How to calculate unit economics

Strong unit economics are foundational to the health of a business. Learn how to think about and calculate this key metric

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Strong unit economics are essential for sustainable growth over a long period of time, or maintaining a healthy balance sheet during economic downturns. Unit economics are a key metric in assessing the health of a business, and investors frequently look to it to inform their investment decisions. Decomposing unit economics for a particular product or a customer into the different costs and revenue components over their lifetime gives you insight so you can optimize your overall spend allocation and avoid waste.

Topics included in this article:

What are unit economics?

Unit economics answer a simple question: are we making money selling X unit (or to Y customer)? Think of it as the profit-and-loss statement for a single unit sold, or a single customer sold to, before accounting for more general company-wide expenses.

We can define unit economics in two ways: 

  1. “One unit = one customer”: Typically, the ratio of a customer’s lifetime value (LTV) to the costs to acquire that customer (CAC, which stands for customer acquisition cost). 
  2. “One unit = one item sold”: The incremental profit a company makes when it sells a single unit of its product. This is equal to the selling price minus the variable costs of making the product (e.g., material inputs, direct labor costs). This metric is commonly referred to as the contribution profit. 

For SaaS companies, unit economics are typically thought of in terms of individual customers. For example, once a customer subscribes to a piece of software, they typically generate recurring revenue with minimal incremental costs over their lifetime as a customer (i.e., until they unsubscribe).

The cost of making the software is then akin to the overhead costs of a company selling physical goods, and the ratio of the total lifetime recurring gross profits (until unsubscription) to cost of acquiring the customer is more indicative of the health and sustainability of the business.

For companies selling physical products, the second definition provides better insights into potential product optimizations. For example, for a company that sells soap bars, the variable costs could include the raw materials, packaging, and labor associated with each type of soap bar the company sells. The revenue would simply be the sale price, i.e., the amount of money received from selling a finished product (in this example, a bar of soap).

Unit economics change over time, often as a result of changing input costs (e.g., materials, labor) and competitive pressures (e.g., pricing changes). As such, maintaining a real-time pulse on unit economics from a company’s earliest days and optimizing as needed gives a company the best chance of survival long-term.

Why are unit economics important?

While important for companies of all sizes, unit economics are especially crucial for startups. Failing to find product-market fit before funding runs out is a textbook mode of failure for venture-funded companies.

It is not uncommon for founders to adopt a “growth-at-all-costs” strategy early on, only to find that the product was never viable without subsidy. At the earliest stages, understanding direct revenues and costs help establish a path to profitability, a key ingredient to long-term stability. Having a clear picture of your unit economics can help you:

  • Understand market suitability: Regularly examining whether a product’s pricing strategy and costs align with what the market can accept can help you understand whether your product has a business case. If a product does not have positive standalone unit economics, it would need to be “subsidized”, either by a more profitable product in your portfolio, or by your balance sheet (e.g., investor funding, other cash on hand).
  • Determine the viability of your product at scale: Unit economics indicate how well a product does independently of fixed costs, such that if enough units are sold, the company can more than offset these costs. From here, your company can develop optimal pricing and customer acquisition strategies, figuring out the right moves for market introduction and continued competitiveness.
  • Deploy capital effectively: Breaking down cost structures and revenues reveals the levers your company has to achieve profitability, enabling you to focus on increasing ROI from capital deployed.

How to calculate unit economics

What are you selling? As mentioned above, you’ll look at slightly different measures when you choose to define a “unit” as a single customer acquired, or as a single item sold.

For example, a B2B SaaS company would typically consider the total dollar value of subscriptions purchased by the average customer over their lifetime, whereas a B2C company selling jewelry might want to use a single necklace as a reference point for analysis.

Two Methods: One Customer vs. One Item Sold

Method 1 - “One Customer”: LTV/CAC

For SaaS companies, as well as other types of companies with minimal marginal costs per unit sold, an individual customer can be thought of as a “unit”. If you choose this method, unit economics is measured by a ratio of two other important metrics – CAC and LTV. 

Unit Economics = LTV / CAC

LTV/CAC is a ratio measuring the overall value a customer provides in their lifetime to the cost of acquiring them. Given how these metrics show both the net revenues and costs of a customer over their life, LTV and CAC can directly inform sales and marketing decisions. LTV can be thought of as the return on closing a new customer, while CAC represents the difficulty of closing new customers to generate this return.

