Scaling a business: the importance of unit economics

For leaders focused on growing their business, "scaling" often evokes thoughts of rapid expansion and taking market share. However, successful growth is grounded in one key principle: Unit Economics.

Scaling goes beyond simply increasing sales; it requires replicating a profitable business model. Attempting to grow a business with poor unit economics is not a viable strategy. It risks depleting capital and could lead to bankruptcy. Mastering this concept is essential for any executive looking to build not just a large company, but one that is self-sustaining.

Understanding Unit Economics

Unit economics measures the direct revenues and costs associated with a single unit sold by a business. The definition of the "unit" varies widely by industry. For a ride-sharing company, the unit is a single ride. For a fast-casual restaurant chain, the unit is an average transaction. For a manufacturing firm, it might be a specific product, such as an iPhone.

Contribution Margin, a measure of unit economics, tells us how much each unit a business produces "contributes" to covering the company's other costs. These costs can include R&D, real estate expenses, or other corporate overhead. Contribution Margin is calculated as the revenue from selling a unit minus its direct variable costs.

The Unit Variable Costs must include all costs directly tied to producing that unit. These costs can include direct labor, direct materials, payment processing fees, and shipping costs.

A positive Contribution Margin means each unit a business sells contributes positively to covering its overhead expenses. If the Contribution Margin is negative, every unit sold to a customer results in a loss. This situation can quickly lead to cash depletion.

Lifetime Value (LTV) and Customer Acquisition Cost (CAC)

While Contribution Margin evaluates a single transaction, scaling requires examining two other measures of unit economics that model the profitability of a long-term relationship with a customer: Lifetime Value (LTV) and Customer Acquisition Cost (CAC).

1. Lifetime Value (LTV)

LTV represents the total Contribution Margin a business expects to earn from a single customer over the entire duration of their relationship. It is the financial projection of a customer's total worth, calculated by summing up the contribution margin from all future transactions.

The Customer Lifetime (Years) variable is commonly estimated using the inverse of the annual Churn Rate. This rate is the percentage of customers who stop purchasing over a year.

For example, a business experiencing a high 50% Annual Churn Rate has an estimated Customer Lifetime of 1 / 0.5 = 2 years.

2. Customer Acquisition Cost (CAC)

CAC is the total amount of sales and marketing expense, including salaries, commissions, and ad spend, divided by the number of new customers acquired in that same period.

Unit economics is all about comparing these two metrics: the contribution margin generated over a customer's lifetime (LTV) relative to the cost of acquiring them (CAC).

Unit Economics in Action: Two Case Studies

To better understand contribution margin, LTV, and CAC, let's look at two examples. Note that the numbers in these examples are plausible assumptions based on publicly available data and analysis.

Case Study A: Chipotle

Let's first examine the unit economics of Chipotle's business.

Metric	Notes	Value
Unit Revenue	Average transaction value	$15.00
Unit Variable Costs	Includes ingredients, packaging, and direct labor	$6.75
Contribution Margin	($15.00 - $6.75)	$8.25
Units Purchased Per Year	Estimated # of visits/year per customer	20
Annual Churn Rate	Assuming strong brand loyalty	20%
Customer Lifetime	1 / 0.20 Annual Churn Rate	5.0 Years
LTV (Lifetime Value)	$8.25 Contribution Margin x 20 visits/year x 5.0 years	$825.00
CAC (Customer Acquisition Cost)	Assumes $25,000 in local store marketing per 1,000 new customers	$25.00
LTV:CAC Ratio	$825.00 / $25.00	33:1

Chipotle's Contribution Margin is robust, and the resulting LTV:CAC of 33:1 is exceptional. Chipotle's business model is well-suited for scaling. Every dollar spent on attracting a new customer generates $33 in lifetime profit.

Case Study B: DoorDash (During Its Early, High-Growth Phase)

Next, let's explore the unit economics of DoorDash during its high-growth phase. Note that DoorDash's early business model maintained a positive contribution margin but struggled with low LTV due to intense competition, resulting in high churn and high CAC.

Metric	Notes	Value
Unit Revenue	Assumes 20% Take Rate on $30 Average Order Value (AOV)	$6.00
Unit Variable Costs	Includes payment processing fees, driver subsidies/incentives	$2.00
Contribution Margin	($6.00 - $2.00)	$4.00
Units Purchased Per Year	Estimated # of orders/year per customer	10
Annual Churn Rate	Assumed high churn due to intense competition	80%
Customer Lifetime	1 / 0.80 Churn Rate	1.25 Years
LTV (Lifetime Value)	$4.00 Contribution Margin x 10 orders/year x 1.25 years	$50.00
CAC (Customer Acquisition Cost)	Aggressive promotional marketing, incentives	$75.00
LTV:CAC Ratio	$50.00 / $75.00	0.67:1

DoorDash's LTV:CAC of 0.67:1 meant that for every dollar the company spent on customer acquisition, it was receiving, on average, just $0.67 in LTV. This deficit was intentionally funded by venture capital firms to help DoorDash build out its network. However, it demonstrates the risk of scaling a business with poor economics.

DoorDash has since pivoted to achieve a healthy LTV:CAC ratio through various initiatives. These include introducing its DashPass subscription service to boost Lifetime Value and reducing reliance on costly consumer promotional incentives to lower Customer Acquisition Cost.

Common LTV:CAC Guidelines

The LTV:CAC Ratio is the ultimate measure of a business's unit economics. It brings together all three measures we discussed above: contribution margin, LTV, and CAC. If the measure is strong, it provides management and investors with the confidence they need to further scale the business.

Here are the key LTV:CAC benchmarks:

• LTV:CAC < 1: The business spends more on acquiring customers than it earns from them. This ratio is unsustainable for scaling; improvements are necessary before growth.

• LTV:CAC = 1: The company breaks even on each customer but lacks the financial cushion to cover other expenses like overhead and R&D. Scaling is not advisable until this ratio improves.

• LTV:CAC > 3: This is the ideal benchmark for management and investors. It indicates healthy margins, strong customer retention, and efficient acquisition, making the business attractive for scaling.

  
  

Conclusion

One of a leader's primary responsibilities is to ensure that every dollar spent on scaling a business is invested in a system proven to generate more than a dollar in return. Only when the unit economics are firmly positive does scaling make sense.

For any business aiming to scale, the initial focus must be on optimizing the LTV:CAC ratio. This requires consistent effort on two fronts:

1. Increasing LTV: Through improved retention, effective upselling/cross-selling, and product quality that keeps customers engaged longer.

2. Reducing CAC: By optimizing sales and marketing spend and leveraging organic growth levers like referrals and word-of-mouth.