Welcome to part three of Tandem Innovation Group’s first blog series: Startup Financial Management 101! In this four part series, we will be providing the basics on managing your startup’s finances. From breaking down key concepts, to providing tips and illustrating through examples, this series is the go-to resource for entrepreneurs. Curated with the expertise of Tandem network professionals, we want to make it simple for you to understand your startup’s finances.
Today we are deep diving into unit economics and profitability. We will be explaining what it is, why it is important, and how you can execute it.
Is Your Business Profitable?
There are four levels to consider when evaluating whether or not your business is profitable:
- Unit economics – revenues and costs associated with a specific unit
- Gross margin – net sales revenue minus cost of goods sold (link previous post)
- Operating profit – profits from core business functions
- Net profit – money leftover after subtracting expenses from revenue (aka the bottom line)
What Are Unit Economics?
Unit economics are how much value each unit creates for your business. The definition of a “unit” varies depending on what kind of business it is. A unit could be a physical product sold, a contract, or even a subscription. The goal is to determine how much profit the unit produces.
There are two key concepts that determine profit generated per unit:
- Contribution margin – money generated per unit sold minus variable costs
- Customer lifetime value – revenue generated per customer
A contribution margin is used for one-time sales, whereas net customer lifetime value is used for repeated sales and long-term relationships.
Contribution margin is calculated as follows:
CM = sales per unit – variable cost per sale
Net customer lifetime value is calculated as follows:
Net CLV = total revenue over customer’s lifespan (CLV) – acquisition/servicing costs per customer
How Can You Optimize Contribution Margin & Customer Lifetime Value?
To optimize contribution margin and customer lifetime value, you need to break down each into smaller parts.
Contribution margin is composed of sales price per unit and the variable costs per sale. Increasing sales price per unit and/or decreasing variable costs per sale will optimize your CM.
Net customer lifetime value is composed of customer lifetime value and customer acquisition costs. Increasing the customer lifespan and/or reducing marketing/servicing costs per customer will optimize Net CLV.
That’s Not All!
This is only one part of our financial management series! Our goal at Tandem is to make it easy for you to establish a sound financial platform to build your business on. Our last posts looked at financial modeling and cash flow, so don’t forget to check those out. Next, we will be looking at cap tables and stock options; what they are, why they are important, and how you can execute them.
Jacinthe Koddo – Contract CFO/COO, Tandem Co-Founder & Director of Client Experience
Tania Lo – Contract CFO/COO, Tandem Co-Founder & Managing Director
Matthew Stevens – Contract CFO
Teresa Pang – Contract CFO