Customer lifetime value (LTV) represents the total expected gross profit for any given customer over their lifetime. More precisely, LTV is the (net) total dollar amount a company receives from a customer before they churn (i.e., stop being a customer). This has 4 components, and is calculated as follows:

LTV = Average Purchase Value x Gross Margin × Purchase Frequency in Period × Customer Lifespan per Period

Put more simply, total gross profitin a given time period times average lifespan (measured in units of that time period). Cross-functional teams at big and small companies alike use LTV to quantify how much money they can spend on retaining, acquiring and engaging customers while still being profitable, or if profits will be negative when spending more on customer acquisition.

LTV is usually calculated at a snapshot in time, with a time horizon depending on product dynamics. For example, if you sell a ready-to-drink beverage, a customer may purchase 10 units per month, sometimes not purchasing for 2 or 3 months at a time. LTV is a good measure of customer loyalty, but could look very different on a 1-month, 3-month, or 6-month timeline.

Customer acquisition cost (CAC) is the cost of attracting and acquiring a customer. This can include marketing, discounts, or any spend to help close a sale.

CAC = Total Sales & Marketing Costs in Period / Number Customers Acquired in Period

CAC Payback Period is the amount of time it takes to recoup the customer acquisition cost from that customer or customer cohort.

CAC Payback (in Months) = CAC / (Monthly Revenue x Gross Margin) 

If you choose to use the CAC of a single customer, then adjust all values accordingly to reflect that as well. If a software product costs a user $5 per month and you spent $50 to close the sale, it will take 10 months to recoup that CAC (assuming a 100% gross margin).

Venture-backed companies often have a longer horizon for CAC Payback. They’ll shoot to recoup customer acquisition costs between 12 and 18 months, and sometimes longer. Bootstrapped companies on the other hand need a quicker ROI to keep the business running.

To calculate these metrics using the attached Causal model, refer to the section below entitled “How to use Causal model to calculate unit economics” 

So what’s a good ratio anyway?

It’s commonly said that 3:1 is a good LTV/CAC ratio, where your business gets 3x the value of acquisition cost from each new customer.

If your ratio is lower, for example 1:1, you’re paying as much to acquire one customer as they spend on your product. Any lower than that and you’re in negative profit territory – you’ll want to spend less on customer acquisition and test some other strategies.

If your ratio is higher, for example 6:1, you’re likely missing out on growth opportunities. If you get 6x the value from a customer compared to costs of acquiring them, then you could reinvest that money back into your sales and marketing efforts to find additional leads and boost your bottom line.‍

For venture-backed companies, a low LTV/CAC ratio may raise red flags to investors, as it suggests that the company is struggling to acquire high-value customers and/or may require further capital to grow. On the other hand, a strong ratio is a green flag for growth – whether venture-backed or not, allocating capital differently will improve growth and injecting capital is one means of acceleration.

Method 2 - “One Item Sold”: Contribution Margin


With individually sold items, you’re aiming to figure out how the variable costs associated with that unit affect the overall price per unit. You’ll want to find the contribution margin, which is the difference between sales price and variable cost per unit.

Contribution Margin (%) = (Price per Unit - Variable Costs per Unit) / Price per Unit x 100%

To calculate these metrics using the attached Causal model, refer to the section below entitled “How to use Causal model to calculate unit economics” 

How to use Causal model to calculate unit economics

Note: For all methods, refer to the image below each, where the step number corresponds to the image label in blue (e.g., for step 1 in the SaaS example, the relevant image section is in the top-left corner).

Method 1 - “One Customer”: LTV/CAC

SaaS example

Let’s walk through an example of how to use the Causal model to calculate unit economics for a fictitious B2B SaaS company that sells video conferencing services, billed monthly:

Step #1:

  • Select ‘SaaS’ from the ‘View’ dropdown menu

Step #2:

  • Enter the number of new customers you gained in the period (in this example, we will use months as the period)
  • To get this number, simply subtract the number of customers you had at the beginning of last month from the number of customers you had at the beginning of this month

Step #3:

  • Enter the new MRR from this period. (Note: MRR stands for Monthly Recurring Revenue, which is calculated by multiplying (a) the number of customers in a given month by (b) the price each customer pays per month)
  • You can calculate “New MRR in period” by subtracting the MRR in the prior period (in this example, last month’s MRR) from that of this period (i.e., this month’s MRR) 

