Economics – Dutch Uncles

How the Best Pricing and Costing Practices Can Help You Achieve Great Unit Economics

Chayanika Sen — Fri, 11 Jun 2021 10:35:09 +0000

Unit economics is a term that is loosely used a lot, but often startup owners do not pay much attention to it. This could be a real mistake. But what is unit economics, anyway?

In simple terms, unit economics means measuring the profitability of selling goods, products, or services. For example, suppose you are a widget-making company. In that case, your unit economics will be the relationship between the revenue you receive from selling the widget versus expenses you bear for producing, marketing, and selling the widget. If you’re a service offering company like Uber, your unit economics will be the relationship between the revenue you earn from your services (for example, one ride of one passenger) versus the cost associated with marketing and offering the service to the customer.

Unit economics considers the direct revenues and costs connected with the essential elements of a company’s business model. In other words, it can be said that with this data, one can predict how profitable or not profitable a company can be and when it can reach the profitability state. And if you care about profitability, you can’t ignore to know about unit economics.

To understand unit economics, your first task will be to understand your basic unit. It is the most fundamental thing that reflects how you operate. Once you know the basic unit, you need to do the calculation in the next step. This will tell you how much revenue you will earn and what cost you need to pay to achieve that revenue.

In this context, it is essential to know about LTV or lifetime value which denotes how much revenue you can expect to earn from a single customer account during the entire lifetime of that account with you. To calculate LTV, you need to know the gross margin, how much each customer spends every month, and your monthly churn percentage. Mathematically, it can be represented as:

Lifetime Value = Gross Margin % X (1 / Monthly Churn) X Avg. Monthly Subscription Revenue per Customer

Coming to the cost side, the most frequently used term that you should know about is customer acquisition cost or CAC. It is determined by subtracting all the costs from the total sales and marketing costs to acquire a single customer. Representing mathematically,

Cost to Acquire a Customer = Sales and Marketing Costs / New Customers Won

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If you’re spending more to acquire a customer than its lifetime value, you won't survive in the business for long.

Why Is It Essential to Understand Unit Economics?

“If you can’t measure it, you can’t improve it.” – Peter Drucker.

Understanding and determining your unit economics is extremely crucial for early-stage startups to establish a healthy growth curve. Often, startup owners are so engrossed with their product ideas that they fail to recognize the importance of product-market fit, pricing strategy, cost structure, etc. which is why many startups fail to survive their initial days. But, knowing your unit economics from an early stage can help you make long-term financial projections. And the more accurate your financial predictions are, the more accurately you can predict your revenue trajectory.

How to Calculate Unit Economics?

Before we start calculating, we need to understand what a unit is. A unit can be anything depending on your business model. But as long as you are not mixing your units, your calculation will be impactful.

Customer as a unit

If you have a subscription-based model, every subscription you sell or get a new subscriber, a subscriber (customer) can be one unit.

Units as products sold

This model is more standard for manufacturing business where there is some cost attached to manufacturing a product. However, if you are a SaaS business, then customers as a unit would be more of interest to you than units as products sold.

The easiest way to calculate unit economics is to find the revenue per customer and then divide it by the costs associated with the customer. However, remember since no two businesses are the same, how you derive those values and what you determine as a unit will largely depend upon your business model. For example, for a SaaS business model, unit economics is usually LTV divided by CAC. However, for a more accurate future prediction, you need to consider other metrics, too, as simply LTV metric might not be sufficient. If you’re a new business, a startup, or have a new product launch, using a flexible LTV calculation makes more sense. Whatever you choose, you need to divide the result by CAC to get the unit economics.

Predictive LTV

This formula helps to avoid a sudden and unexpected drop-off in sales by considering how customer preferences change over time.

Flexible LTV

The predictive LTV works better for established companies. But if you’re starting, a flexible LTV would be more helpful to you.

Why Do You Need to Track It?

