Friday, September 23, 2016

Unit Economics Explained - Part 3: The Formulas

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.


Contribution = Revenue per Unit – Variable Costs

Contribution (aka Gross Profit per Unit… I use these terms interchangeably) is the amount you and your business nets on each sale to “contribute” to overhead and profits. Revenue per Unit is usually just the sales price received from one unit sale, though you could also consider the lifetime value of one sale, as with subscription sales.

Break Even 

Break Even = Fixed Period Costs / Contribution

Break Even (BE) is how many units you need to sell in order to cover your recurring overhead costs (FPC). If you don’t reach BE in a given month, you’ll be paying for some or all of the FPC out of your own pocket. As soon as you reach BE, the contribution from the very next sale and every sale thereafter for the rest of the month goes toward profits.

Pre-Tax Cash Flow 

Pre-Tax Cash Flow = Monthly Unit Sales X Contribution – Fixed Period Costs 

Pre-Tax Cash Flow (PTCF) is how much profit your business will earn after paying all variable costs and FPCs, but before paying taxes. PTCF is roughly the same thing as EBITDA on an Income Statement.


Payout = Primary Sunk Investment / Pre-Tax Cash Flow 

Payout is how long it takes to recoup the initial cash investment in the business. It doesn’t matter if this was your own money or if it came from an investor, or if you borrowed it. As an analysis tool, you want Unit Economics to compare how quickly you’ll recoup that investment with the Payout time of other opportunities.  


Let’s say you have an idea to start a business that designs and sells t-shirts online. We’ll use one single t-shirt sale as our basic unit for calculating the Unit Economics. Let’s also assume the following costs: 

If you charge $10.00 for each t-shirt, and you expect to sell 1000 t-shirts per month, the unit economics look like this:

That’s it. The basic formula calculations are that simple.


Click here to read the next post in the series:
Unit Economics Explained - Part 4: Advanced Unit Economics

Click here to read the previous post in the series:
Unit Economics Explained - Part 2: Units and Costs

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

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