Going deeper, there are two ways one can approach the calculation of

unit economics, and the key differentiating factor is how one defines a
unit. If one were to define a unit as one item sold, then the unit
economics becomes a calculation of what’s commonly referred to as
the contribution margin. Contribution margin is a measure of the
amount of revenue from one sale that, once stripped out all the
variable costs associated with that sale, contributes toward paying
fixed costs.

Contribution margin = Price per unit - variable costs per unit

If instead one defines a unit as one customer, then the commonly

calculated metrics are customer lifetime value (CLV) and its
relationship with customer acquisition costs (CAC). In essence,
these are the same as contribution margin, in that they express the
profitability of one customer vs. the cost of acquiring said customer.
But the main difference is that they are not fixed in time. Rather, CLV
measures the total profit generated by a customer throughout the
lifetime of that customer’s relationship with the company. The reason
this is important is that startups naturally have to invest in acquiring
customers, often at a loss on the first sale. But if the customer makes
multiple transactions with the company in time, the company will be
able to recoup, and hopefully make a substantial return on the initial
investment.

Understanding Which Costs Are Truly Fixed vs.

Variable
By far, the biggest mistake people make when performing unit
economic analysis relates to the cost side of the equation. As we saw
above, whether you’re simply calculating your contribution margin or
whether you’re doing a more ROI-based CLV/CAC analysis, a vital
part of the equation is what costs you choose to discount from your
revenue. In principle, the rule is simple: Unit economics only
considers variable costs, not fixed costs. But in practice, the
distinction between fixed and variable costs is often not so
straightforward.
The textbook definition of a variable cost is that variable costs are
those directly associated with sales. Variable costs
therefore vary according to the volume of output. Common examples
of variable costs are cost of goods sold (COGS), things like shipping
and packaging costs for eCommerce startups, or sales costs for
enterprise/B2B startups.
But while some costs are obviously variable, others aren’t quite as
clear-cut. The cost of providing customer service is a common area of
confusion. For many startups, the ability for customers to speak to a
customer service rep is crucial, and thus becomes a vital part of the
sales process. In such situations, customer service should be
accounted for as a variable cost, especially since the size of the
customer service team will naturally expand as sales volumes
expand. The growth in customer service may not be 1:1, but the
relationship is there, making this a variable cost that must be
accounted for in unit economics analysis.

There are a multitude of other “quasi-variable” costs that often get

mistakenly archived as fixed. For eCommerce companies, for
instance, the cost of returns is a good example. Since many
eCommerce companies offer free returns, and since all will have
some level of returns per X number of sales, this therefore becomes a
variable cost that again must be included. Technology costs are
another example. There are many types of technology costs (e.g.,
server costs, software costs) that vary as sales and output increase.

Being thorough about including all variable costs in an analysis of unit

economics is vital because this can make a very material difference to
the breakeven scenarios. Let’s look at an example to illustrate the
point. Sofas.com is a fictional company selling sofas online. Their
contribution margin calculation is shown in the table below. As one
can see, sofas.com has a fairly straightforward business. For each
sofa it sells, the company incurs four standard variable costs: COGS,
shipping and packaging costs, and the payment processing costs of
the payment provider it uses (e.g., Stripe or PayPal). With these
variable costs, sofas.com seems to have a very healthy contribution
margin of 38%. Assuming fixed costs of $50,000 per year and a linear
growth trajectory, they would break even somewhere in Year 2. Not
bad.
But if we now include other variable costs such as customer service,
returns, and server costs, the picture changes substantially. The company’s
breakeven moves out by two years!

My suggestion to founders, when in doubt, is to err on the side of

caution. Include as many costs as you can in your unit economics.
That way, you’ll only receive positive surprises rather than the other
way around. It also forces you to pay attention to costs that you’d
otherwise never think about since in the first two to three years you’ll
spend little time thinking about fixed costs. If you mistakenly account
for certain costs as fixed, you’ll find yourself further down the line
struggling to understand why you’re cash burn isn’t looking like what
your business plan was projecting (trust me, I’m speaking from
experience).