Unit economics is an efficient tool to determine if the cost of acquiring a customer exceeds or not the lifetime value of a customer. If you’re spending more to acquire a customer than its lifetime value, you won’t survive in the business for long. However, there are some other benefits too of tracking your unit economics.

A tool to measure early success

This is an important metric that often gets ignored by startups. It helps you determine how much you can spend on acquisition and how much you can expect in return. In short, it is an important metric to help you gauge the financial stability and financial health of your business in the long run.

Tool to tweak your model

Unit metrics are helpful as a yardstick to measure and determine if you need to tweak your pricing model, marketing budget, sales approach, or any other parameters that can help you earn more revenues.

Efficient financial planning

By combining your unit economics with your acquisition rate, you will be in a better position to do effective financial planning for your business. So, unit economics is a measure of growth for your business.

Evaluate the changes

Unit economics enables you to evaluate the changes you make to your pricing structure, marketing budget, or any other parameter. Simply determining if sales would increase or not is not as effective as understanding the LTV to CAC ratio. If there is an unfavourable change in the ratio, you need to reconsider your tactics. Thus, it can be safe to say that unit economics helps you to make an informed business decision.

Unit Economics as a Lever of Growth

Unit economics can be considered as a lever of growth or a tool to foresee if any hindrances are coming. It is that yardstick that you can use to your benefit to determine the health of your business. Keeping track of the LTV to CAC ratio is thus very important. Because if you are spending more, your business can get into serious trouble if not intervened early.

It is also easy to predict the growth of your business using unit economics. If your LTV is higher than the CAC, you are making profit from the existing customer base. If you’re able to maintain your LTV and CAC ratio, while expanding your customer base, your business is on a growth trajectory.

While unit economics helps you perfect your business growth, it also enables you to foresee any possible failure. While there can be occasional incidents where you can bear additional expenses, you can’t afford to make it a regular affair of throwing away money just for the sake of acquiring customers. At the same time, you don’t have much business traction, if you’re not acquiring customers and if your CAC value is increasing at a fast rate reaching closer to your LTV rate. Well, a failure is almost inevitable.

When you start a business or launch a new product, you need to hit a certain amount of profit when you can break even. Determining your LTV and CAC early can give you an idea of when you would be able to hit the break even. And not just that, if your units are correct, and if you track it diligently, you will also be able to predict accurately if you are in the right direction or your business decisions need some tweaks.

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An estimated unit economics measure can help you gauge how fast and how much you can spend on the marketing budget before you run out of all the funds.

Best Practices to Keep Your Unit Accurate

Unit economics is a powerful metric to help your business grow, but it won’t be of much use if you are using all the wrong metrics or if your metrics are calculated incorrectly. If you want to predict your profitability accurately, you need to be accurate with your metrics and, if required, recalculate it often.

Here are some examples to give you a better idea

Change of price

It is easy to keep track of your LTV; however, if you have done any updates in your unit economics and forget to update your unit economic calculation, then your LTV to CAC ratio will change because your LTV will be impacted. This can mislead you as your calculations will be incorrect. So, whenever you are making changes to your pricing structure, remember to feed it back to your unit economics calculation.

Capital expenditure

When you are just starting, you need to do more expenses to see growth in your business. However, an estimated unit economics measure can help you gauge how fast and how much you can spend on the marketing budget before you run out of all the funds.

Recalculate whenever costs change

Just like pricing change can affect your LTV change, similarly, when your cost changes, your CAC gets impacted too. This means if you are not feeding back the updates in your unit economics calculations, your CAC value will be impacted. To avoid any faulty calculations, make it a habit to immediately calculate any change in the cost to your unit economics. This way, there will never be a miss, and you will always be using the most up-to-date data.

Improving your unit economics

There are two ways to improve your unit economics. The first option is to cut down your sales and marketing budget. However, this can impact the growth of your business. But at times when your CAC and LTV ratio is too out of balance, cutting down the expenditure budget is a more appropriate measure.

