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MVP Lab
2 July, 2024 • 5 minutes

HOW TO CALCULATE UNIT ECONOMICS

High revenue but low profit is a common story, especially for startups. Increasing revenue doesn't significantly improve the situation because expenses rise alongside it. To address this, it's essential to analyze all business processes. Unit economics can help with this.

HOW TO CALCULATE UNIT ECONOMICS

High revenue but low profit is a common story, especially for startups. Increasing revenue doesn't significantly improve the situation because expenses rise alongside it. To address this, it's essential to analyze all business processes. Unit economics can help with this.
In the previous article, we provided a general approach, explaining that unit economics varies depending on the business model. If you are new to the framework, we recommend starting with that article, where we explain the key ideas and metrics of economics.

In this article, we will analyze unit economics using an online store as an example. First, we'll define what constitutes a business unit in e-commerce. Then, we'll model unit economics and identify specific growth points to increase profit.

By the end of the calculations, you will obtain values for variable costs, contribution margin, and marketing budget.

BUSINESS UNIT IN E-COMMERCE

Unit economics is a tool for assessing business costs and revenues per unit. It helps understand how different factors impact the final result.

In e-commerce, the unit is considered the "visitor," who becomes a "buyer" after making a purchase. However, many expenses depend on the number of products rather than the number of buyers, complicating the calculation. Therefore, some formulas transition from the "visitor" unit to the "product" unit.
In the previous article, we provided a general approach, explaining that unit economics varies depending on the business model. If you are new to the framework, we recommend starting with that article, where we explain the key ideas and metrics of economics.

In this article, we will analyze unit economics using an online store as an example. First, we'll define what constitutes a business unit in e-commerce. Then, we'll model unit economics and identify specific growth points to increase profit.

By the end of the calculations, you will obtain values for variable costs, contribution margin, and marketing budget.

BUSINESS UNIT IN E-COMMERCE

Unit economics is a tool for assessing business costs and revenues per unit. It helps understand how different factors impact the final result.

In e-commerce, the unit is considered the "visitor," who becomes a "buyer" after making a purchase. However, many expenses depend on the number of products rather than the number of buyers, complicating the calculation. Therefore, some formulas transition from the "visitor" unit to the "product" unit.

GROWTH FORMULA

Regardless of what you sell, the business model of an online store boils down to a single equation with four variables. It is called the growth formula in e-commerce.

CM = (UA × C1 × ARPU) − VC

CM (Contribution Margin) — Margin profit per store visitor.
UA (User Acquisition) — Number of visitors.
C1 (Conversion) — Conversion rate from visitor to buyer.
VC (Variable Cost) — Variable costs.
ARPU (Average Revenue Per User) — Average revenue per visitor over a period.

The task is to answer the questions:

  • What needs to be done to get the user to visit the site (UA)?
  • Make a purchase (C1)?
  • How to deliver purchases at the lowest cost (VC)?
  • Become a repeat customer (ARPU)?
We will calculate the values of the variables in order.

GROWTH FORMULA

Regardless of what you sell, the business model of an online store boils down to a single equation with four variables. It is called the growth formula in e-commerce.

CM = (UA × C1 × ARPU) − VC

CM (Contribution Margin) — Margin profit per store visitor.
UA (User Acquisition) — Number of visitors.
C1 (Conversion) — Conversion rate from visitor to buyer.
VC (Variable Cost) — Variable costs.
ARPU (Average Revenue Per User) — Average revenue per visitor over a period.

The task is to answer the questions:

  • What needs to be done to get the user to visit the site (UA)?
  • Make a purchase (C1)?
  • How to deliver purchases at the lowest cost (VC)?
  • Become a repeat customer (ARPU)?
We will calculate the values of the variables in order.

VARIABLE AND FIXED COSTS

Unfortunately, to make a profit, you first need to spend money. All business expenses are divided into variable and fixed costs.

Fixed costs are those that exist regardless of sales and do not change with their growth. They may include rent, utilities, salaries, etc.

Variable costs (VC) are incurred when a sale is made. They increase as the order volume grows.

VARIABLE AND FIXED COSTS

Unfortunately, to make a profit, you first need to spend money. All business expenses are divided into variable and fixed costs.

Fixed costs are those that exist regardless of sales and do not change with their growth. They may include rent, utilities, salaries, etc.

Variable costs (VC) are incurred when a sale is made. They increase as the order volume grows.

DELIVERY COSTS

In e-commerce, variable costs are delivery expenses. They include all expenses from purchasing goods from suppliers to their return by customers.

  1. COGS — Cost of Goods Sold.
  2. Delivery from suppliers.
  3. Acquiring.
  4. Collection and packaging.
  5. Delivery to customers.
  6. Return costs.

COST OF GOODS SOLD
This includes the cost of goods from the supplier or the expense of materials and labor if you manufacture the goods yourself.

DELIVERY FROM SUPPLIERS
Delivery is often thought of as only the cost of shipping to the customer, but it also includes expenses for transportation from the supplier, such as packaging, loading, and logistics. If you don't have your own warehouse, it also includes storage rental.

ACQUIRING
To receive payments, you need to pay for acquiring services. The average merchant processing fee is 2%.

COLLECTION AND PACKAGING
These expenses could be included in "delivery to the customer," but typically different people handle collection and delivery.

DELIVERY TO CUSTOMERS
This is the second-largest expense after the cost of goods. There are two ways to account for it. The first is to include delivery costs in the product price, excluding them from variable expenses. The second is to calculate delivery costs separately, based on the product's weight and the distance to the customer.

RETURN COSTS
Returns are a natural part of the sales cycle, including transportation costs and handling return requests. On average, 15% of the product cost is allocated for this.

