4 min read

What are Unit Economics & why every Engineering Lead should care

Jez Back : Jun 28, 2022 12:48:30 PM

Defining Unit Economics

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Understanding Unit Economics is key in predicting current financial conditions and future growth. Associated with the most basic principles of a business model, Senior Technology Leaders can use the unit economics concept to calculate technology cost and value contributions to products and services, effects on driving revenues, whether the product or service is profitable, and much more.

Business woman using tablet with financial, cloud connectivity concept-1 At a business level, unit economics describes a specific business model's revenues and costs in relation to an individual unit. A unit refers to any basic, quantifiable item that creates value for a business. Thus, unit economics demonstrates how much value each item—or “unit”—generates for the business.

For an airline, for example, a unit might be the technology cost per single seat sold, whereas a logistics Technology Leader could define a unit on a per parcel or on a per customer each month basis. These units are then analysed to determine how much value they individually produce.

Using FinOps to Calculate Unit Economics

To calculate the unit economics, the organisation should in the first instance establish a FinOps capability to conduct these calculations.

FinOps is the Financial operating model for cloud. It is about making informed trade-offs between technology, business, finance and governance to attain optimal efficiency of spend, thus creating value for the business. This is not just about saving an organisation money, it is about enabling organisations to accelerate how they make money. This, in turn, unlocks the budget and the justification to invest in innovation to improve Technology Efficiency and wider value creation initiatives.

An effective FinOps capability will be embedded in the technology organisation but can break down the barriers of communication and form a common language between the Business, Finance, Procurement and within the Technology organisation itself.

Not only does it optimise the current spend of consumption based IT, it is also focused on the value technology creates – this is where unit economics is essential to success.

Calculating Unit Economics

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The FinOps team should determine, at the very least, the following factors:

How much does the technology vertical spend to sell the unit?
How much revenue does the unit generate for the business?

These questions in economic terms are the Customer Acquisition Technology Cost (CATC) and Customer Lifetime Technology Value (LTTV), respectively.

In order to calculate Customer Acquisition Technology Costs (CATC):

Total all of the technology costs associated with a product or service over a given period. This includes everything from cloud spend to any related wage costs and more.

This totality of cost is then divided by the number of units within that same given period.

Example:

An airline has spent £100,000 on technology costs over one month for its flight booking system. In the same period, they received 50,000 bookings.

100,000 / 50,000 = CATC of £2.00

To determine Customer Lifetime Technology Value (LTTV):

Total the revenue generated by every unit for each individual customer since they first purchased.

Then, to work out the average, divide this total by the number of units. Now, both your CATC and LTTV are on a per-unit basis.

Example:

To continue the airline theme, Customer A spent a total of Flight 1 of £600, Flight 2 of £500 and Flight 3 of £400. The average LTTV is (600 + 500 + 400) / 3 = £500.

There are numerous ways to calculate the Customer Lifetime Technology Value which would depend on the unit economics of your organisation’s specific business model. For example; an eCommerce organisation might take into account:

Customer retention rate or churn rate
Number of purchases per month
The average cost of each purchase

Technology Efficiency

These two key unit economics metrics also give insight into technology efficiency on a per-unit basis. It also explores the relationship between LTTV and CATC. It, therefore, follows that if the following calculation is done, technology efficiency can be determined:

LTTV – CATC = Technology Efficiency.

Example:

Taking the LTTV from the example above of £500 for Customer A and the CATC of £2 per booking:

£500 - £2 = £498 or 99.6% for that customer

As CATC decreases and LTTV increases, the technology efficiency increases; creating accretive growth and, as such, contributing directly to larger gross profit margins.

Unit economics analysis can be performed by focusing on technology efficiency as well as unit profitability and other financial aspects of the business. This includes looking at the payback period, gross margins, or ROI (return on investment) of product development and ongoing management, for example.

Improving the relationship between CATC and LTTV

To improve your unit economics, the business will need to either:

Increase Customer Lifetime Technology Value;
Decrease Customer Acquisition Technology Cost; or
Achieve both

To increase LTTV, Engineering Leaders must now take a business-centric view on how to help product owners to increase average order value, customer retention rate, or frequency of orders, by:

Using cost optimisation savings from FinOps activities to innovate existing or new products, including add-ons or enhanced features that improve customer experience;
Taking a closer look at analytics to identify additional efficiency opportunities or enhancements;
Tracking user cohort behaviour for more effective segmentation of your audience, leading to a lower churn rate;
Improving your frequency of orders is all about customer experience. When you make it easier for customers throughout the order process, there are lower abandonment rates, for example. This could also positively impact the number of new customers you take on, although this may not affect LTTV.

Obviously, the longer your FinOps team can collect and analyse data, the more accurate and insightful these unit economics will be.

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Summary

Actively managing Unit Economics isn’t just good for enabling business conversations for the Senior Technology Leaders, it’s indispensable for justifying the business case for technology investment and how technology budget is allocated for Engineering Leads as well.

By taking a Unit Economics approach; Engineering Leaders can drive greater insight into the current health of technology spend under their control, be able to discern accurate growth and scalability predictions to forecast future budget and articulate the value of their technology investments and justify the investment in wider innovation to drive growth.

These also help the wider business as they give sight to the direct revenues and costs per unit and inform true margin values. So, whether your business is product or service-based, focusing on these financial figures can enable and empower an Engineering Leader to have data-driven conversations centred on value creation.