What are unit economics in SaaS? Definition and explanation
Danette Acosta Mar 9 2021
Unit economics are often considered one of the foundational building blocks of business, but many business owners don't even know what the term means. In this post, we'll talk about what unit economics are and tell you how you can use this knowledge to expand your understanding of your business. This newfound way to look at your business will allow you to make more informed decisions and increase profitability.
1. What are unit economics?
2. Unit economic metics
3. How do you calculate unit economics?
4. What exactly is a 'unit'?
5. Why track unit economics?
6. How unit economics can help growth
7. Best practices
8. FAQs answered
What are unit economics?
Unit economics refers to the direct revenues and costs of a particular business measured on a per unit basis. This calculation makes it easier to forecast things such as break-even points and margins. Most businesses are probably, at least on some level, using these calculations even if they didn't know the term. But fully taking advantage of it requires a little more commitment and understanding.
Unit economic metrics
Before we can tell you how to calculate your unit economics, you need to understand the metrics that go into the calculation. There are many ways to measure the success of a business and to predict its financial stability. Each of those has its own set of key performance indicators that need to be tracked. Basic unit economics needs just two: LTV and CAC. But the more accurate formulas we'll discuss later rely on much more in-depth metrics. This section will cover all you need to know. The abbreviations given will be used when describing the various formulas in the next section.
Lifetime value (LTV)
The average amount of money that you earn per customer over the lifetime of their relationship with you. In SaaS, this is the amount of money you make from the time they sign up, to the time they cancel and don't return. Calculating LTV accurately can tell you a lot about your business.
Customer acquisition cost (CAC)
The total amount of money you spend on sales and marketing to acquire a customer. If you spend too little, you don't get customers. If you spend too much, you don't get profit. The right amount to spend is very directly tied to your LTV, so calculating and understanding your CAC is extremely important.
Churn rate is the percentage of your customers that cancel their subscription during a given period.
Retention rate (R)
Retention rate is the opposite of churn. It's the percentage of customers that remain subscribed during a given period.
Average customer lifetime (ACL)
This is the average amount of time a customer stays subscribed before they churn. It is a key component in calculating their lifetime value.
Number of customers (C)
This is the total number of customers subscribed to your service during the period in question.
Number of transactions (T)
Not every customer is billed at the same frequency. This metric covers the actual number of transactions that have been made during the period and may not equal the amount of customers.
Total revenue (TR)
This is the total amount of money you've made from your customers over the course of the period.
Gross Profit (GP)
This is your total revenue minus your cost of sales.
Average Order Value (AOV)
This is simply total revenue divided by number of orders.
Average Gross Margin (AGM)
This is your gross profit divided by your total revenue.
Gross margin per customer lifespan (GML)
This is similar to your raw LTV rate, except it only takes the margin into account, rather than total revenue.
Discount rate (D)
Your discount rate is the rate of return on your investment.
How do you calculate unit economics?
The easiest way to calculate the unit economics for your company is to find the revenue per customer and divide by the costs associated with that customer. How you derive those values, and what qualifies as a unit, varies depending on the business model. For most SaaS businesses, the basic calculation boils down to LTV divided by CAC. Later in the post, we'll discuss ways to take more information into account in order to make a more accurate prediction.
Simply using your LTV metric, however, doesn't always tell the whole picture. It's looking at the past to try to predict the future. Instead, you can use additional metrics for a more accurate prediction. There are two popular ways to accomplish this. For well-established businesses, predictive LTV is a good choice. For newer businesses, or newer product launches where revenue hasn't quite stabilized yet, using a flexible LTV calculation makes more sense. Whichever you use, divide the result by CAC just as you did above for the simplified version to get the unit economics.
This formula tries to take into account how customer preferences change over time. It can help you avoid a sudden and unexpected drop off in sales. Using the abbreviations from the section detailing the metrics, the formula for calculating predictive LTV is:
- (T x AOV x AGM x ACL) / C
Predictive LTV is good when revenue is rather stable. When you are just starting out with a new business or a new product, this isn't always the case. Flexible LTV is a metric that will take retention and discount rates into account to provide a more accurate results during those times. The formula is:
- GML x (R / 1 + D - R)
So what exactly is a 'unit'?
Let's take a closer look at what we mean when we talk about units. A unit will always, on some level, represent a customer. How exactly that is defined may vary though. What ultimately matters is that you are consistent in your own usage of the term. Other than that, as long as you understand what units are and aren't measuring some irrelevant metric, your calculations will be beneficial. Let's look at how you may define a unit in SaaS.
Units as customers
If you have a large business make a purchase with your company, they are likely to purchase several subscriptions. They have a large number of employees who need to use your software. So, is the business a unit, or are each of the individual subscriptions? With the units-as-customers model, the business counts as one unit.
Units as products sold
For the units-as-products-sold model, the above scenario flips. For a SaaS business, that would mean each subscription is counted as one unit. For SaaS this is less common. For physical products — where there are production costs per item to account for — units as products sold is more standard.
If you're still wondering whether it makes sense to count the multiple accounts of your business clients as one unit or several, consider the effort put into acquiring those accounts. What unit economics is tracking is how much it costs you to acquire a customer compared to what they bring in. If your business accounts require active effort on the part of your sales staff to add additional users to their accounts, then those are expenses that should be counted. On the other hand, if the business simply adds and removes users as their need grows, then your CAC is the same and those accounts should be counted as a single unit.
