why are unit metrics so important for your business model?

Photo by Lenny Kuhne on Unsplash

Very often after an entrepreneur finishes pitching his company to us at Expon Capital and we start the Q&A session, I start drilling down on his unit metrics, trying to understand his business model, ie how he expects to make money.

Often, the entrepreneur says s/he is grateful for the questions, but more surprisingly to me, is how often the entrepreneur has not thought about his business with this tool / technique in mind.

Let’s kill a misconception immediately: a business model is not your list of different prices you expect to charge (example: 9,99€/month for a music subscription service); this would be your rate card or price list. Your business model is how do you make a margin from whatever product or service you are expecting to sell or are already selling. And this means your business model has to take into account costs. And they have to be correctly allocated to the right revenue stream. Simply put:

Margin = Revenues — Costs

Simple ? then how is it that so many business plans and presentations never discuss their business model in this way ?

Let’s dive into a bit more detail. Again, this is a simplification (that’s why we call it a model). I’m not a chartered accountant, and I use this approach to quickly model P&L for businesses I analyse and/or invest in.

Revenue is price x quantity.

Let’s use the example of a company selling branded T-shirts. If I sell 100 T-shirts (Q) at 10€/unit (P), then Revenue is P x Q = 100 x 10 = 1.000€.

It you have different product lines (and startups always seem to want to have different product lines ;), not just one), then R = R1 + R2 + R3…

I would recommend modelling your business on the main product line, build a whole P&L around it, and when the model is robust, start adding a second revenue stream, check that all works, then a third revenue stream eventually. Beyond, we’re getting in the realm of real science fiction modelling too many revenue streams.

2. Costs

Costs = Fixed Costs + Variable Costs x quantity

Variable costs represent all costs directly incurred when you have ONE extra sale. So if you sell one extra T-shirt, then costs could be one unit of a white T-shirt sourced somewhere, the cost of the sticker ironed on the T-shirt, the 30 min required to iron the T-shirt + pack, the packaging costs, the shipping costs. To be clear, if there is no sale, these costs are not incurred (= do not exist =not paid).

Fixed costs represent all your costs incurred even if you have no sales. These are usually broken down into 4 main categories (no need for more):

  • Technology : this includes people associated with R&D in software (developers), software licences (Oracle for example) needed to build and run the product, costs of a transactional website (AWS servers for example), costs of people associated with running these services. Product development (R&D), and Operations could be separated under this header.
  • HR / People: this includes costs associated with people not in sales & marketing, not in Technology. These are usually HQ people, such as management, admin, finance, etc. I would factor in here also the costs of equipment of these people here (computers, etc.) and all extra benefits (private insurance, meals, etc.).
  • General & Administration : this includes everything else, usually professional services (lawyers, auditors, accountants), general bills not associated with a specific group such as office rentals, electricity, central phone bills, central amenities such as water cooler, etc.

3. Margin

so if Margin = Revenues — Costs, then

Margin = (Price x quantity) — (Fixed costs + Variable costs x quantity)

Margin = Quantity x (Price — Variable Costs) — Fixed Costs

Margin = Quantity x Unit Margin — Fixed Costs.

We all want to have a positive Margin, hence Margin > 0, which implies

Quantity x Unit Margin — Fixed Costs > 0, or

Quantity x Unit Margin > Fixed costs.

And that’s the great insight. An entrepreneur needs to understand how s/he builds a Unit Margin, so that it becomes positive. Sell more than what it costs to sell. And make that Margin as controllable, and large enough to be competitive. The difficulty here is to identify what is the unit : is it one contract with a customer, is it the lifetime value of a customer, is it one product, is it one licence. Whatever makes it easy to understand and model the business.

Talking to a marketplace operator the other day: there are costs associated to building the supply and costs associated to building the demand. Both should be taken into account vs. the revenue of a transaction on the marketplace.

Another insight here, is that with volume, more and more fixed costs could be treated as variable costs. Examples :

  • Technology: if you are a streaming video business for example, and that one server can handle 500 simultaneous streams (hypothetical), then when you are acquiring customers by the thousands, you can associate a variable cost of 1/500 for each new customer. Specifically on Excel, you model this with a Mod() function, and a RoundUp(). With large volumes, the rounding for the last modulo is negligible (ie you only have 357 customers instead of 500 on the last batch).
  • People: If you have 1 accountant every 50 large customer for example, you can factor that like a variable cost. This is where productivity comes in : the more work one person can do, and spread it out over more units, the better the unit margin.
  • G&A : try to affect costs to specific revenue streams, or customers, etc.

4. Business model definition

Looking at the previous equation

Unit margin x quantity > fixed costs

The entrepreneur’s job is to

  • Increase the quantity of units sold. This has to be associated with the size of the market: a larger market makes it easier to have more units sold with the same marketshare :)
  • Focus on understanding when the generated margin from sales will cover fixed costs. This is what we call break-even ! The money deployed until this point is the amount needed to finance the business, and this is why entrepreneurs raise capital.
  • Just getting to break-even (not spending more cash than generated) is not enough. That’s the first quantity1 to understand. Then you need to generate more unit margin x quantity2 to be able to reimburse the deployed capital. This is typical of a loan, where you have to reimburse the “borrowed” capital.
  • Keep in mind that capital often requires remuneration or interest. It is very often the case for VCs for example, where we have to return a minimum interest for a fund (the famous “hurdle” rate). So a quantity3 is necessary to pay back the interest part of the borrowed capital. At that point, the entrepreneur has built a real asset, that generates unit margins with every new sale, after having financed its building (q1), and paid back the building costs (q2 + q3).

Of course, there is no one answer to a specific market opportunity. Marketing theory and Strategy recommend building different scenarios, and choose the one that maximises the expected goal (profit if working on shareholder value, impact if that is your thing, etc. Another way to look at it is to analyse a volume-based business (usually low prices) or a price-based business (usually low volumes), or both (which means shifting the demand curve > this is for a future Micro-Economy post :).

As always, happy to hear your questions and comments.

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