Unit Economics

To make this point, lets take a 5-year growth accounting statement / MIS of a fictional company in D2C brand space - this company ships high value fashion accessories costing $10 each.

Simple right? Take a moment to observe the MIS below. If you feel lost in the table below, please refer to my previous post on reading and building a MIS.

Now, I want you to focus your attention on three things:

(1) Units: Actual units shipped in that year. You can read this as number of items as well.

(2) Orders: Total number of orders. Please note that in an order, there can be multiple units/items.

(3) Unit/Order Ratio: On an avg. how many units are shipped per order, which in Year 1 is 1.5, and moves up to 3.5 in Year 5.

Both (1) and (2) can be basic “unit” of building unit economics (UE). Again, If unit confuses you, please read (1) as items. I have drafted UE on order basis and as well as unit (item) basis below:

The above table explains that it is fundamentally very expensive to ship this $10 product online. The gross margin per unit is $2 and it takes $13 to pack and ship (direct costs) this product on a unit level. Then the company is giving discounts to make new users transact. This is typically true of all venture capital run business. This is our answer to the first question (A) That, the UE does not makes sense today from the section above.

Now as growth finance professionals, investors, or even as key managers of this company, the subsequent question will be (B) - will the unit economics make sense at scale?

For the purpose of this post, I will keep this simple and not have many moving variables which obviously wont be the case in real life. I now want you to focus your attention on UE per order in Year 1 - it takes $20 to fulfil this order and one order has about 1.5 units on average. This fictional company is directing all its energy into shipping more units per order #(3) as you can see in unit/order ratio trend in the MIS.

It simply means that in one packet, you are able to stuff more items / units. The cost to ship more products in the same order does and should not theoretically increase linearly. For the first three years, I have assumed that a step up increase of 0.5 in Unit/order ratio increases the direct cost by 1$. And from Year 4, the company is able to further decrease it, say by building scale efficiencies.

By stacking & shipping more units per order, the unit economics in Year 5 looks very different. Instead of losing $15 per unit in Year 1, the company is losing $4 in Year 5. Are you able to see that business looks more feasible at scale in Year 5? So, let me ask you this What is your answer to (B)? Does it work at scale? Will it look better in Year 6, or even breakeven?

My answer is maybe or maybe not.

I will try to understand if there is further room to increase the unit/order ratio or whether it is possible to increase the selling price from $10 to get more gross margin per unit. Or, launch a new line of products that have better gross margin, which on a portfolio level will make sense. There are a lot of things to peel here, like I said, this is not a real life scenario and this will have lot of moving parts.

To give you a real life anecdote, portfolio approach is something eCommerce companies use aggressively. For example, in case of Flipkart or Amazon, it just does not make sense to ship a high volumetric product such as a baby diaper. The cost of shipping alone outstrips the little gross margin you make on such product.

But, diapers is a key category in eCommerce, it engages the spenders in a household, the mothers, to continue to come on the platform - drive repeat behaviour. The hope is that these spenders in coming back to the platform again and again, may stumble and order products such as an iPhone, which have amazing unit economics -high GM and low shipping costs. Thus, overall, the eCommerce companies (should) make money on a portfolio (of categories) level.

I hope this post gives you insights that unit economics are not just merely a table that one puts on a powerpoint. UE actually is used very aggressively in strategic decision making by growth finance professionals, as I described in the eCommerce startups. We investors love it the most.

I will cover these topics in more depth in the future. I will also cover what unit economics mean in an insurance company or even in a content company, like the basic drafting of it could be challenging there. Please comment below if you would like to talk about something specific.

Before I part, a small announcement!

I am launching a 4-week Cohort Based Course (CBC) on Startup and Growth Finance starting 18th of October. If you like what I write and would like to sharpen your nails with a few topics, do check the course below.

https://growthfinance.airtribe.live/course

Feel free to write back in case you have any questions. Talk to you soon.