Amazon really turned everything upside down for me. They operated for seven years before a profit was turned. As an accountant raised by immigrants who harped on job security, and investing money in property and not stocks, I just did not get it. Why did so many people flock to invest in a company that was losing money in the hopes that they would one day turn a profit?
I was seeking the stability my parents effectively engrained and landed myself at a Global corporation whose US operations served as a cash cow. The laser focus was always on year over year sales growth and profitability. After years of aggressive earning targets set by Global and consequently missed by our team, the menial bonuses required action. I sought out a new role in our eCommerce division that was experiencing something foreign to me — triple digit sales growth.
I was hired to lead Financial Planning & Strategy and was pleasantly surprised with the peers around me that had either successfully created and sold a business or were heavily intertwined in the investment world. I knew the mechanics of financials, but I had much to learn about the world of eCommerce.
Unit Economics was a term frequently thrown around and after hours of financial analysis and conversations with peers and founders, it started to make sense. So what is it — what is unit economics, why does it matter, and why should you care?
Unit Economics summarizes the revenues and costs associated with a single unit. The unit varies and is defined by what is most relevant to the business model.
A simplified example is a restaurant fulfilling a food order for pick-up— what we will define as our one unit. In this order of one pizza, the revenues are the price of the pizza less any discounts offered to entice the customer, while the costs include the ingredients, the pizza box, and the labor of your employee. All of that revenue less that cost, is any money being made on that one pizza order? Seems simple, right?
Where it gets a little more complicated is the path to profitability. More directly put — can the business make money in the future? Can they decrease their cost to acquire customers, retain customers, or maintain operating costs as they scale?
If a company is paying a high cost to acquire their customers, there is still the possibility that they will recover that cost in the future. An example is if Amazon offered a $100 gift card to use their platform. They are doing this to entice you to join and with the purpose of gaining a loyal customer. The hope here is that the customer lifetime value (the benefits of a customer remaining with the platform and spending on it over time) will outweigh the customer acquisition cost. Amazon may not be profitable on that first customer order unlike the pizza example, but they will eventually recover that $100 and make more money.
Another example is Uber. Widely popular. Public company. Not making any money. Even if we write off 2020 due to lack of travel from COVID, they also reported a loss in 2019. Uber requires the use of incentives to attract customers and unfortunately with competitors like Lyft and emerging competitors like Tesla self-driving vehicles, retention has proven to be difficult. On the delivery front, Uber faces similar challenges. No one wants to pay delivery fees, especially in New York where you have a plethora of options right outside your door.
While Uber has managed to level off the cost of labor in their corporate offices, the reality is that their unit economics are awful.
So now what, why should you care? Understanding unit economics helps you become a smarter investor. A smarter investor in yourself, your business, and in the stock market.
You have been offered an amazing new role at a hot start-up that has a cool lounge, free beer, and remote working perks? SIGN ME UP! While that all sounds glamorous, you may be out of work sooner than you know it. What is the company’s business model? Are they profitable? If not, is there a viable path to profitability?
If you are a business owner, how much are you making per unit or order? Is that sufficient to cover your operating costs? Are there things you can do to retain customers, refine pricing, or reduce operating costs?
If you have downloaded your Robinhood app, loaded your money and are ready to go. What do you know about the company you are looking to invest in? A few google searches will reveal information about profitability, business model, and future company plans.
You only know what you know, and knowing more about Unit Economics has changed the way I analyze, join, and invest in companies.