Isn’t it the case that revenue is essentially price times quantity times a growth rate and hence should be rather easy to be determined!? Not at all!
Revenue doesn’t just magically grow, because you started offering your product. Even if some customers come in by word of mouth, almost always you will need to spend at least employee time on marketing and hence your revenue plans need to be based on your advertising budget and need to reflect the underlying sales dynamics, which are called unit economics.
Unit Economics: Revenues and Costs associated with one Unit of sales
Unit economics are the direct revenues and costs associated with one unit of sales of your business model. The term is used relatively loosely in the startup world as there is no finite formula to derive it and the trick also lies in defining what exactly is your smallest business or revenue generating unit.
What is a “Unit of Sales”?
This can be a single subscription to your software, one car that you produce, or one airplane ticket that you sell and so-on. But especially in tech companies with non-physical products and indirect revenue generation, this question can get pretty complex. Think of any social network or messaging app where using the service is free and revenue comes-in through advertisement. Here you could define an end user account as a unit that essentially drives your revenues and that you want to grow or as an expense to generate the audience from which you can generate advertising revenues. Under the latter consideration advertiser accounts would be the thing to track as opposed to user accounts of your software.
Without getting Unit Economics right your Startup WILL FAIL
Getting unit economics right is the single most important part of your financial model, and surprisingly few people, even in the startup community, actually are aware of it or comprehend it. If you don’t know how much advertisement you need to generate what level of revenues, your financial model will always be wrong. Now let’s be clear on this, of course, every financial model is just a prediction. But:
Life Time Value vs Customer Acquisition Cost
If your business can’t make revenues which are higher than your advertising budget, spending more on advertisement will generate more sales, but your expenses will always outgrow your revenues and you will never make any profits!
As just learned, one of the most underappreciated concepts in the startup world, and even in business schools is the relationship of how much it costs to drive what level of revenues. The technical terms that every founder in this regard should know are Customer Acquisition Cost – or CAC for short – and Life Time Value – abbreviated as LTV.
CAC is the cost to acquire an average customer
LTV is the amount of money you can earn from an average customer
Again, maybe the most important take away from “the Basics” is as follows:
If the cost to acquire a customer is higher than her lifetime value, a business will never be able to make a profit, no matter how much growth or transaction volume exists.
If, however, the lifetime value is larger, then every additional customer means more money for the business and since the customer acquisition cost by definition covers all advertising dollars, it makes sense to put as much money into marketing, as is available.
There are however two caveats to this conclusion: Both variables change as the business matures and the lifetime of the lifetime value matters. To appreciate this let’s take a look at how both metrics are calculated.
Table of Contents