Step #4:

  • Enter your gross margin %. For this number, you can use the gross margin from your financial statement for the period
  • This is usually calculated as (Revenue - Cost of Goods Sold) / Revenue x 100%, and is typically 60-80% for SaaS companies

Step #5:

  • Enter your total sales and marketing spend this period. You can get this number from your financial statements 
  • This would include all costs associated with sales and marketing, which typically consist of marketing spend (including paid ads), marketing team compensation, and sales team compensation

Step #6:

  • Enter your average monthly churn %. This is the percentage of existing customers you expect to unsubscribe from your services each month
  • One way to estimate this is to divide the number of customers that unsubscribed in a month by the total number of customers at the beginning of that month

Output:

  • The Causal model will take the inputs above and output the LTV/CAC ratio, as well as CAC Payback Period in months at the top section
  • To see CAC, LTV, average MRR, and customer lifetime (in months) individually, refer to the Additional Details section below the main outputs

DTC example

Now we’ll walk through an example for a fictitious Direct to Consumer company. Let’s say we’re a company that sells baseball caps, and are looking to understand our unit economics on an annual basis:

Step #1:

  • Select ‘D2C’ from the ‘View’ dropdown menu

Step #2:

  • Enter the number of total orders and revenue (total orders * revenue per order) you expect in the period. In this example, we will use yearly

Step #3:

  • Enter your average number of orders per customer for this period
  • For example, if we typically see customers make 3 orders per year, we will use that as our input. Note that each order can contain multiple units (i.e., baseball caps in this example)

Step #4:

  • Enter your average gross margin % per order. The calculation is the same as our SaaS example above (i.e., (Revenue - Cost of Goods Sold) / Revenue x 100%)
  • Most DTC companies will target ~50% as a successful gross margin benchmark

Step #5:

  • Enter the expected lifetime of your customer for the selected period
  • In our current example, typical customer lifetime is 2 years (i.e., on average, a customer will make 3 orders per year for 2 years before completely churning)

Step #6:

  • Finally, enter the number of new customers gained in the period and sales & marketing spend in the period. The calculations here are the same as in Steps 2 and 5 of our SaaS example above

Output: 

  • The Causal model will take the inputs above and output the LTV/CAC ratio, as well as CAC Payback in # of orders at the top section
  • To see CAC, LTV, average MRR, and average order value individually, refer to the Additional Details section below the main outputs

Method 2 - “One Item Sold”: Contribution Margin

We can also use the Contribution Margin calculator to determine the difference between sales price and variable cost per unit for up to 3 separate products at one time:

Step #1:

  • Select ‘Contribution Margin’ from the ‘View’ dropdown menu

Step #2:

  • Enter the number of products you sold and the revenue in the period. If we are using monthly, enter total # of units sold/month, and revenue/month

Step #3:

  • Enter your variable cost per product. This is defined as the production cost for each unit produced 

Step #4: 

  • You can enter inputs for up to 3 products. Ensure that you have the correct ‘Product #’ selected across all inputs

Output:

  • The Causal model will take the inputs above and output the Contribution Margin %, as well as the Average Price per product

How to accurately assess and improve unit economics

Improving your unit economics isn’t as simple as raising prices or cutting the cost of inputs. Using the metrics outlined above can help expose levers for you to build a more sustainable path toward profitability over time. Especially in a downturn, it is critical to build long-term solutions and avoid quick fixes. Below are just a few examples of ways of you can assess and improve your unit economics:

1. Keep all your data in one place

Take back control of your financial data, so you’re not digging through 10 identical excel documents for something buried in an email chain. Combine this with real-time visibility and digitized audit trails to make it easy on your accounting department.

2. Automate your expense reports

Miscategorizing expenses is an easy way to misjudge your unit economics. Tracking expenses, organizing receipts, and compiling expense reports are all tedious jobs that waste your employees’ time. Expense automation and automated reports can save your employees hundreds of hours each month, time that can be spent on more productive work that will actually move the needle.

3. Renegotiate contracts

The best business relationships are built on long-term partnerships. Especially as it relates to the suppliers of your input materials, renegotiating contracts can save you money where you least expect it. Look to other companies in your industry for comparable metrics and see if you can identify savings or optimize your deployments.

FAQ

What does unit economics mean?
What does contribution profit mean?
Is CLV the same as LTV and CLTV?

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