Chapter 9. Pricing in Practice

Unit Economics | Price Leaks | LTV:CAC

[6 min. read]

“Unit economics” is an academic phrase.

But it’s really cool and important. Here’s what it means.

9a. Unit Economics

The ”unit” is a way of defining the zoom level. Zoomed all the way out we can see the company as a whole. Zoom in a little and we could look at a division or department. Zoom in even further and we can view a single purchase.

“Economics” here means we’re looking at cash flow—the flow of money in (revenue) minus the flow of money out (expense). As one investor explained it to me, we add up all the “goes-intas” and subtract all the “goes-outas.”

In principle the macro view is a sum of all the micro views.

Company-level economics are shown on the Income Statement (where the sum of revenue minus expenses is the proverbial “bottom line.”) An Income Statement for a division or department is often called a Profit and Loss Statement or P&L. And all levels, including down to individual purchases can be analyzed using a price waterfall chart.

Zoomed in at this level, revenue is simply the unit price or value, i.e., what the customer pays. Expense is the single-unit cost of goods sold (COGS), or what the company pays to deliver the product. Adding these up shows us whether or not we are “unit profitable.”

The following chart shows unit economics for simple purchases.

The most granular “unit” might be your unit of sale from Chapter 4.

Simple purchases are easy. For example, if I buy a sandwich the seller either made or lost money at the moment of purchase.

Many purchases, especially B2B, are more complex. There are lead times, discounts, shipping, ongoing customer support, returns, etc. Analyzing unit economics with all factors in mind can help ensure you are as profitable as you think.

Because they are so complex, McKinsey coined the term Pocket Price to help zero in on what the customer actually pays “out of pocket.”

9b. Price Leaks

A detailed waterfall chart can help identify price leaks.

Price leaks are like little profit thieves hiding in the complexity of your purchases. A price leak happens when you think you‘re charging one price, but discover the customer is actually paying less due to an unintended practice in the sales process.

According to Insight2Profit.com, three of the most common price leaks are,

Shipping/Freight
Payment Terms/Trade Credit
Exceptions: Order Minimums and Rush Delivery

Let’s break those down.

Shipping

We live in a world where free shipping is common. But does it make sense for you? If your margins are thin, fluctuations in freight cost may be stealing your profits. Or, your sales team may be throwing in free freight when they shouldn’t be. Make sure your team is sticking to a policy that protects your profits.

Terms

Payment terms are better described as trade credit and they are a key part of your cash conversion cycle—the timeline between when you pay for raw materials and when you get paid for finished goods.

Note: Dell famously flipped this on its head in the 1990s by getting paid by customers before they had to pay for raw materials. Unfortunately that’s not a model every business can imitate.

Terms might look something like 5% 10, Net 30, meaning customers who pay within 10 days get a 5% discount; customers who pay within 30 days pay the net price on the invoice.

When you give the customer time to pay, that’s a financial transaction and you become a creditor. There is a cost as you wait for access to those funds. Are you factoring that cost appropriately into your pricing? Are your terms being abused?

Exceptions

Production is often most efficient in large batches and standard time frames. When you have to alter the process, efficiency goes down and cost goes up.

Are you adequately charging for small runs or rush delivery?

You can expand the waterfall chart to include these details.

Knowing your unit economics helps ensure that you have the makings of a profitable business—versus what a banker once sarcastically asked me, “I see you’re going to lose a little on every sale and make it up in volume?”

Unit Economics for SaaS

Software businesses look simple from a retail or manufacturing perspective. There’s no inventory, no shipping, and very simple production once the code is written. Where software becomes very sophisticated is in how it’s bought and sold.

A manufacturing company might wrestle over a 60-day lead time and whether or not to offer 30, 60, or 90 day terms. But a software company might need to look at trends over multiple years to know if it is profitable.

Often for software companies the question is, will the company eventually be profitable?

The J-Curve

One way of visualizing this dynamic is as a J-curve. In the beginning we spend money to acquire customers, so we start in the hole. Over time subsequent payments bring us positive and into profitability.

Another way of breaking down these dynamics is using a “magic ratio,” LTV:CAC.

9c. LTV:CAC

The magic ratio is the lifetime value of your customer divided by your customer acquisition costs.

LTV, or lifetime value, is used when the full value of a customer is not captured up front, but comes over time, like in a SaaS business.

Because of this, LTV/CAC is not useful without recurring purchases, nor is it useful if your payback period is less than one year.

LTV can be calculated on a single customer, but for LTV:CAC we want your average LTV across all customers. On average, how long does someone stay a customer and continue making payments? This is calculated as Gross Margin times Total Customers less Churned Customers

CAC stands for customer acquisition cost. How much do you need to pay to get one more customer?

That average is calculated as total sales and marketing spend, divided by total new customers.

The amount of time it takes to break even on your CAC is called the Payback Period. In SaaS you ideally want a payback period of 24-30 months. 18 months is considered very good.

Take note: LTV:CAC is not appropriate if your product doesn’t generate recurring payments or if your payback period is less than one year.

And at some point you will lose customers. We call this churn. These are the customers that don’t renew. Ultimately you’ll have an average lifespan of your customer. Once they churn out, they no longer contribute to LTV.

To make a profit, you must not pay more to acquire customers than they will ultimately pay you. LTV gives you the flexibility to see not just what you can spend to make one sale, but what you can spend to acquire the customer and still turn an eventual profit. LTV is the present value of all future profits that customer will generate.

In highly competitive, winner-takes-most markets, the strategic question might be, can I spend more to compete for customers today so I win tomorrow? This is often the motive for raising capital.