Recap

During Week 14, we introduced the topic of Unit Economics & defined it in simple terms as below:

Unit Economics is about identifying the smallest unit responsible for creating value for a business or from where a business earns it's revenues

We then broadly classified the topic of unit economics under two heads:

1. Product-based Unit
2. Customer-based Unit

Visualizing the above:

During Week 15, we deep dived into Product-based unit economics where the smallest unit under analysis is a single product.

If the company is a single product company, the focus will be on that particular product & if the company is a multi-product company, each product is the focus of analysis.

Unit economics at the product level focuses on

1. Direct Revenues through pricing &
2. Unit costs associated with producing / manufacturing & selling a single unit of a product

We used our cafe owner, Jack's signature Matcha latte for understanding product-based unit economics. The steps Jack needs to take to use unit economics are :

1. Identify the Unit (1 cup of Matcha Latte)
2. Calculate Revenue Per Unit
3. Determine Variable Cost Per Unit
4. Calculate Contribution &
5. Identify Breakeven Point

So, what does Jack need to do to increase profitability? Increase Contribution margin. How will he do that? Do one or more of the below :

1. Increase Pricing
2. Reduce Costs
3. Optimize Product Mix

This week, we deep dive into Customer Unit Economics

Customer Unit Economics

During Week 14, we defined Customer unit economics as below:

Unit Economics at the customer level focuses on :

1. Direct Revenues &
2. Costs

associated with acquiring, serving & retaining a single customer.

In simple terms, it's measuring revenues from a single customer vs. costs of acquiring & maintaining that customer.

Key Terms

Before we get into the weeds of customer unit economics, they are some key terms to understand.

These are :

1. Customer Acquisition Cost (CAC)
2. Average Revenue Per User (ARPU)
3. Gross Margin Per Customer
4. Customer Lifetime Value or Lifetime Value (CLV or LTV)
5. Churn Rate
6. Payback Period

Let's dive in.

Customer Acquisition Cost (CAC)

A customer doesn't come to a store to buy something unless they are aware of a product or service which satisfies their current or future demand. For that, companies incur costs to make prospective customers aware of their products / services & that happens through marketing, promotions & related expenses.

Customer Acquisition Cost (CAC) is the cost of acquiring a single new customer.

CAC = Total Marketing & Sales costs / No. of new customers acquired

For e.g., Netflix marketing expenses in 2023 amounted to USD 2.66 Billion & they gained 30 million subscribers. (Source : here)

So, using the above formula

CAC for Netflix in 2023 = USD 2.66 billion / 30 million = USD 88.6 (approx)

Average Revenue Per User (ARPU)

This is a straightforward definition :

ARPU is the average revenue generated per user over a specific period.

E.g., In 2023 for Netflix, the ARPU was USD 181.92 (Source : here)

Gross Margin Per Customer

A company derives revenue from it's customers by selling their products or services. It incurs operational costs to make & sell these products or services.

The net difference between the two is called the Gross Margin. If we divide this number by the total number of customers over the same period, we get gross margin per customer.

Gross Margin Per customer is the percentage of revenue per customer remaining after deducting direct costs (Cost of Goods Sold or Service Delivery)

Customer Lifetime Value (CLV) or Lifetime Value (LTV)

CLV or LTV is the gross profit a customer delivers to your business during their entire relationship with the business.

LTV = Average Revenue Per User (ARPU) * Gross Margin * Customer Lifespan

Churn Rate

If we consider a subscription business, it is inevitable that a certain percentage of customers will stop the subscription & leave. It can happen either before their subscription period ends or they will cancel at the end of their subscription period.

The churn rate refers to the percentage of customers that discontinue their use of a product or service over a specific period of time. (Source : here)

Payback Period

Payback refers to the length of time it takes for the profits a company makes from a given set of customers to recoup their acquisition costs.

Each of the above key terms on it's own defines an individual aspect of customer unit economics. However, to understand customer behavior & to develop insights to improve profitability, we have to see

1. How all the above concepts are related to one another &
2. How these numbers trend over a period of time to see if they move favorably or unfavorably for the company

To add more context to the above, let us go one step back to understand what drives these numbers - the customer life cycle.

Customer Life Cycle

There are various stages in a customer's interaction with a company from the time they become aware of the company's product or service till they leave or stop their interaction with the company permanently.

The customer lifecycle is the process that runs from when a customer first becomes aware of a business to when they last do business with them. (Source : here)

The customer life cycle is broken down into five stages :

1. Reach / Awareness
2. Acquisition / Consideration
3. Conversion / Nurturing
4. Retention
5. Loyalty / Advocacy

Visualizing the above :

We will just quickly glance over each of the above stages as our objective is to understand the story behind the numbers for CAC, ARPU, LTV, Churn etc.

Reach / Awareness

During this phase, a consumer becomes aware of a company's goods or services for the first time through social media, advertisements, word of mouth or other sources.

The objective is to establish a connection between the brand & a present or future demand, irrespective of whether there is an urgent need of the product or service or not.

Acquisition / Consideration

Interested buyers learn more about the product or service at this stage by visiting the company website, speaking to sales people, or visiting a store.

Conversion / Nurturing

Here, buyers purchase a product or service. The buyer then becomes a customer who then becomes part of the company's CRM (Customer Relationship Management) system.

Retention

Now that the customer is onboarded, the company ensures the customer is satisfied with it's products &/or services on an ongoing basis.

Understanding customer needs is critical at this stage to ensure continued relationship.

Loyalty / Advocacy

As the customers become satisfied with the ongoing products / services, they may purchase new products or services, upgrade to new products etc.

The will also refer these products / services to others which results in new loyal customers & less customer churn.

Next week, let us link all these to get a complete picture of customer unit economics.