My product management toolkit (25): understanding the “unit economics” of your product
As a product manager it’s important to understand the unit economics of your product, irrespective of whether you’re managing a physical or a digital product. Unit economics are the direct revenues and costs related to a specific business model expressed on a per unit basis. These revenues and costs are the levers that impact the overall financial success of a product. In my view there are a number of reasons why I feel it’s important for product managers to have a good grasp of the unit economics of your product:
- Helps quantify the value of what we do — Ultimately, product success can be measured in hard metrics such as revenue and profit. Even in cases where our products don’t directly attribute to revenue, they will at least have an impact on operational cost.
- Customer Value = Business Value — In an ideal world, there’s a perfect equilibrium between customer value and business value. If the customer is happy with your product, buys and uses it, this should result in tangible business value.
- P&L accountability for product people (1) — Perhaps it’s to do with the fact that product management still is a relatively young discipline, but I’m nevertheless surprised by the limited number of pr0duct people I know who’ve got full P&L responsibility. I believe that having ownership over the profit & loss account helps product decision making and and accountability, not just for product managers but for the product teams that we’re part of.
- P&L accountability for product people (2) — Understandably, this can be a scary prospect and might impact the ways in which we manage products. However, owning the P&L will (1) make product managers fully accountable for product performance (2) provide clarity and accountability for product decisions, (3) help investments in the product and product marketing and (4) steep product management in data, moving to a more data informed approach to product management.
- Assessing opportunities based on economics — Let’s move away from assessing new business or product opportunities purely based on “gut feel”. I appreciate that at some point we have to take a leap, especially with new products or problems that haven’t been solved before. At the same time, I do believe it’s critical to use data to help inform your opportunity assessments. Tools like Ash Maurya’s Lean Canvas help to think through and communicate the economics of certain opportunities (see Fig. 1 below). In the “cost structure” part of the lean canvas, for example, you can outline the expected acquisition or distribution cost of a new product.
- Speaking the same language — It definitely helps the collaboration with stakeholders, the board and investors if you can speak about the unit economics of your product. I know from experience that being able to talk sensibly about unit economics and gross profit, really helps the conversation.
Now that we’ve established the importance of understanding unit economics, let’s look at some of the key components of unit economics in more detail:
Profit margin per unit = (sales price) — (cost of goods sold + manufacture cost + packaging cost + postage cost + sales cost)
Naturally the exact cost per unit will be dependent on things such as (1) product type (2) point of sale (3) delivery fees and (4) any other ‘cost inputs’.
In a digital context, the user is often the unit. For example, the Lifetime Value (‘LTV’) and Customer Acquisition Cost (‘CAC’) are core metrics for most direct to consumer (B2C) digital products and services. I learned from David Skokand Dave Kellogg about the importance of the ‘CAC to LTV’ ratio.
Granted, Skok and Kellogg apply this ratio to SaaS, but I believe customer acquisition cost (‘CAC’) and customer lifetime value (‘LTV’) are core metrics when you treat the user as a unit; you’ve got a sustainable business model if LTV (significantly) exceeds CAC. In an ideal world, for every £1 it costs to acquire a customer you want to get £3 back in terms of customer lifetime value. Consequently, the LTV:CAC ratio = 3:1.
I’ve seen companies start with high CAC in order to build scale and then lower the CAC as the business matures and relies more on word of mouth as well as higher LTV. Also, companies like Salesforce are well known for carefully designing additions (“editions”) to increase customer lifetime value (see Fig. 2 below).
Netflix are another good example in this respect, with their long term LTV view of their customers. Netflix take into account the Netflix subscription model and a viable replacement for another subscription model in cable. The average LTV of Netflix customers is 25 months. As a result, Netflix are happy to initially ‘lose’ money on acquiring customers, through a 1-month free trial, as these costs costs will be recouped very soon after acquiring the customer.
Main learning point: You don’t need to be a financial expert to understand the unit economics of your products. Just knowing what the ‘levers’ are that impact your product, will put you in good stead when it comes to making product decisions and collaborating with stakeholders.