Friday, September 23, 2016

Unit Economics Explained - Part 2: Units and Costs


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
run the Unit Economics for each of those different units to see what each has to teach you about the nature of the opportunity. Similarly, if you sell different products, run the Unit Economics on each product to compare Break Even, Pre-tax Cash Flow, and Payout on each in order to know where to best focus your company’s efforts and resources. Sell high-margin products with low overhead and low investment first.

Three Kinds of Costs 

Business expenses, or costs, fall into three distinct categories. Many entrepreneurs misidentify cost categories, or worse yet, list all types of costs together, and are thus continually confused by why their business never seems to create as much available cash flow as they thought it would.  

The three kinds of costs are:
  1. Variable Costs – VC
  2. Fixed Period Costs (aka Overhead) – FPC
  3. Primary Sunk Investment – PSI  

Variable Costs 

Variable Costs are expenses you incur for each individual unit manufactured and sold. For example, if you have a pizza restaurant, then the ingredients (dough, sauce, cheese, toppings) are your variable costs. If it costs you $4 in ingredients to make 1 pizza, and you sell 100 pizzas, then you’ll be spending $400 in Variable Costs. If you sell 101 pizzas, then you’ll spend $404 in Variable Costs. Variable Costs are always labeled $/unit. So with your pizza restaurant, that would be $4/pizza.

Fixed Period Costs 

Fixed Period Costs, commonly known as Overhead, or just FPC for short, are recurring costs that do not go up or down regardless of how many units you sell or don’t sell. FPCs are typically expressed as monthly costs, though any given FPC could be for a longer or shorter time period.  

Whatever the time period, the periods must match. If you pay your $1200 insurance premium annually and your rent is $1500 monthly, you can’t simply add these numbers together and say your overhead is $2700/mo, even if you paid the whole insurance premium this month. Most months it won’t be that high, and you’ll be using faulty data in your analysis. You must first divide the annual cost by 12 months to make sure the units match. $1200 annual premium / 12 months = $100 / month. Add that $100 monthly insurance expense to the $1500 / month rent to get $1600 / month in FPC. Unit economics isn’t for calculating cash flows in any particular month, because monthly expenses will vary, but rather identifying whether the opportunity is a good one, given a typical month. 

In your pizza restaurant, FPCs include employee salaries, rent, utilities, insurance, and your monthly marketing and advertising budget. Let’s say that you have one employee besides yourself, and that employee’s salary is $2000/mo. Let’s also say rent costs $1500/mo, utilities cost $100/mo, insurance costs $100/mo, and you spend $300/mo on marketing and advertising. Add those together, and your FPC are $4000/mo.

Primary Sunk Investment 

Your Primary Sunk Investment, or PSI, is all the expenses it takes to get your business off the ground. These are costs you pay once, up front, when you launch your business or invest in the opportunity. These costs could include acquiring a building, building out the space within the building, buying furniture, purchasing equipment, building a website, creating a logo and branding, signage, uniforms, computers, etc. It also includes expected monthly cash flow losses until the business makes enough sales to break even every month.  

In your pizza restaurant, you decided to rent a space, so you don’t have to buy a building, but you do have to fix up the interior to get ready to open. Let’s say that costs you $20,000. Ovens, tables, chairs, cash registers, signage, and uniforms cost another $14,000, and the website, logo, and branding cost another $2000. Further, let’s say that it takes you two months to build out the space, during which time you have to pay all your FPCs except for the employee’s salary, because she hasn’t started working yet. This overhead costs you $2000 X 2 mos = $4000. All these PSIs total $40,000. You’ll need to invest at least that much money to launch this pizza restaurant.

OK, Now What?

Once you have your units selected and your costs separated out, you can now apply them to the formulas, which we'll do in the next post: Unit Economics Explained - Part 3: The Formulas.


Click here to read the next post in the series:
Unit Economics Explained - Part 3: The Formulas

Click here to go to the previous and first post in the series:
Unit Economics Explained - Part 1: Why Unit Economics Matter

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