Absolute Numbers Matter

Another common mistake founders make in their unit economics
analysis is forgetting that absolute numbers matter. It can be tempting
to focus exclusively on contribution margins as percentages or on
CLV to CAC ratios. But the point is that larger absolute numbers tend
to be very helpful! A large share of a small number may end up being
less than a small share of a large number, and that matters when the
fixed costs involved are the same in either scenario.

Let’s stick with sofas.com as our example to illustrate the point further. Imagine that
sofas.com is just getting started, and has decided to only sell one type of sofa to
begin with. The first option is a compact sofa made with cheaper fabrics that retails
at $500. Management believes this will retail well with younger professionals who are
just moving into their first apartment. The alternative would be to sell a much larger
L-shaped sofa made from premium fabric which retails at $900 but only appeals to a
smaller set of wealthier customers. The compact sofa has gross margins of 55%
because the supplier is based overseas, whereas the larger sofa has much lower
margins of 40% because the supplier is local and much of the work is done by hand.
Given the larger margins and the bigger addressable market, sofas.com may be
tempted to choose the compact sofa to start. But what they’re forgetting is that their
fixed cost base is going to be exactly the same in both scenarios: they’re going to
need the same size of office and the same size of team. Even accounting for a larger
volume of initial orders and higher growth for the compact mass-market sofa,
sofas.com may be better off selling the larger, more expensive sofa.
The overarching point about absolute numbers being important matters
especially because in reality, there is no such thing as a fixed cost. Over
the long term, all costs are variable. They just vary at different rates and on
different schedules. Consider the cost of an office, the most commonly
cited fixed cost: while the office may do for several years, as a businesses
grows, it will at some point need to expand to larger offices. Same thing
with supposedly fixed costs such as the size of your tech team. Just
compare the size of the tech team at a large, Series C funded tech
company versus a small Series A funded one. I guarantee you that the
Series C funded company will have a considerably larger tech team.

So if fixed costs are never really fixed, selling products or services with
large ticket sizes and therefore larger absolute profit numbers helps add
more cushion to support the fixed cost base, making the promise of
profitability that much more tangible.

Not All Cash Burn Is Created Equal

There are fundamentally two reasons why it makes sense for both
parties (management, investors) to back an unprofitable business.

Level up: The first acceptable scenario is when there has been an
investment into a fixed asset (say, a piece of expensive machinery or
the salaries of an expensive team) that makes the business
unprofitable at its current output levels but allows the business to grow
to a much larger output level than it otherwise would have been able
to operate at. When the business eventually reaches this larger output
level, it will be very profitable, perhaps more so than prior to the
investment. In other words, you level up.

Go faster: The second reason is that both parties may simply be

interested in reaching larger levels of output more quickly. The
business could reach those output levels organically on its own, but it
would take much longer. If management is willing to sacrifice part of
their ownership in their business to go faster, then it’s a mutually
beneficial arrangement for both parties.

Looking at the scenarios above, both imply investments, and

consequently increases, in the fixed cost side of P&L, rather than the
variable cost side. So burning cash because your business incurs
larger fixed costs than your contribution or operating profit can sustain
can be acceptable so long as there is a realistic path of growth and
that, at some point, your contribution/operating profits will exceed the
fixed costs and the business model makes sense again.

If you look at large public (or even private) companies, none of them
do unit economics analysis (at least not publicly. They may do so
internally but for reasons that are beyond the scope of this article).
They do financial analysis the old-fashioned way, using P&L
statements, cash flow statements, etc. The reason is simple: For
larger, more established companies, the distinction between fixed and
variable costs is irrelevant. They need to cover their costs, no matter
what type they are.

Unit economics analysis exists precisely because startups turn this on

its head and instead embrace a strategy of cash burn in the initial
years to reach profitability later. But how do you show an investor that
your business, which is burning cash now, will at some point stop
burning cash? Unit economics. Unit economics analysis can illustrate
in a clear and believable manner that your company is intrinsically
profitable, and that you just need greater volume to cover your fixed
costs.
With all this in mind, it baffles me when I see pitches for startups that
are not profitable (or barely) on a variable cost basis. Showing a unit
economics slide that omits key costs, or worse still, that is negative,
completely defeats the purpose of such analysis.
To be fair, there are certain situations in which razor thin (or even
negative) contribution margins might make sense. Here are some:

