“Take care of the pence, and the pounds will take care of themselves.” A phrase attributed to William Lowndes (1652-1724) has been resonating in my mind. Due to the current Covid-19 pandemic, most businesses and individuals have experienced a sharp contraction in income. Personally, this crisis has made me re-examine my spending habits and deeply understand the costs of essential needs while learning to prioritize these needs. Businesses are no different. To grow, especially during trying times, it is critical for entrepreneurs to have a strong grasp of the costs and profitability of producing one unit of a product or delivering a service. This is called unit economics.
Understanding Your Costs
Andrew Carnegie updated Lowndes’ quote to, “Watch the costs and the profits will take care of themselves”. To begin understanding profitability, you need to be able to determine if a cost is fixed or variable. Fixed costs are costs which do not change due to the number of products produced for sale. Variable costs, however, change in line with the number of products produced.
Many business leaders do not have a clear understanding of the difference between fixed and variable costs. It is important to note that fixed cost does not mean that the amount payable will always be the same – it is just that the cost itself does not vary with the volumes produced. For example, imagine that you run an enterprise that leases office space to other businesses. Your electricity bill is a fixed cost, but the amount payable will vary from month to month. On the other hand, the monthly rent payable for your office space will be the same in accordance with the lease agreement. Or, in another example, if you manage an enterprise that manufactures doors and window grills, you might view the electricity usage as a variable cost. Though most businesses have similar fixed and variable costs, there will be differences due to the structure or type of business.
No matter what your business structure looks like, it is important to identify the units your business will use. So what is a unit? If your business makes cakes, one might say they want to identify the cost to make one cake. However the cakes come in different sizes, so it would be better to determine the cost per kilo of cake. For a milk distributor, a litre might be the right unit to measure. Businesses providing services rather than products also need to identify their units. A financial consulting business could use hours, an event provider might use events, whereas a school would determine their cost per student. When the unit is defined, it becomes easier to identify costs as either fixed or variable.
Calculating Your Cost Per Unit
Profit is the difference between revenue (the income you generate) and costs (the expenses of running your business). If you want to be more profitable, you need to have a clear understanding of your cost per unit. This is the amount of money you spend to produce each unit of product. Knowing that amount helps you determine how many units you must sell to cover fixed costs. Did you know that some businesses actually lose money every time they make a sale? How is that possible? When the variable costs of producing a product or service are greater than the revenue generated by that sale, the business loses money from each new sale. The sale of every unit must positively contribute to paying for fixed costs and ultimately generating profit. When entrepreneurs do not understand their unit economics, they can sell themselves into bankruptcy. Understanding and applying these concepts is essential to evaluating a business model, projecting breakeven, and setting profit targets.
Now that you understand the costs and units of your business, how do you grow your profit? To begin, you must understand your current market. What elements are driving up your costs of production? Are there any opportunities to save money on fixed costs, such as electricity? Are there ways to minimize key variable costs? Once these questions are answered, you can make informed decisions that will increase your profit.
The Covid-19 crisis offers an important opportunity to reassess your unit economics or perhaps apply these concepts for the first time. You might begin by re-thinking your unit(s) or cost model. Where does your business spend money? How will you divide your products or services into units? When you make a sale, is this making a positive contribution to covering your fixed costs?
Evaluating questions like these may take work, but the positive effects for your business are well worth it. Additionally, potential investors will expect you to know these details. It is vital to stay prepared for investment opportunities during hard economic times. Examples like these show why applying unit economics means so much more than calculating numbers. These ideas help you achieve success in many areas of your business, and ultimately, fulfill your goals as an entrepreneur.
by Monica Mumbi Wahome
Monica is a Sinapis trainer, Fellow of Chartered Certified Accountants (UK), budding entrepreneur and most important – follower of Christ. She is committed to helping entrepreneurs grow through supporting them in finance and strategic thinking. She loves finding ways to connect and inspire people.