Why SaaS businesses should track this metric
What unit economics is tracking is whether or not the lifetime value of a customer exceeds the cost of acquiring that customer. That alone is fantastic information. If you're spending more to get a customer than you'll get out of them, you won't be in business very long. Let's look at some less obvious benefits:
Measuring early success
In the early stages of a business, unit economics are an even more important factor in determining how much you can spend on acquisition and how much you can expect to get in return. They are a great predictor of the long-term financial health of your business model.
Unit economics are a useful measuring stick for changes you may make to your marketing strategy or budget, pricing model, or any other changes that may affect sales or churn rates. Simply knowing whether sales go up isn't enough. If the LTV to CAC ratio changes unfavorably, you might want to rethink the decision.
Your business benefits when you can plan its growth. To do that, you need to have some idea on how much capital you will have in the future. Combing unit economics with your acquisition rate will give you any idea of how much your company will be bringing in and aid with financial planning.
How unit economics can help you grow (or see an oncoming failure)
Using unit economics gives you a glimpse into the health of your business by telling you exactly what you're spending versus how much you can hope to get in return. This LTV:CAC ratio is important to keep track of. If your spending is too high, then you'll not only struggle to see any growth, but your business could be in trouble of failing in the long term. By tracking these metrics right from the start, your business will stay lean and fit.
Predicting growth using unit economics is easy. As long as your LTV stays suitably over your CAC then you are turning a profit on the customers that you have. If your customer base is growing while you are maintaining that optimal LTC:CAC ratio, then your business is on a nice growth track.
When you're starting out, you need to grow quickly. But if you spend too fast, you'll sink your business instead of growing it. When you know your unit economics, it's trivial to calculate how many months you'll need to get your CAC expenses back. This will give you an idea of how fast you can spend your working capital on marketing without leaving nothing left for other expenses.
You can't throw money at every problem. While there are a few edge cases where having a CAC higher than your LTV can be acceptable, those aren't common. If you aren't getting customers, spending more on acquisition will only sink you faster if those CAC values climb too close to your LTV.
It costs money to start a business or launch a new product. In those cases, you have a certain dollar amount you must hit in order to break even. Knowing your LTV and CAC will help you estimate when that break even point will occur. Tracking this over time will also give you an idea on whether you're trending in the right direction or the wrong one.
Best practices to keeping your unit accurate
It doesn't matter how powerful a metric is as an indicator if the value you're using is improperly calculated or out of date and no longer applicable. Because you'll be using unit economics to drive important business decisions, some of which may have severe implications on profitability, you want to keep the value you use as accurate as possible. Aside from doing the rather simple math equation correctly, having an accurate unit economics calculation means recalculating it whenever the need arises. Let's take a look at some examples of when that might happen.
Recalculate your CAC
Your LTV isn't easy to mess up the calculation for. Tools like our free ProfitWell Metrics make it easy to keep track of KPIs like that one. CAC, however, relies on you maintaining an accurate accounting of what you are spending on sales and marketing. If you decide to increase your ad budget one month, you can't forget the affect that is going to have on your CAC.
Recalculate whenever pricing changes
It may be easy to keep track of your LTV, but if you forget to roll any updates to it into your unit economics calculations, then your LTV:CAC ratio will be incorrect and any insights gleaned from it will be based on faulty information. Whenever you change your pricing, there's going to be movement in your LTV. Our Price Intelligently service can help ensure that LTV movement from pricing changes goes in a direction favorable to you.
Recalculate whenever costs change
Similar to LTV above, having an accurate CAC doesn't mean anything if you don't also roll that into your LTV:CAC ratio calculation. Whenever something causes your CAC value to change, make it a habit to also immediately calculate your new unit economics so you are always using the most up to date values.
Unit economics FAQs
Because this is an important, yet possibly confusing topic, it is worth going over some of the common questions people have. Hopefully you'll come away from this post feeling that you have a firm understanding of how understanding your unit economics can help your business.
Are unit economics important in business?
Yes. Understanding exactly what it costs you to bring in a customer, and exactly how much money you can expect from that customer is vital to properly budgeting. If you aren't maximizing your LTV:CAC ratio and the benefits it brings, then you aren't maximizing your growth, profitability, and sustainability. It's one of the most important metrics your business can work to improve.
How do you calculate the economics of one unit?
The first step to calculating your unit economics is to decide what one unit will represent. For a SaaS business, it makes sense to count a company, and all of the subscriptions they have, as one unit. This is even more true when you are a B2B business. You can, however, count individual subscriptions as a unit if that makes sense for your company. Once you have your unit, calculate how much the lifetime revenue for that unit is, and divide it by your CAC to get the basic economics of that unit. It is a better practice, however, to use the predictive LTV or flexible LTV values, given above, when calculating your unit economics.
How do you improve unit economics?
There are two ways to improve unit economics. The first is to spend less on sales and marketing. This is not the best way, as it will slow growth. Sometimes, you have to reign in spending though, and if the LTV:CAC ratio is too out of balance, cutting the budget makes sense.
The better way, is to improve your LTV. ProfitWell can help you can do that by optimizing your pricing, as well as help you take the right steps toward reducing churn and increasing the amount of time a customer stays with you.
By Danette Acosta
Editorial Lead at ProfitWell, helping ProfitWell take its content to the next level. When she's not busy creating dope content, you can listen to her on the radio.