1. Economies of scale: There are situations in which sales volumes

make a material impact on your unit costs. An example would be
in COGS, where retail businesses typically receive far more
favorable terms from their suppliers at larger output levels.
2. High ROIs on marketing: Certain businesses reap substantial
returns on the acquisition of new clients over the lifetime of such
clients. Investing in marketing, and thus losing money on a unit
basis at first, may make sense so long as that investment returns
significantly more in time. One needs to be sure about the ROI of
this marketing expense, and CLV/CAC analysis is one way of
assessing whether this strategy may make sense.
3. Investing in customer service/loyalty: Similar to the above,
certain businesses may be able to run thin margins on their first
sale to a customer, because doing so creates loyalty and therefore
increases the ROI of that customer.
4.
But the above are all much riskier strategies than if your business had
strong unit economics. So many things can go wrong. Customers are
never as loyal as you think. Your ability to upsell or increase prices is
far more limited than you might expect, particularly if you’ve acquired
customers on the basis of discounted offerings, making them more
sensitive to price than you’d like. Cutting costs and replacing people
with technology is much more complicated than you anticipate. All of
the common defenses of poor unit economics are relatively weak, and
building your entire business case on these is a very risky path to
take.

If you don’t believe me, here are some very well-respected and
knowledgeable people who think the same.
“One of the jokes that came out of the 2000 bubble was we lose a little
money on every customer, but we make it up on volume…There are
now more businesses than I ever remember to explain how their unit
economics are ever going to make sense. It usually requires an
explanation on the order of infinite retention (‘yes, our sales and
marketing costs are really high and our annual profit margins per user
are thin, but we’re going to keep the customer forever’), a massive
reduction in costs (‘we’re going to replace all our human labor with
robots’), a claim that eventually the company can stop buying users (‘we
acquire users for more than they’re worth for now just to get the flywheel
spinning’), or something even less plausible…

“Most great companies historically have had good unit economics soon
after they began monetizing, even if the company as a whole lost money
for a long period of time.

“Silicon Valley has always been willing to invest in money-losing

companies that may eventually make lots of money. That’s great. I have
never seen Silicon Valley so willing to invest in companies that have
well-understood financials showing they will probably always lose
money. Low-margin businesses have never been more fashionable here
than they are right now.”
– Sam Altman, President, Y-Combinator and Co-chairman, OpenAI, Unit
Economics

“There’s been a lot of talk coming out of silicon valley lately about fast
growing companies with high valuations that are going to face problems
in the coming year(s). But how is this going to happen? The most likely
scenario is the thing that has been driving growth (and valuations) for
these companies ultimately comes home to roost. And that is negative
gross margins. We have seen a tremendous number of high growth
companies raising money this year with negative gross margins. Which
means they sell something for less than it costs them to make it….Why
would [they] take this approach? To build demand for the service, of
course. The idea is get users hooked…and then…take the price up…
“The thing that is wrong with this strategy is that taking prices up, or
using your volume to drive costs down, in order to get to positive gross
margins is a lot harder than most people think….

“[M]ost of the companies out there who are growing like weeds using a
negative gross margin strategy are going to find that the capital markets
will ultimately lose patience with this strategy and force them to get to
positive gross margins, which will in turn cut into growth and what we will
be left with is a ton of flatlined zero gross margin businesses carrying
billion dollar plus valuations.
– Fred Wilson, Co-founder, Union Square Ventures, Negative Gross
Margins

“It’s like the old adage, [when you’re] handing out dollars for 85 cents,
you can go [infinitely]…Chosen unicorns are being given hundreds of
millions of dollars, but you have to ask how much margin is there. The
unit economics would be very difficult, I’d think…It’s like, the last time, all
this Postmates and Shyp stuff happened [in] ‘99, with [the failed online
delivery startup] Kozmo, [and] it’s the same shit. It’s the same shit…The
question for all of those things has to do with core economics that’ll be
proven out over time.”
– Bill Gurley, General Partner, Benchmark Capital, Interview

Editor’s note: Shyp has since shut down ($50m in funding, valuation
of over $250m), and Postmates has been through severe funding
struggles.