However, it is always desirable to improve your unit economics by increasing the LTV value. You can achieve this by optimizing your pricing and reducing churn, and ensuring the customer stays for a longer time.

The Key Takeaways

Being aware of direct revenues, best pricing and costing prices, and knowing your unit economics is a must for any early-stage startup. By knowing your unit economics depending upon your business model, early-stage startups can better understand and plan their growth trajectory. Giving importance to unit economics can help identify opportunities, take care of a healthy cash flow, and overcome some of the challenges of scaling up your business.

Expert Connect

Chinmay Ananda
Business Storyteller, Financial Educator Finance Academy
Connect with our expert to assess your unit economics and plan your growth trajectory

The post How the Best Pricing and Costing Practices Can Help You Achieve Great Unit Economics appeared first on Dutch Uncles.

Understanding External Debt: All you need to know

Aakash Sharma — Fri, 26 Feb 2021 04:35:04 +0000

External debt is a national debt borrowed from foreign lenders, including commercial institutions, banks, governmental or global financial entities. The loan has to be repaid with interest applied on it over time. To even out the loaned capital, a borrower nation can adopt various repayment methods, including trade and export options for the lending country.

If a country fails to repay its external debt, it spirals down the vicious debt trap. If the state does not repay its external debt, it is declared as a defaulter on the global financial institution’s books. External loans can take the form of supplementary loans, where the borrower has to use the lender’s financing costs in the state.

How can an external debt crisis occur?

A debt crisis can arise when a country with a weak economy cannot pay off its external debt because of its incapacity to produce, sell and profit from its assets. The International Monetary Fund (IMF) is a critical organisation that supervises countries’ external debt. The World Bank issues a quarterly bulletin on external debt statistics.

If a country is incapable or unwilling to pay its external debt, it is considered bankrupt. This can lead lenders to reject future asset sales required by the foreign country. Failing to repay the loan threatens the borrower’s currency with the collapse and stagnation of its macroeconomic growth.

Source: International Monetary Fund

How do borrowers use external debt?

In addition to governments, corporations can also borrow external loans. In many cases, the external debt is tied up in fixed loans, which means that the money secured by the funding must be used in the country providing the financing. For example, a loan can allow a country to purchase its resources from the loan sanctioning country.

Foreign loans, especially this bond sort of loaning system, can be taken for specific purposes. Borrowers can use this financial support to respond to human needs or disasters. For example, if there is a drought in a country and the affected nation cannot provide emergency aid with its own funds, it can ask for the foreign debt to buy essentials from a foreign donor country. Or, when a country needs to build energy infrastructure, it can use its external debt by acquiring resources such as materials designed to produce energy in, say, an unoccupied area.

The debtor, or the entity that owes money, can be a government, business, or citizen of that country. Debt includes amounts owed by private commercial banks, foreign governments, or international financial institutions such as the International Monetary Fund (IMF) and the World Bank.

Role of principal and interest in external debt

If borrowed charges are paid regularly, as is often the case, they are called interest payments. All other expenses of financial value from the lender to the borrower that reduce the principal amount are called costs.

However, the interpretation of external debt does not differentiate between the initial payment and the payment of interest or the cost of both. Besides, the description does not indicate that involved parties must know the principal and/or interest’s future price for the obligation to be classified as debt.

Vital elements of external debt

The IMF defines the main components of external debt as the following:

Residency Clause

To be considered an external loan, the loan must be sanctioned by a non-resident to a country’s resident. Place of residence is determined by whether the centres of economic interest of creditors and borrowers are common- and not necessarily by nationality.

Current and not contingent

The definition of foreign debt does not include contingent responsibility. These are defined as contracts in which one or more conditions must be met before a financial transaction can occur. But from a weak perspective, there is analytical interest in the potential consequences of contingent liabilities in the economy, especially in institutional sectors such as government.

