Week 4 - Bridge2
Unit Economics and why every great idea is a spreadsheet with skin on it.
“If it don’t make dollar, then it don’t make sense.”
“If it don’t make dollar, then it don’t make sense.”
”No, no, yeah, it don't make sense.”
Hook of “Dollar & Sense” on the Album “BlakRoc”
Dream Year
In 2012, I was in a program led by Ben Arment to help creators progress an idea forward, even if just a little. He called it “Dream Year.” The 12-week program culminated in a booth at one of his events in Chicago, a website, a video, a book outline, and a manuscript. The project was titled “Outside Looking In,” which housed my collected essays and reflections while living in a tent for six months, commuting to work to join a small digital team building the Bible App.
I never published the book, but I got a few essays published out of the manuscript, which I consider a #win. Intrigued? See below for a short documentary on my experience with #tentlife.
One of Ben’s quotes that has stuck with me over the years is, “A great idea is a spreadsheet with skin on it.”
And this is a perfect introduction to the concept of “Unit Economics,” the subject of our fourth Bridge2 meeting.
Unit Economics
Unit economics is how you communicate your company's value in terms of costs associated with one production unit.
Which seems simple until you begin to unpack how you get to the costs of one production unit.
I think a spreadsheet becomes useful here, as napkin math can only take you so far. First, you must be able to define one unit of production, which takes its lead from your Revenue Model and Product Market Fit (discussed last week).
If you are a subscription product, like ours, we must think about a “unit” as one shop willing to pay for one month of service.
1 Unit = A monthly subscription by a shop that sells something.
And in this definition of a unit, we can begin to line out the costs associated with that unit.
Unit Cost = Cost to support one store with daily orders below 150.
Unpacking this… we’ll need to know the cost of one order (sub-unit) and find what one shop might cost with a maximum of 150 orders daily. Why 150? Well, it’s an assumption.1
We can assume that a profitable coffee shop has around 150 orders a day, and if we take 25% of those orders via the barista bot, we have the number of orders (38) that have an associated cost.
Each order then has the following cost:
capitalized development costs
vendor costs
cost of SMS
cloud hosting
marketing automation
LTV and Unit Economics
Notice there are other costs not associated with the “Unit Cost,” like additional employee/contractor costs, marketing & advertising, equipment and office supplies, etc. This is because we are trying to find the customer's Lifetime Value (LTV) by navigating through the unit cost economics and NOT trying to solve profitability for the business (that will come later).
Make sense? Ok, let’s keep it rolling.
LTV, then, is the average revenue a customer will generate during their lifespan as a customer. This is where it gets pretty fuzzy from an ethics standpoint — your LTV needs to be profit-based, not revenue-based. Otherwise, you are overinflating your profitability, which can be hidden for a short while on your balance sheet but is easily identified and called out by the more astute VCs and investors.
Proper LTV reporting should consider the cost of delivering the service/product and not just the gross sales generated.
LTV = (Unit Price - Unit Cost) * Avg Lifespan
But wait, there’s more.
CAC and Unit Economics
Not only should LTV include Unit Costs, but it should also include the Cost of Acquiring Customers (CAC). So, we continue down the Unit Economics path and encounter another calculation that must be considered.
Do you see why this would be better presented as a spreadsheet?
CAC = Cost of Acquisition / Number of Customer Retained
In our case, one customer = one coffee shop, with a maximum of 150 daily orders. The cost of acquiring that customer can be deduced in another section of the spreadsheet by considering how you funnel customers to sign on the dotted line and purchase your product/service.
The cost of acquisition could come from the following:
Advertisements where conversion can be tracked:
Facebook
Google
Pinterest
Apple App Store
Google Play Store
X.com
Other landing pages, podcast discounts, and partnerships can be traced into the conversion funnel.
Cost of Acquisition does NOT consider word-of-mouth (WOM) marketing, billboard advertisements, magazine spreads, or other ways your brand receives eyeballs and recognition (organic traffic). It is the traceable and trackable conversion data that makes digital ads so damn useful when trying to build a business and convert sales.
Once we have our Cost of Acquisition, we need to understand our Retention Rate or the rate at which we retain users on our platform. Sometimes referred to as our attrition or the rate at which users leave the platform.
Retention Rate = Number of customers who sign up per month / Number of those customers who leave within X months.2
Since we are focused on building a business, we aren’t going to get into Customer Retention Cost, as we are focused on getting customers and not yet super focused on retaining them.3
In Summary
A great idea is a spreadsheet with skin on it. So, now it’s time for me to jump away from storytelling (the skin) and get into the foundational ideation built in Excel (the spreadsheet).
#gowin
Assumptions are how we drive pre-revenue business strategy and pro forma calculations… you have to have a number, and it can’t be entirely made up… well, I guess it can be. You just need to be able to explain your made-up number (assumption) without sounding like a complete idiot.
Here is an excellent example of squishy math… A customer may leave in the first month, second month, or sixth month; as the business, you define the metric and then stay disciplined in reporting that metric.
Both acquisition and retention costs help drive business growth. While CAC is typically incurred upfront at the start of the customer relationship, CRC is ongoing and incurred throughout the customer relationship.
It would be best to focus more on acquisition than retention when launching new features/products to expand your customer base or when the market share or churn rate is low.
Customer retention requires more focus when you have high churn rates, high acquisition costs, and a business model reliant on recurring revenue.