Unit Economics are the most important quantitative tool for opportunity analysis. Having even read this chapter, you’re in the company of an elite group of savvy entrepreneurs and investors who actually understand the basics of Unit Economics. Reading about it, however, is not enough.
Friday, September 23, 2016
Even though basic Unit Economics and the four formulas are simple, novices often make mistakes when calculating Unit Economics. Here are a few of the most common mistakes people make:
Don’t Confuse the Types of Costs.
Many entrepreneurs don’t understand Unit Economics or even how much it costs to make their products simply because they confuse the various costs, often lumping them together. This creates confusion in the best case scenario, and in the worst case, causes entrepreneurs to go bankrupt without understanding how it happened. Here are some common examples of how costs could end up being miscategorized.
The Unit Econonics in some businesses can be quite complicated. Airlines and schools are good examples. Airlines must understand how many tickets they must sell to Break Even, but each plane has limited numbers of seats. Therefore, the airlines must also understand how to Break Even on each individual flight. However, each route – with Austin to Denver being one route and Austin to Des Moines being another route – has limited flights that can be taken each day, so they must understand the Unit Economics of each route.
Unit Economics are calculated using four separate formulas that build upon each other and use the various cost totals as detailed in Unit Economics Explained - Part 2: Units and Costs. The first formula calculates Contribution. Once you calculate Contribution, then you can calculate Break Even, then Pre-Tax Cash Flow, and lastly Payout. Below, we'll dig into each formula and run through an example business's Unit Economics from start to finish.
When calculating Unit Economics, you must first decide what unit you will use as your base unit for the calculations. If you’re a pizza restaurant, you could run the Unit Economics based on one slice of pizza as your unit, or one whole pizza. You could also consider one new customer as a unit, one customer visit, one table, one restaurant location, or even one whole city that you’re thinking of opening locations in. It’s not a bad idea to
The single best tool for analyzing a potential entrepreneurial or investment opportunity is Unit Economics. Unit Economics answer three basic questions, perhaps the three most important questions to ask when analyzing a new opportunity:
- Break Even – How many units must you sell in order to pay your monthly overhead?
- Pre-tax Cash Flow – How much profit is this business likely to make every month?
- Payout – How long will it take to recoup the up-front capital investment?
There are plenty of other financial questions you could, and should ask, but many are more relevant to more established businesses. Other questions require different tools.
Why These Three Questions?
If Break Even is too high, then it’ll be hard to get the business off the ground, and the business will be at risk from