Understand and improve unit economics for profit growth

As more and more DTC retailers swap rapid growth gains for profitability levers, a new metric has emerged as the need-to-know for e-commerce managers. It’s time to get acquainted with the mother of all online fashion formulas, unit economics. 

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This crucial piece of financial data is going to help you measure profitability against product performance, and understand how your store is tracking as a business.

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Let’s get into the basics, the math, and how to improve your unit economics with insights from retail and brand specialist, Nick Gray of I Got You consultancy. 

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What is unit economics?

Unit economics for fashion and apparel brands is the revenue and costs produced by a single unit. The ‘unit’ could be a) the acquisition of one customer or b) the sale of a single SKU, and the ‘economics’ is the analysis of each unit to determine how much profit or loss it produces. Meaning, it is essentially the cost per transaction. 

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Unit economics is a critical growth metric. By staying on top of it, you can measure the turnover of your individual products to help gauge the long-term sustainability of your business model.

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Measured on a per-unit basis, with unit economics you are trying to improve the contribution margin you get from: the cost of one click, acquiring a single customer, retaining that customer, and delivering one product. That is your profit per unit, but more on the math shortly. 

For brands to attain sustainable profitability, you need to analyze contribution margin at a granular product category level, to make quick and informed decisions with real-time data. 

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Why are unit economics important?

Analyzing products down to their individual units is like scrutinizing every little cog in a big machine; it's understanding that every moving part affects your overall profitability.

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Calculating unit economics helps retailers measure profitability per unit, make long-term growth projections, ensure they get the highest return on investment for every product and take proactive moves to raise profits. 

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Long-term growth projections

Unit economics helps you accurately forecast demand for individual products. Once you know your monthly sales and revenue per item you can gather buying trends and make more informed long-term forecasts from your insights. 

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These forecasts will guide your OTB budget, help you calculate how many units you need to sell to break even or reach profitability, and inform your marketing spend. With all the necessary details on incoming revenue, you’ll be able to monitor cash flow for inventory replenishment or order volume adjustments.

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Inventory optimization

Unit economics helps you determine if a specific product is overpriced or undervalued, so you can react to maximize profits for strong sellers or increase demand for slow movers. By revealing opportunities for inventory optimization, you can refine your inventory strategies to maintain optimal inventory levels, retain as much revenue as possible and lower your unit economics for higher profits.

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Product potential

Many retailers use unit economics in the early stages of growth to inform a product’s scalability; you can quickly see what’s working and what isn’t. The early stages are when unit economics can more easily improve, however, naturally, unit economics will dive as your brand continues to scale.

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How to calculate unit economics

Units can be calculated in two ways, by one product sold or one customer gained. 

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Method 1: One product sold

You can determine product unit economics by calculating the contribution margin. The contribution margin is the revenue amount from one sale minus the variable costs associated with that sale. 

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(Price Per Unit - Variable Costs) = Contribution margin

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The variable costs can include cost of goods sold (COGS), shipping and receiving, 

pick-and-pack fees, shipping and fulfillment, and return rate relevant to your business. 

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Method 2: One customer acquired 

To calculate units by customer, you need to figure out the revenue per customer, and divide it by the costs associated with acquiring that customer. You can determine customer unit economics by calculating the ratio of lifetime value (LTV) and customer acquisition cost (CAC). 

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Unit economics = LTV/ CAC

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Where LTV =  (average purchase value x number of purchases per year x average length of customer relationship in years)

Where CAC = (sales and marketing costs/ number of new customers acquired)

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The benchmark ratio for LTV to CAC is usually 3:1. In any case, you will always want the lifetime value to be higher than what it costs to acquire them.

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How to improve unit economics

The best way to improve unit economics is to increase LTV while decreasing CAC. So, how do we do it? While unit economics is very much a numbers game, adding or increasing an emotional element and brand authenticity to your retention strategies is what will ultimately up your LTV and bring down your acquisition costs.  

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Loyalty and rewards programs and word-of-mouth referrals are a step in the right direction, however, Nick Gray, retail and brand specialist of I Got You consultancy, says brands need to go further. 

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“If brands want to gain true allegiance and loyalty they need to prioritize a deep understanding of their customers' psychometrics—such as values, lifestyles, and emotional triggers—beyond mere transactional data,” Nick explains this starts by knowing customers on an emotional level so brands can clearly define the emotion or feeling they are selling, before the product itself. 

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“By fostering genuine connections, brands can offer personalized experiences that truly resonate,” he says. Nick suggests loyalty programs should focus on rewarding behaviors that align with the brand's ethos or tailoring events to celebrate customer milestones. 

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“Trust is a huge challenge in society today so the importance of gaining trust with a customer is greater than ever,” says Nick. To encourage word-of-mouth referrals and decrease customer acquisition costs, brands should focus on practices that help build strong, lasting emotional bonds with customers throughout their journey.

• Prioritize ‘invisible PR’ by making sure staff, regardless of touchpoint, are brand ambassadors with a deep understanding of the brand's ethos in order to create strong emotional connections with customers. 
• Engage in storytelling that is focused on a brand's psychographics of personas, personalized experiences, and celebrates customers in a meaningful way to inspire genuine enthusiasm and loyalty. 
• Use customer data to tailor communications, offering the right meaningful and authentic exclusive rewards that align with their values.
• Regularly seek and act on customer feedback to demonstrate genuine care.
• Celebrate milestones and show real appreciation to foster a sense of belonging when balanced with surprise and delight.

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Examples of brands who do this well include Patagonia which appeals to a customer's shared values, like-minded beliefs, and sense of cause. The brand provides a sense of belonging and community executed through, physical stores, subscriptions, memberships, environmental activism and greater purpose. 

Nick also cites Hodinkee, a brand passionate about wristwatches. Through blogging, editorial, podcasts, and YouTube, the brand embodies a full media network and has moved to open a marketplace—trusted implicitly as the authority on watches.

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“These efforts not only help retain customers but also transform them into long-term advocates, enhancing LTV naturally and in harmony with the brand's identity, but in turn, decreases CAC.”

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Image Credit: Elle