Unit Economics

The concept of unit economics forms the underpinning of any venture’s economic model: you can make one unit of something for a price of X, and you can sell that unit at a price of Y. If you’re a bakery, your unit economics are pretty simple: every loaf of bread costs you X to make, and you can sell that loaf for Y. If you’re a consulting firm, every hour of time costs you X, and a client is willing to pay Y for that hour. For hotels, the units are room nights. For airlines the units are seat miles. Every venture distills down to unit economics.

For most companies, unit economics improve with scale. As your factory grows, your cost of producing one unit goes down, and maybe the price you can sell that unit for goes up as your marketing and distribution improve. However, if your unit economics are fundamentally upside down (your cost of making a unit is hopelessly higher than you’ll ever be able to sell a unit for), then scale just makes you go broke faster (which is not usually the desired outcome).

How to Calculate Your Venture’s Unit Economics

The first step is to figure out what you’ll consider “one unit” for your business. For a taco shop, a unit is one taco sold. For a consulting firm, it’s one billable hour. For a SaaS company, it’s one monthly subscription. For a fertilizer company, maybe it’s one ton of fertilizer. Everything distills down to Unit Economics, so think about what one unit is for your venture.

Now, what does it cost us to produce one unit? Don’t include any general overhead, just the incremental cost of making one unit. For a widget factory we don’t include the cost of the factory, or the manager’s salaries, just include the materials and labor to product one single widget.

For our taco shop, each taco we make has several ingredients, so let’s say those amount to $1.20 per taco, on average. We have some labor to assemble the taco ($1.50), some packaging ($.83), and we pay a revenue share to DoorDash to deliver the order ($.73). Adding those up, our cost-of-goods-sold (COGS) is $4.26 per unit, and if we sell that taco for $5.00, then our gross profit on one unit is .74 – nice, easy unit economics.   

The concept of unit economics is pretty simple, but of course it gets more complicated in real life. What if we offer several different tacos, each at a different price point? In this case, the easiest approach is to think of one unit as being an “average order.” 

The reality, of course, is that most ventures are more complicated than just “we make tacos for four dollars and sell them for five dollars.” Unfortunately, many entrepreneurs make the fatal mistake of waving their hands and saying, “Well, unit economics doesn’t really apply to what we do, because what we do is new and different.”

History says otherwise. Many startups have met painful demises because they didn’t really understand the concept of unit economics. You can avoid one leading cause of startup death by taking the time to understand your venture’s unit economics. Once you do, you can build a full economic model for your venture and go on to find great success (while eating some delicious tacos along the way).

The notion of unit economics even applies to nonprofits and social enterprises. You have fixed costs (overhead) for your nonprofit organization, and then maybe you run programs that help kids learn to read. Your costs for that work out to five dollars per kid per month, and the school district reimburses you at six dollars per kid per month. So there’s your unit economics. Funders and donors will want to understand the unit economics of your social venture, and so should you. It’s the key to creating sustainable impact.

How this flows into Enterprise Economics

Unit economics then feed into enterprise economics. We need to sell a certain number of units every month in order to cover the enterprise’s overhead. Once we’ve covered the overhead for the month, then additional units sold represent profit. Not only is this how a simple lemonade stand works, it’s also exactly how nearly every business works.

Let’s say the overhead for our taco shop is $2,000 per month. This includes the rent, utilities, insurance, etc. Since our unit economics say we make $.74 per unit sold, we need to sell 2,700 tacos in a month to cover the overhead. Each additional unit sold after that turns the whole operation profitable for the month, as the gross profit on each additional unit is pure net profit for our taco shop. Nice.