Friday, September 23, 2016

Unit Economics Explained - Part 5: Common Mistakes

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.

You can’t add rent to your variable costs and assume that’s how much it costs to make one unit, even if your sales are only 3-4 large items per month, such as houses. What happens if you sell 3 more houses in a month? Your office rent does not go up accordingly, and is, thus, a Fixed Period Cost. 

You also can’t assume that all your raw materials should be considered a monthly Fixed Period Cost because you only order them once a month and the orders are usually the same size. What happens if you don’t sell any product for an entire month? You won’t make any that month, and thus, you won’t have used any of the raw materials you ordered last month and that’s just sitting in the warehouse. Are you still going to place that monthly order for still more raw materials? Of course not. Thus, your raw materials are still a Variable Cost. 

You can’t assume your liability insurance premium is a Primary Sunk Investment, since you only pay it once a year. That’s a longer period of time, but it’s still not a one-time, up-front expense. Divide the annual premium by 12 and add it to your Fixed Period Costs per Month total. 

Conversely, you can’t assume that your website is a Fixed Period Cost just because you have to pay it this month when you happen to be calculating the Unit Economics. You’re only paying it once, and therefore, it’s a Primary Sunk Investment.


Make sure to always use labels, and make sure they match. You may have noticed in the t-shirt example above, every cost and every calculation is labeled, and many of the labels are slightly different. If you aren’t diligent about labeling every last number in your Unit Economics, you are likely to make mistakes or even miscommunicate the results of your Unit Economics to other stakeholders (investors, employees, partners, lenders, etc.).  

One common example is when the time periods don’t match. If your insurance premium is paid annually, but your Fixed Period Costs are listed monthly, you must divide the annual premium by 12 before you can add it to the total, even if the whole premium is due this month.  

Another common labeling mistake is to mix up the base units. If you sell beverages, are you using one can, one bottle, or one case as your base unit? If you sell eggs, are you using one egg or one dozen eggs for your base unit? 

The easy solution is to always include the label and always make sure it matches. If you see a number without a label, then add a label, and make sure it matches the others before you use it in any total or calculation.

Don’t Include Debt 

Unit Economics are a tool for analyzing a potential opportunity on its own merits. How you pay for that opportunity is irrelevant to the calculations. It doesn’t matter if you pay for all the PSI or if an investor does. The Payout stays the same. Similarly, if you decide to take out a loan, that doesn’t change how the opportunity stands on its own in comparison with other opportunities. 

Further, if you take out a loan to pay for the PSI (or even some of the FPC or VC), and simply add the debt payment to the FPC, then you’re confusing what constitutes the various costs and how they relate to and impact the attractiveness of your opportunity. 

Further, if you pay off the loan in three months instead of 30 years, then the Unit Economics will shift dramatically if you had included a monthly loan payment in your FPC. The expense once again looks a lot more like a PSI, because you’ll need to know how long before you recoup that expense.  

Lastly, if the business fails, and assuming you personally guaranteed the loan (and nearly all startup loans are personally guaranteed these days), you’ll still be on the hook for that money. In other words, you invested it and still need to recoup it. If you simply list the loan payment as a FPC and don’t include the accompanying purchases in the PSI, then you’re not taking into account the fact that you’re still risking all that money and will have to pay it back, possibly over many years, if the business fails.  

Side note: never personally guarantee a business loan, especially for a startup. Yes, you believe the business will succeed, and for your sake, I hope it does. But many great businesses still fail, for reasons outside your control. If you personally guaranteed the loan, you’ll personally pay it back. If you aren’t able to, you’ll personally file bankruptcy. I know, because I made that mistake once. I guaranteed some business loans, the business failed, and I was forced into bankruptcy by our creditors. 

Side note: never borrow money. If you feel you must, don’t borrow money until the business is profitable, cash rich, stable, and growing. If it’s all four of those, then you may consider borrowing a very small amount of money relative to your sales and cash reserves, without a personal guarantee, of course. That said, if the business is profitable, cash rich, stable, and growing, why do you need to borrow money at all?

