Most businesses die within the first year because they run out of money. At the same time, the death of a business directly depends on the decisions made within that business. The ability to make the right decisions that allow a business to grow and become profitable is important. For making decisions, a tool is needed that allows selecting from a list of options only those that will be implemented and that will have the greatest impact on the business results. Unit economics is exactly such a tool.

Unit economics shows how a business earns from a flow of users. The business model: at the input we accept users, who pass through the black box of the business and bring in money. At the same time, we remember that money can come with both a plus and minus sign.

If we know how much we spent on each visitor who entered our “black box” and calculate how much money they brought in, we can calculate the amount of money generated by the business from the user flow. 

Contribution Margin = UA x (LTV — CPA)

Where, Contribution Margin (CM) — the amount of money earned from the user flow, taking into account our cost per deal. Unit acquisition (UA) — the number of users in the flow. Lifetime value (LTV) — the amount of money each user in the flow brings in. Cost Per Acquisition (CPA) — the cost of acquiring one user into the flow.

By analyzing these parameters, we can only talk about the effectiveness of our business on the user flow. If LTV is greater than CPA, then we are earning, if less — then we are losing money. However, these metrics say nothing about why we are at a loss or how to grow 10x. To make decisions, we need to link these metrics to product metrics that change when decisions are made.

Let’s take a look at the LTV metric. This is the gross profit brought by each product user, regardless of whether they pay or not. Let’s also agree that we are talking about an internet business, meaning we imply a website, and we will call a user a website visitor. So, LTV is the gross profit of a visitor over a certain period of time. In other words, LTV is a function of time.

LTV30 = LTV (30 days)

LTV = LTV (LT)

A simple way to calculate the value of this function is to take the money received over the selected time period and divide it by the number of visitors during that time.

LTV = Gross Profit / UA

However, this approach says nothing about the product or how to grow 10x. The second way to get the LTV value is through CLTV — the gross profit from a paying visitor. These values are connected just like visitors are linked to paying visitors — through the C₁ conversion.

LTV = CLTV x C₁

Where C₁ is the conversion to the first purchase. It is important to understand that we are interested in the conversion to the first purchase because it separates regular visitors from those who have paid at least once. 

Now let’s figure out what CLTV is — the gross profit from one paying customer over a certain period of time, a function of time. However, unlike LTV, this function is calculated through product metrics.

CLTV = (AOV — COGS) x APC — 1sCOGS

This is a simplified version of the function that suits most business models. AOV — the average order value paid by our clients over the selected period. COGS — cost of goods or services sold. APC — the average number of purchases per client; this number includes repeat transactions made by our clients. The higher this number — the better. It means clients are willing to pay again and again. 1sCOGS — special costs on the first deal, which are not included in COGS. For example, the cost of connecting a client to the service, trial periods, etc.

As we can see, our CM formula now takes the following form:

CM = UA x (CLTV x C₁ — CPA)

CM = UA x (((AOV — COGS) x APC — 1sCOGS) x C₁ — CPA)

This links product metrics with growth metrics.

To grow, you need to know which product metrics affect growth. It is clear that if LTV is less than CPA, there will be no growth — only losses. Moreover, scaling the audience will result in scaling the losses. 

The value of LTV is connected with the conversion of a visitor into a customer (C₁) and tells us how our product sells. How understandable are the necessary processes for this, how we convey our value, etc. AOV — how well the price matches what our customers are willing to pay. This parameter together with COGS determines how well we chose the monetization model for our product. 1sCOGS shows how we convey the product’s value to our client, for example, whether we bear the cost of integration with the client’s software.

Thus, we get a simple function for CM, which depends on a set of simple metrics — and those depend on business processes and decisions, allowing us to focus on bottlenecks and grow exponentially.