In our effort to reduce complexity and wrap our heads around our businesses, we simplify to ratios and percentages. Percentages and ratios can be helpful, but risk boxing in our thinking and narrowing our options and actions. Percentages and ratios become the assumptions in our models and we mistake those for our levers when in fact they are the outputs. Thinking in terms of unit economics grounds us in what we really do - sell products to people - and opens up better options and actions. Unit economics unlock all the levers.
We all know our percentages and ratios:
- Discounts are X percentage of Gross Sales.
- COGS are Y percentage of Net Sales.
- My MER is Z and my aMER is Z1.
The percentages becomes our margin structure and the ratios our guiding metrics.
With this margin structure and ratios in mind, when we want to increase profits, we then:
a/ increase sales in an attempt to increase the notional contribution profit sufficiently to cover OpEx and deliver more profit
b/ attempt to change our margin structure by raising prices, lowering discounts, reducing returns, cutting COGS, lowering shipping & fulfillment and cutting OpEx.
c/ some of both
We turn a, b and c into assumptions and feed them into our models. We tweak assumptions until the models deliver the outputs we want. One innocuous assumption stacked on top of another form our base case which in reality requires a cascade of good luck to come true.
In trying to take actions to turn our set of assumptions into reality we are faced with a mountain of questions.
- ‘OK, we are going to reduce discounts from 9% to 7%.’ But how? On which products and which customers?
- We need to cut COGS by 3 points. OK, given our product catalog and supply chain, is this across the board or will some products go up while others have to come down 20%?
Percentages and ratios add a foggy layer of obfuscation from what really happens in our business. What really happens in our businesses is that we sell products to people. What we sell matters and who we sell them to matters.
I love unit economics because they remove the layer of simplification. They ground us and enable us to get to the financial implications of what really happens in our business. We get to bare metal so to speak. So, what do I mean by unit economics?
Our SKU’s aren’t equally profitable. They carry different prices, discounts and return rates. Their cost to manufacture is different as are their inbound freight and duties. They have different costs to store, pick, pack and ship. When they get returned, they have different re-sell values. Our customers buy them in different amounts and repeat customers buy different SKU’s in different quantities than our new customers.
Our goal is to understand our product catalog and our customer base at that level of detail. When we see our business in this way - units and customers - winning moves are easier to make and dangerous or over optimistic moves based on simplified assumptions are easier to avoid.
- There is clear demand for more of SKU 456 among this subset of customers.
- We’ve never sold more than 1,000 units of SKU 789 to current customers, but the AOV assumption in this plan would require us to increase that by 50%.
One of my favorite uses is looking at the customer journey by per unit contribution profit. Another favorite is applying per unit contribution profit to customer acquisition. I will dive into these topics in detail in future posts.
For now, remember that
- monthly profit is the sum of all the individual contribution profits from our various product sales to all our various customers.
- our margin percentages and ratios are averages.
- our averages are simplifications.
- the truth (and the gold) lies shrouded beneath that layer of simplifications.
Getting to real unit economics can be daunting and requires the right processes and tools. Reach out if you have questions about to best do this or need help.