DELIVERY COSTS

In e-commerce, variable costs are delivery expenses. They include all expenses from purchasing goods from suppliers to their return by customers.

  1. COGS — Cost of Goods Sold.
  2. Delivery from suppliers.
  3. Acquiring.
  4. Collection and packaging.
  5. Delivery to customers.
  6. Return costs.

COST OF GOODS SOLD
This includes the cost of goods from the supplier or the expense of materials and labor if you manufacture the goods yourself.

DELIVERY FROM SUPPLIERS
Delivery is often thought of as only the cost of shipping to the customer, but it also includes expenses for transportation from the supplier, such as packaging, loading, and logistics. If you don't have your own warehouse, it also includes storage rental.

ACQUIRING
To receive payments, you need to pay for acquiring services. The average merchant processing fee is 2%.

COLLECTION AND PACKAGING
These expenses could be included in "delivery to the customer," but typically different people handle collection and delivery.

DELIVERY TO CUSTOMERS
This is the second-largest expense after the cost of goods. There are two ways to account for it. The first is to include delivery costs in the product price, excluding them from variable expenses. The second is to calculate delivery costs separately, based on the product's weight and the distance to the customer.

RETURN COSTS
Returns are a natural part of the sales cycle, including transportation costs and handling return requests. On average, 15% of the product cost is allocated for this.

CONTRIBUTION MARGIN (CM)

Next, calculate the contribution and net profits.

Contribution margin is the revenue from product sales minus variable costs, in this case, delivery expenses. It is also known as gross profit or contribution margin.

Net profit is the revenue minus both fixed and variable costs.

CONTRIBUTION MARGIN (CM)

Next, calculate the contribution and net profits.

Contribution margin is the revenue from product sales minus variable costs, in this case, delivery expenses. It is also known as gross profit or contribution margin.

Net profit is the revenue minus both fixed and variable costs.

CUSTOMER ACQUISITION COST (CAC)

Customer acquisition cost (CAC) is the total marketing expenses divided by the number of new customers. The marketing budget includes advertising costs, discounts and promotions, employee salaries, and contractor fees.

It's essential to understand how much money can be spent on marketing:

CAC ≤ CM − NetProfit

For example, if a product costs $100 and variable expenses are $49, $51 can be invested in acquiring new customers.


CUSTOMER ACQUISITION COST (CAC)

Customer acquisition cost (CAC) is the total marketing expenses divided by the number of new customers. The marketing budget includes advertising costs, discounts and promotions, employee salaries, and contractor fees.

It's essential to understand how much money can be spent on marketing:

CAC ≤ CM − NetProfit

For example, if a product costs $100 and variable expenses are $49, $51 can be invested in acquiring new customers.

REVENUE DISTRIBUTION

But should all this money be spent?

Revenue is divided into four parts:

  1. Variable expenses (in our case, Delivery Costs).
  2. Marketing expenses.
  3. Fixed expenses.
  4. Profit.
The first two items' amounts directly depend on the "product" and "buyer" units, making them particularly important.

The challenge is to determine the necessary CAC to achieve the desired profit since increasing CAC increases revenue but doesn't guarantee profit.

REVENUE DISTRIBUTION

But should all this money be spent?

Revenue is divided into four parts:

  1. Variable expenses (in our case, Delivery Costs).
  2. Marketing expenses.
  3. Fixed expenses.
  4. Profit.
The first two items' amounts directly depend on the "product" and "buyer" units, making them particularly important.

The challenge is to determine the necessary CAC to achieve the desired profit since increasing CAC increases revenue but doesn't guarantee profit.

LTV AND CUSTOMER CHURN

The time a person continues to make orders is called customer lifetime.

The total revenue generated during this time is called LTV (Lifetime Value). However, waiting for the entire lifecycle to get this metric is impractical.

Therefore, another metric, ARPU (Average Revenue Per User), is used in economic modeling. It is the revenue per user over a period, typically measured monthly, quarterly, half-yearly, or yearly.

ARPU = Total Revenue/UA

Where Total Revenue is the overall income.

ARPU can indicate customer retention. To do this, calculate the necessary value for economic viability. If this metric doesn't reach the required value, it means users aren't returning for repeat purchases.

LTV AND CUSTOMER CHURN

The time a person continues to make orders is called customer lifetime.

The total revenue generated during this time is called LTV (Lifetime Value). However, waiting for the entire lifecycle to get this metric is impractical.

Therefore, another metric, ARPU (Average Revenue Per User), is used in economic modeling. It is the revenue per user over a period, typically measured monthly, quarterly, half-yearly, or yearly.

ARPU = Total Revenue/UA

Where Total Revenue is the overall income.

ARPU can indicate customer retention. To do this, calculate the necessary value for economic viability. If this metric doesn't reach the required value, it means users aren't returning for repeat purchases.

MAIN METRICS IN E-COMMERCE: LTV AND CAC

To increase revenue, there must be more purchases. But to gain more buyers, acquisition costs must rise. For e-commerce, ARPU can break the "revenue growth – CAC growth" cycle because it accounts for repeat sales.

Economics aligns if you know how many purchases a customer must make to cover variable costs, fixed costs, acquisition costs, and achieve desired profit.

MAIN METRICS IN E-COMMERCE: LTV AND CAC

To increase revenue, there must be more purchases. But to gain more buyers, acquisition costs must rise. For e-commerce, ARPU can break the "revenue growth – CAC growth" cycle because it accounts for repeat sales.

Economics aligns if you know how many purchases a customer must make to cover variable costs, fixed costs, acquisition costs, and achieve desired profit.
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