How's business? Good? How can you tell? Intuitively, humans use ratios determine value. If I put $15k into getting a car, am I getting more value than that back? Businesses tend to operate the same way. If I spend $10k on sales and marketing to generate $20k in revenue, is that a healthy business? Some might say yes, but you can't actually know based on just that. You might say "good" in response to a passing question, but to know how healthy your business really is you need to put the right variables on the right sides to make the right ratio.
People use the term "ROI" or "Return On Investment" very loosely. If you want to be able to see the "ROI" on, say, your ecommerce marketing team's pay-per-click campaign, you can't just look at the number of sales and the amount you've spent in total. While total profit-and-loss is useful for business owners to make sure they can keep the lights on, in order to know how healthy your business is and whether or not you can grow it, you need to consider the unit economics of your business.
Unit economics might sound fancy, but it's a really simple concept. Essentially, it's how much you put in to getting one "unit" and how much profit you get back from it. If you think of your business as a money machine, unit economics answer the question of whether putting more money into acquiring more "units" will help you grow your overall revenue. It's an important metric to figure out how fast, if at all, you can grow your business.
I kept putting "units" in quotation marks because what you look at as your unit of economic value can significantly change how you approach growing your business. We wrote about Southwest Airline's model and how that may have led them to ignore potential revenue sources because the revenue wasn't helping them build a healthy, sustainable business. Below we'll cover two different ways to look at your unit economics: transactional (solving for the sale) and customer centric (solving for the customer).
Transactional Unit Economics
I remember someone once described selling through marketplaces, like Amazon.com, as the most addictive experience in the world. You just list your products and transactions start flowing in. This is part of what leads so many ecommerce marketers to invest heavily in multi-channel strategies centered around marketplaces.
Transactional unit economics are expressed using a simple ratio:
Cost Of Transaction Acquisition (COTA) : Average Order Value (AOV)
This can be read as: "For every dollar I put in to acquiring a transaction, I get $X back." So, for example, if you spend $100 on your PPC campaign and get one transaction where the average customer orders $200 worth of products, your ratio is $100:$200 or 1:2. Not bad! If I said to you "give me a dollar and I'd give you two dollars back" you'd probably be pretty happy with our friendship.
For the sake of whole numbers, there's nothing wrong with flipping that ratio around and using AOV:COTA which, from our example, would give you a nice round ratio of 2:1 (which you can reduce to a nice, clean "2"). It messes up the nice visualization of putting money in to get money back, but it's really up to you. Whole numbers are valuable for lots of things, including cool graphs and charts where ratios can't really be plotted on an axis, but that's a topic for another day.
Customer Centric Unit Economics
Every year we conduct our annual "State of Inbound Marketing" report. One of the most interesting metrics that I found in our report was that 50% of marketers consider themselves to be a "customer centric" company. There is, however, a huge flaw with that response. Although it may make marketers feel warm and fuzzy to call themselves "customer centric", are they really?
What makes an ecommerce marketer "customer centric"? I'd argue that, simply, you can't call yourself a customer centric marketer unless the customer is a unit of economic value that you're solving for with your marketing efforts. There's great power in how you end the phrase "Solve for ______". You can say solve for revenue, solve for market share, solve for AOV:COTA, or -- as a customer centric company would -- solve for the customer.
Customer centric unit economics, therefore, are expressed using a slightly different ratio:
This can be read as: "For every dollar I put into acquiring a new customer, I get $X back over the course of their life time." So if, for example, you spend $1,000 on a PPC campaign where 5% of the visitors turn into pre-transactional contacts and 10% of those turn into customers, your CoCA is $400. If the average customer spends $4,000 with your company over their lifetime (which isn't a stretch -- check out the average LTV of a Starbucks customer) then your CoCA:LTV ratio is $400:$4,000 or 1:10 (or just 10 if you want to use whole numbers).
You can see how this analysis of unit economics might change your approach to marketing. If you're a marketer at Starbucks, are you going to spend $400 to acquire a $5.90 AOV? Probably not. That's an absurdly bad ratio. But, you'd definitely be willing to spend $400 to acquire and maintain a $14,099 customer -- right? Of course.
This ratio also opens up a whole new universe of marketing activities that can contribute to the overall health and growth of the business. LTV has many more contributing variables than CoTA and therefore opens up significant growth opportunities for CoCA costs than are allowed in the CoTA:AOV calculations. For example, many ecommerce companies invest a lot of time and money into lowering their CoCA by minimizing PPC costs, avoiding long-tail strategies like blogging, and avoiding expenses in rich media like video or educational content. Instead, ecommerce marketers can focus on raising the LTV of their customers by improving their ability to up-sell, cross-sell, and re-sell additional products though a targeted and contextually relevant experience for each of their customers.
Ecommerce marketers are going to have to start thinking in terms of CoCA:LTV. It's simply implausible that you're going to win the CoTA:AOV battle against low-margin competitors, especially against marketplaces like Amazon. The problem with playing the price competition game is that there's always someone willing to make less money than you. If you want to build a healthy, sustainable business, you have to out-leverage your competitors (including sites like Amazon) in growth costs by investing in growing customer LTV.
Photo credit: TheBostonChow
Originally published Oct 24, 2013 10:00:00 AM, updated January 18 2023