Calculating unit economics: 5 mistakes to avoid
Here’s a sobering statistic that's painful to type.
90% of all new start-ups will fail.
It’s that sort of bleak figure which makes getting to grips with unit economics even more important because doing so could help make sure you stay in the successful 10%, not the failing 90%.
Understanding how this metric works in the early stages of a business is key to understanding current sustainability and predicting future growth.
Unit economics refers to a company’s revenues and costs related to an individual unit. A unit is simply one separate, quantifiable element that the company can create and sell and that adds value to both customers and the business.
It’s super important. But calculating it isn’t always easy.
We often see the same mistakes being made. Here we share our top tips so you can avoid the common traps.
Unit economics – common mistakes and how to fix them
1. Get your data structures right
Don’t group together sales, refunds, shipping, and discounts. Instead, embrace individuality.
It might seem logical to net off any combination of sales, refunds, shipping income and discounts together in your profit and loss, but these are very different, controllable components.
Breaking them out and viewing them separately can make a huge difference to understanding the strategic levers in your business.
By keeping these separate you’re able to see how each one impacts your unit economics over time, helping you spot where you can improve your sales and operations strategy or customer journey.
Discounting is a good example. By netting this off against the gross sales value it’s not clear whether fluctuating gross profit margins are the result of discounting or other business drivers.
The result might be more sales, but if you can’t see how the discount impacts both volume and average order value (and so profit) you might carry on discounting when, actually, it’s hurting your business.
2. Inconsistent calculation of product margin
If you’re not consistent in how you calculate cost of goods sold, you’re not alone. But inconsistency will mean fluctuating product margins every month that can’t be explained.
The gold standard is to have an inventory management system in place that automates the process, calculating cost of goods sold on a First In, First Out (FIFO) or Average Cost basis.
If this isn’t possible, we recommend setting a standard stock keeping unit (SKU) cost (based on recent data) and reviewing these quarterly (or as required). Using these standard SKU costs, along with the number of units fulfilled during the month from your website platform or warehouse portal, you’re able to effectively track cost of sales for the period.
3. Time lag between shipping and billing
There can be a time lag between when your products are shipped and when your shipping provider bills for the delivery, often much later than when you need to be reviewing your most recent month’s financials. Shipping is a key driver in your unit economics and so it’s important to accrue in line with your sales and cost of sales recognition.
A simple approach is to accrue based on a percentage of sales (pre discounts), or to apply a weighted shipping cost per order using your provider’s rate card and region data from your website platform. Similarly, to cost of goods sold, it’s good practice to review this set weighted shipping cost quarterly (or as needed).
This should help to iron out fluctuating margins and make sure the trends you are seeing aren’t the result of invoice timing differences.
4. No single version of ‘data’ truth
Do you know what’s been fulfilled this month? Not clicked sales, but actual fulfilled sales?
If you have multiple sales channels, can you easily see this in one centralised view? And, have you included or accounted for returns or replacements and samples sent out?
It can be difficult to know the answer to these questions for sure if you are relying on data from lots of different places.
You may have to view this through a mix of Shopify, invoices raised directly on Xero and Excel exports from your warehouse. One system that captures everything in one place can make a huge difference. If you don’t have an inventory management system, it’s important to have visibility of all fulfilled orders in the month with good, clean data.
5. Not knowing your CM1 and CM2
Are you familiar with your contribution margins, CM1 and CM2?
If you track these elements, are you consistently recognising the components of each on the same basis? Are you recognising sales when you receive the cash or when the order leaves the warehouse? Are you tracking transaction costs in the right period? Are you accounting for returns you've not only received but will receive relating to this month?
Best practice is to recognise sales when the order is fulfilled, to match with the timing of cost of goods sold and delivery, as the goods leave the warehouse according to your warehouse management (integrated with your website platform) or inventory management system.
There are exceptions to this, but, generally, it’s a good rule to follow.
Unit economics is one of the most important metrics to get right in an e-commerce business. It is a powerful tool that will help direct your strategy and focus for your products, sales, supply chain and marketing. But getting it right can be hard.