Entrepreneurship is an uncertain activity. However, one of the most important aspects of reducing that uncertainty lies in unit economics. The primary questions of unit economics are:
- How much does it cost you to make one unit?
- What do you sell each unit for?
- How much does it cost you to sell one unit (or acquire a paying a customer)?
- What is each customer worth to the business?
In the actual metrics of unit economics are:
- Cost of Goods Sold
- Cost of Customer Acquisition (COCA)
- Lifetime Value of a Customer (LTV)
If you do not know the answer to these four questions, you could be driving blind. Let’s take the first two questions as an example. For simplicity’s sake, let’s say it costs us $5 to make a bag of dog food and we can sell each bag for $6. Seems ok right? We are making $1 on each sale!
Let’s even assume for a moment that we have no overhead costs. Many entrepreneurs tell me they have no overhead because they plan on making them out of their homes and don’t plan to pay themselves until the business “takes off.” I often ask them when that “take off” point is and they cannot give me a specific answer. But I digress…
Ok, so we are going to go with making $1 profit for every unit we sell. My next question is: what does is cost us to get that paying customer? Well, let’s say we decide to attend a dog trade show to showcase and sell our product. We pay the $1,500 vendor fee, purchase booth displays (we will say $2,000), and a few giveaways ($500). We end up selling to 100 customers at the trade show.
Our total Cost of Customer Acquisition (COCA) is the total marketing expenses ($4,000) divided by the total customers acquired: 100. We get a COCA of: $40.
What this means is that for each new customer we acquire, it will cost us $40. If we are making a profit of $1 per customer, each new customer is actually costing us $39.
However, in this example, it is something dog owners will need to repurchase each month. Dogs have to eat right? Each customer we acquire will theoretically continue to purchase our dog food every month to replenish their supply.
If our customer, let’s say they are 30 years old, buy our dog food for the rest of their lives every month until they die (let’s say 70). We can calculate the following:
40 Years = 480 Months
480 Months = 480 Purchases ($1 profit per purchase) = $480 Lifetime Value of a Customer
Ideally, you want your ratio to be at least 3 to 1. In other words, you want the LTV to be at least 3 times your COCA. In this example, our COCA is $39 and our LTV is $480. Wow! That is a ratio of 12.3 times the COCA! We will make $444 on each new customer!
I imagine that you might already see some problems with this logic. Here are just a few problems:
- The average lifespan of a dog is 10-13 years (not 40).
- Not every customer will buy the same dog food for the entirety of a dog’s life.
- The average number of dogs a person owns in a lifetime is two.
- Not every customer will immediately buy our dog food once the dog is born.
- Not every customer will continue to buy our dog food after purchasing one bag.
So how does one go about taking all of these problems into account? The simple answer is with historical sales. Those of you that are able to track the number of customers you gain each month versus the number of customers you lose will find yourselves in the enviable position of being able to calculate a “Churn Rate.”
A Churn Rate is calculate by dividing the total number of customers you lose in a month divided by the number of customers you had at the beginning of the month. So let’s go back to the 100 customers we gained at that trade show. If 40 of those customers did not buy the dog food the next month, we have a churn rate of 40%. That means each month we are losing 40% of your customers. In other words, our customer, on average, stays with our brand for 2.5 months.
So, let’s take some of the problems we identified above and put them into the full example.
We are going to assume that we will be able to access and acquire our customer when their dog is 3 years old AND we are going to assume that they will have one more dog in their lifetime. Let’s also assume the dog will live for 10 years. For kicks, let’s even assume that the typical customer will continue buying the same dog food for their NEXT dog (who will also live until 10) starting when they are .5 years old. We now have:
Dog 1: 7 years
Dog 2: 6.5 years
13.5 Years = 162 Months = $162 Profit (Lifetime Value)
This still looks pretty good! We are spending $39 to acquire a customer that is worth $162.
Let’s add our historically based assumption here (hopefully by now you can see the importance of assumptions):
We will lose 40% of customers every month.
Our actual Lifetime Value of a Customer turns out to be $2.50. That does not look promising after a COCA of $39. We are losing $36.50 on every customer we gain.
For those entrepreneurs that do not have historical sales, some ways to calculate a churn rate can be found in looking at averages in their industry. As an example, here is a report on the average churn rate of apps.
This approach also does not take into account any overhead costs such as staff, rent, etc. If we were to add that into the equation, the picture may be even more bleak.
While this is a simplified example, it is a necessary exercise for testing your business model. A 3:1 ratio is the MINIMUM ratio for a solid business model.
For those of you that interested in deeply exploring your own company’s assumptions, there is a tool linked at StartUpFinancialModel and was founded by Wade Myers, an experienced investor who teaches financial modeling at Harvard Business School. He created it to address “what he thinks is the single biggest weakness of most business plans: the lack of a detailed financial pro forma that helps entrepreneurs and investors gain full visibility into all of the assumptions, cash requirements, scalability, profitability, and the ramp up of the business.”
I have to tip my hat to Wade with what he has created. He offers a free trial for 14 days and if you find it helpful, he offers two pricing plans at either $19 or $29 per month depending on how many users you have on your team. This past summer, one of my clients (with no financial background) and I used it for his startup and it worked beautifully. He actually gained a deep understanding of forecasts and assumptions just be using it.
Categories: Economics, Entrepreneurship
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