If you don’t understand your unit economics, your business will die. It might take a while, depending on how much money you have in the bank. But it will eventually go bust!
Unit economics is the fundamental bedrock of every business venture. This is what every business boils down to.
If a company can determine its unit economics, it can determine its contribution margins, break-even points and make realistic ROI calculations.
There are two questions that every founder should take seriously, and compare, as they begin their entrepreneurial journey: (a) What is a customer worth to me? and (b) How much do I spend to get one customer to buy from me?
The customer’s worth over a period of time before attrition is their lifetime value (LTV) and the investment directed at getting the customer to generate revenue for the company is the customer acquisition cost (CAC). The best outlook for a business is for the LTV of a single customer to be greater than the CAC. Like this:
But to compare the number, you need to know how to arrive at them. We’ll go on to explain how.
How to calculate the customer lifetime value (LTV)
There are many ways to calculate the customer lifetime value that involve a lot of mind-bending math. But one of the easiest ways to calculate LTV is to multiply average value of a customer per visit, by the length of average patronage.
Say, you have a business selling patent leather shoes and your average customer spends $5 buy two shoes every time they visit your website. Your average customer does so four times a month. Assuming your average customer stays active with you for two months, the lifetime value of your average customer then is; $40
How did we arrive at that? Let’s arrange all those variables.
– Your average customer spends $5 (AS) on each visit.
– They visit four times a month (TV)
– If their average time with you is 2 months, then they visit eight times their lifetime (TTV)
– Thus LTV = AS * TTV
How to calculate your customer acquisition cost (CAC)
If how much you spent on Twitter Ads or Search Engine Marketing, or any other marketing channel to acquire one customer is $5, then your CAC at the basic level is $5.
Divide how much is spent on marketing and advertising, including employee cost in a month by the amount of new users from the month. For your patent leather business, if you are spending$100 to gain 10 customers every month, then your Customer Acquisition Cost will be $10.
How did we arrive at that?
– You spent $100 (AS) in one month
– To acquire 10 customers (ACC) in one month
– CAC is, therefore S / CC
Continuing with the patent leather shoe startup. With your total cost to acquire a customer at N10, 000, and the lifetime value of your customer at $40, you appear to have a smart business.
It means for every $10 you spend to acquire a customer, they bring $40 in value. Not too shabby.
Investors will beg to give you money at this rate.
Improving your unit economics
There are ways to have a better unit economics, either by increasing your customer’s LTV or reducing your CAC.
Ways to increase the LTV of your average customer include improving retention, increasing the frequency of order over a customer’s lifetime or increasing the order size of your average customer.
To reduce CAC and cost, you could explore cheaper marketing alternatives, including referrals, SEO, affordable content marketing, cheaper raw materials etc.
Understanding your company’s unit economics could mean the difference between profit and bust.
Every investor wants to know that a founder understands their unit economics. Many founders fail at raising money because they fail to grasp the concept and therefore lose investors’ confidence. If you can prove you can replicate this same outlook, LTV>CAC, at scale, then you got the investors’ confidence, and their cash.
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