Yes, I realize many people have made fortunes doing LBOs and in real estate, but I’ll stick with my statement. If any number of outside conditions shift unforeseeably (i.e. a big storm floods half a continent destroying a season’s worth of crops, or the price of energy increases, or banks misgauge big bets the real estate market, or, worse yet, multiple factors hit at once), and suddenly the economy enters a recession, you may not be able to repay the loan or the bank may even call the whole note due, and you’ll immediately lose your whole business as a result.  

Read Antifragile by Nassim Taleb for a deeper understanding of why debt is inherently fragile, and why that’s a bad thing in startups, which are inherently unpredictable.

Investing Too Much Too Early

Keep your PSI and FPC as low as possible at the beginning. Failure to do so is not a mistake with the Unit Economics themselves, but, rather, how they are applied to your business model.  

Instead of investing in PSI or committing to higher FPC in the early days of your business, try to find ways to shift as much as you can into the Variable Cost category. 

For example, you could buy manufacturing equipment (large PSI) and hire employees to help you make your product (high FPC), you could make your early units yourself, by hand, or outsource them to another company with excess production capacity (higher VC).  

In our t-shirt example, don’t buy a screen printing machine on day one and hire an employee to help you make the shirts. Instead, find a company that prints shirts at wholesale and place a small order with them. This will cost you more per shirt, but until you have lots of sales to A. prove the demand of your shirts is sufficient and consistent and B. to provide you with the cash you need to buy the screen printing, there’s no reason to risk the money in buying that machine. Fast forward to when you’re selling 1000 t-shirts a month, or better yet, 10,000 t-shirts a month, and now the economy of scale may make enough sense to buy the press, hire some employees, and bring manufacturing in-house to bring down the cost-per-shirt. 

In general, when just starting out, Variable Costs are preferable to Fixed Period Costs, which, in turn, are preferable to Primary Sunk Investments. As your business grows and leaves the launch stage and enters into a growth phase with more stable monthly cash flows, it makes more sense to shift more of your expenses from Variable Costs to Fixed Period Costs. Finally, when your company reaches a mature stage with large cash flows and large cash reserves, you should consider investing in more PSI to decrease both Variable Costs and Fixed Period Costs.

Vehicles are a good example of costs that can easily be shifted. In the first months after you launch, if you need a truck to make a big delivery, you rent a truck for a few hours. This is a Variable Cost. No need to buy a truck yet. No need to take on the risk of committing to big monthly payments at this point in the game.

Then, a year or two later when you’re making big deliveries nearly every day, it’s more cost effective to lease the truck. You may not have the cash on hand to buy a big truck just yet, but you can certainly handle the monthly lease payments, which are cheaper than renting trucks by the day.

Fast forward another three years, and sales have grown so much that you need a small fleet of trucks to keep up with deliveries, but guess what? You’ve also got $300K in cash reserves sitting in the business bank account. The small fleet of trucks only costs $250K. Buy the trucks outright and you’ll be able to keep both your Variable Costs and your Fixed Period Costs lower than your competition, and thus you can lower your prices, maintain the same profit margins, and gain significant market share, ultimately increasing company profits substantially. Buying the trucks with cash is technically risky, because sales could theoretically decrease enough that you’d never reach Payout, but you calculate a 3- to 6-month Payout and the sales pipeline is full and growing fast. Thus you aren’t that worried about not recouping that $250K investment, so buying the trucks with cash is the best decision at this point in the game.

That said, if you’ve got another new product opportunity that you could invest that $250K in, and that opportunity has the potential for a 2-month Payout, very low risk, and could result in a 100X return within 3 years, you might be better off investing in that new product line and leasing the whole fleet of trucks anyway. How would you know which opportunity to invest in? By comparing the Unit Economics, of course.

Is That All?

Hardly. Even the most experienced entrepreneurs and investors can still make mistakes. Also, sometimes your Unit Economics conclusions simply aren't that relevant because you need to use different units. Often, it's the business model itself that needs to change to fit the reality that your Unit Economics conclusions are trying to warn you about. No matter what the case, make sure to run your Unit Economics by a business partner or trusted mentor. They'll see things you perhaps you missed.


Click here to read the next and final post in the series:
Unit Economics Explained - Part 6: Summary

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

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

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