Generally, external debt is divided into four heads:

Guaranteed Government and State Debt: Guaranteed government and state debt encompass the long-term external responsibilities of the public sector, including the national government, state-owned companies, development banks, and other related industries.

Unsecured Personal Loans: The servicing of unsecured personal loans is the external responsibility of a private lender, which is not guaranteed by any public body.

Deposits with the Central Bank: For deposits with the central bank, commercial banks are usually required to deposit money into a central bank account. This amount is usually part of a bank’s reserve.

IMF Loans: The purpose of IMF loans is to repay member countries’ debts, stabilise their economies, and achieve sustainable economic growth. The role of solving debt crisis is at the heart of the IMF fund.

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If a country fails to repay its external debt, it spirals down the vicious debt trap. If the state does not repay its external debt, it is declared as a defaulter on the global financial institution's books.

External debt stability

Sustainable debt is the level at which the recipient can meet current and future obligations and accept redistribution or repayment to avoid arrears by allowing proper economic growth. The stability of external debt is generally analysed over the medium term.

These terms are statistical evaluations that properly consider economic variables, debt, and other indicators to determine the economy’s appropriate risk and policy adjustment requirements. In these analyses, macroeconomic uncertainties, such as the current account’s opportunity, and policy ambivalence, like fiscal policy, tend to dominate the medium-term outlook.

External debt sustainability indicators

Many indicators determine the stability and sustainability of external debt. The angles abound among economists don’t specify a single predictor for estimating the sustainability of a loan. These indicators are primarily like ratios—i.e., comparing two heads and the relation thereon and facilitating the policymakers in their external debt administration exercise.

These indicators can be thought of as dimensions of the country’s “solvency”. They consider the stock of debt at a specific time concerning the country’s ability to generate resources to repay the outstanding balance.

Examples of debt burden indicators include:

Debt to GDP Ratio: The debt to GDP ratio is an easy way to compare a country’s economic performance (measured in terms of gross domestic product) with its debt.

External Debt-to-exports Ratio: It is defined as the total outstanding debt ratio at the end of the year to the economy’s exports of goods and services for that year.

Risks associated with external debt

Foreign loans carry two main types of risks. First, as with mortgages, unexpected changes in mortgage rates can occur. This can lead to widespread insolvency if interest rates rise, for example, because debtors may not pay higher interest rates, increasing the risk of a systemic crisis.

An unexpected devaluation of the rupee could pose severe problems for Indian companies repaying loans in dollars. They would have to spend more rupees than expected to buy the currencies they need. Lenders usually take possible currency fluctuations into account when determining the interest rates for a loan. However, these predictions are not always perfect. Unexpected changes in exchange rates can still bring you incredible gains or losses.

Since the COVID-19 pandemic began, several emerging market currencies have depreciated sharply against the US dollar. The rupee, in particular, has fallen by around 7% since 2020. The devaluation of emerging market currencies is due to increased demand for dollars by investors who yearn to sell their assets in rising markets and invest in the United States, where earnings are proliferating.

Latest Data as of 2019 (Source: Govt. of India)

External debt and India

Rising interest rates could lead to larger capital outflows from emerging markets, causing unexpected changes in interest rates and rupee prices. Therefore, both the government and non-government borrowers in India are open to foreign debt and are consequently more susceptible to losses.

The Reserve Bank of India (RBI) held foreign exchange reserves as of January 2021 amounted to approximately $584 billion. This power of the central bank’s fire makes it possible to take advantage of the RBI and save troubled debtors.

We cannot conclusively state whether external debts are good or bad for a country. Taking loans from international forums and partners is a good and reliable way to raise money in emergency times. But, failing to repay those loans can prove to be fatal for countries, as is the case in many modern-day economies, like Pakistan in South Asia and Nigeria in Africa, to name a few.

Nevertheless, a well-formed national policy, leadership and international commitment are necessary to help nations and their people in need.

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