There is a quick test to figure out if your business is going to be profitable. And the good news is, you can do it on paper before you jump into a risky adventure. In this article, I’m about to cover the unit economics and how to calculate it for your startup.
Let’s first define what business we call financially viable: it’s such a business that provides a product or service at a price that covers the costs and yields a profit. In other words, the gross profit (price minus cost of goods sold) that your business earns on each item must be positive.
Before you calculate the unit economics, you also need to define the Unit of Sale – the basic unit of the product or service your startup is going to sell according to its type:
- Retail: one item (e.g., 1 smartphone).
- Wholesale: a dozen of an item (e.g., 12 smartphones).
- Manufacturing: one order of any quantity (e.g., 100 smartphones).
- Service: a standard block of service time (1 hour) to accomplish a task (fix a broken glass).
- Combination of differently priced items (e.g., restaurant meals).
Ultimately, the unit of sale determines the structure of your costs and how you calculate the gross profit. We will look at it next.
The unit economics (or economics of one unit, EOU) is the litmus test for the profitability of your startup. Accordingly, if the gross profit is positive, you earn on each item more than it costs you to sell it.
Depending on the nature of your startup, you sell products, provide service or combination of both. If you sell units of a tangible product, it doesn’t come for free:
- you pay costs of materials to make a product (or deliver the service),
- the labor to make a product (or deliver the service) also costs you money.
The combined costs of selling one additional unit are called the cost of goods sold (COGS). Once you know it, you can calculate the gross profit by subtracting COGS from revenue:
Gross Profit = Revenue – COGS
If you provide a combination of service and product, you can calculate the gross profit on each item sold as the average sale per customer minus average cost of goods sold per customer.
Let’s say you run a small bakery:
- it takes you 2 hours on average to make a cake,
- you decided to pay yourself $20 per hour,
- the ingredients for a cake cost $10 on average,
- you set the price $79.99 for one cake.
In this case, the cost of goods sold for each cake will be 2 * $20 + $10 = $50 with the gross profit $79.99 – $50 = $29.99.
Based on the example above, there are not many options to earn more:
- Increase price
- Spend less time on making a cake
- Put extra hours
- Cut costs
Some of them might sound realistic, while others aren’t feasible at all. For example, you don’t want to spend your weekends at work and sacrifice your personal life. Or, spending less time on each cake may worsen the quality and left your customers disappointed. Therefore, you won’t increase your earnings by working more or faster as a single baker.
But what if you hire someone? Because of increased COGS (you have to pay wages), you might need to sell more cakes per year to reach the same annual income. This requires more than 5 employees and your small bakery won’t allow this.
However, it’s not the same as having two or more bakers working independently. Your goal is to optimize your production process and split the task to spend only 1 hour per cake. Besides that, you may negotiate with suppliers about better pricing because you’ll buy more. In effect, your gross profit increases so that you would need to sell less and employ only two full-time bakers.
And that’s how you scale your business.
Based on the last thoughts, you take five steps to make the unit economics work for you:
- Determine the unit of sale: what makes up the cost of goods sold?
- Calculate the unit economics: is your business profitable on a single sale?
- Consider hiring employees: what implications does it have for your gross profit?
- Sell in bigger volumes: make sure to benefit from cost advantages due to increased scale.
- Operate at profit.
Final remark: before you get big, you should include your labor into the calculation of EOU. You take yourself out of the unit economics only after you hire a professional manager and step aside to be a creative leader.
Are you struggling with the unit economics of your startup? Let me help you.