Unit economics metrics are the most important metric to consider when analyzing subscription businesses.
Ok, that’s too dramatic, but it’s a problem.
This set of unit economics metrics will tell you if you’re building a sustainable business, and that is only possible with profits. One can say that making no profits is not necessarily bad, pointing to Amazon as an example.
Amazon has been unprofitable for years but is still a successful company. One of the reasons this might be true is because they are able to raise capital and invest in new business ventures like hiring salespeople or expanding their SaaS (software as a service) offerings.
Despite making investments, we will still need to be careful when it comes to measuring and understanding our unit economics.
Profitability is being misinterpreted
Let’s say Amazon buys a book for $10 and spends more than that on shipping, the total cost of the book is now at $15. Then they sell this item to consumers who are willing to pay an average price of $20, making them a gross profit of about five dollars. After taxes, it turns out that their net profits only come up to three dollars.
Now let’s say Amazon spends $5 on growth. This means that they will have a loss of $2 at the end, right?
They could become profitable if growth wasn’t as high of a priority.
This is a hypothetical example, but if you make money on every single transaction that occurs in your company then there’s no way it won’t be profitable. Unless you choose not to.
In contrast, a commission-only structure is often insufficient to pay the bills. To have a sustainable business, you need to make sure that what your unit economics are producing is worth more than the costs of running it.
When it comes to understanding unit economics metrics, there are a few common mistakes that you should avoid.
Customer Value Over Time
There is one difficult aspect of calculating customer lifetime value, and it’s the term “lifetime.”
Early-stage businesses don’t have a steady churn rate, so they are forced to guess how long their customer will be around before canceling. This is risky because entrepreneurs tend to overestimate the amount of time that customers stay with them.
A common mistake is to look at revenue when calculating LTV. To be accurate, you should use gross profit instead of total sales and deduct the cost of goods sold from it.
If you make $100, spend $70 on the customer to serve them, and have acquisition costs of $50, then your gross profit is only 30 dollars. You are losing 20 because you don’t account for all expenses.
Costs of Customer Acquisition
It is possible to calculate CAC incorrectly if it does not account for the true cost of acquisition.
The common way to calculate CAC is by dividing Sales and Marketing Expenses by the number of new customers.
One of the mistakes often made when trying to figure out CAC is that you only look at what percentage is attributable to marketing, like paid advertising.
You need to spend your entire marketing and sales budget on things like PR, content production, and sales reps advertising marketing software licenses (like Salesforce).
You can calculate your customer acquisition cost by dividing the total amount you spend on acquiring customers (including marketing, sales, and other costs) by how many new customers are acquired.
Payback Period and LTV:CAC Ratio
If you want to be more successful, it is important that you look at the difference between your LTV and CAC. You should measure this ratio because doing so will show how much of a loss or profit each customer brings in.
One of the most important aspects to take into account when hiring salespeople is how long it will be before they break even. In SaaS, you should only sell to customers who are expected not to churn and those with a LTV/CAC ratio that exceeds 1 (which means their lifetime value as well as customer acquisition cost).
But if you don’t have the means to sustain these losses, it doesn’t matter how motivated your employees are.