Do Tech Startups Have High Fixed Or Variable Costs

Executive Summary

Unit of measurement Economics Measure the Intrinsic Profitability of a Company

• Unit economics are a measure of the profitability of selling one unit of your product or service.
• The way in which they tin be calculated vary according to how 1 defines a unit, merely if a unit is defined as ane sale, then the ordinarily associated metric is Contribution Margin, whereas if a unit is considered as a customer, then the nigh relevant metrics would be Customer Lifetime Value (CLV) and its relationship with Customer Acquisition Costs (CAC).
• The key distinction from other, more than traditional measures of profitability is that unit of measurement economics only considers variable costs and ignores fixed costs.
• In so doing, unit of measurement economic science tin can help determine the output level at which a business must be operating at in order to cover its fixed costs. As such, unit of measurement economics is a fundamental part of breakeven assay.

Including All Variable Costs Is Key to Getting the Analysis Right

• The nigh mutual mistake related to unit economics is omission of quasi-variable costs from the calculation.
• Variable costs are those that are direct tied to sales, and that therefore vary with output.
• While some variable costs are obviously so (east.g., COGS, shipping and packaging costs for eCommerce companies, sales costs for enterprise/B2B startups), many are not quite every bit clear and oft get archived as fixed costs mistakenly.
• Examples of such quasi-variable costs could exist: customer service representatives, the cost of returns, engineering science costs, etc.
• In doubt, founders should err on the side of caution and include every bit many costs as possible in their unit economic science assay in order to avert unwanted cash burn surprises.

Absolute Numbers Thing

• Another common fault is focusing on profitability margins and CLV/CAC ratios without remembering that the absolute numbers underlying these calculations still matter.
• Higher ticket sizes, and therefore higher absolute profits, will help companies abound more easily into their fixed cost base of operations, which are ofttimes like regardless of the ticket sizes involved.
• This is specially true since in reality there is no such affair every bit a stock-still cost. All fixed costs vary with output to a certain degree, meaning that very small absolute profits make it more difficult to catch up with fixed costs as output grows.

Scaling Unprofitable Businesses Doesn't Make Sense

• With the frothy market conditions, the amount of founders pitching businesses that are unprofitable on a variable price footing has increased dramatically.
• Banking on improvements of 1's unit economics with scale is a risky strategy. Prices are sticky, customers are less loyal than ane might promise, and cost rationalization becomes hard once company processes and teams have been in place for a certain amount of time.
• The whole point of unit economic science analysis is to show profitability on a variable cost footing so that ane tin foresee a apparent path to profitability. Information technology's fine for startups to lose money at start, but there needs to be scope to grow into a company'south stock-still cost base. If a company loses money before fixed costs, the scope to do so is far more than express (if not impossible).

Study Your Unit Economics to Maximize Your Chances of Success

• Hire an interim CFO to assist assess your business' intrinsic profitability prospects, and more importantly, how you can improve your chances of breakeven. The best investors will await out for this type of assay, making your chances of raising funding far greater.

In 2010, xx venture capital funds had invested in the so-nascent on-need infinite. Over the following five years, that number exploded to more 200, with "Uber-for-X" businesses cropping upwardly in near every unmarried vertical imaginable. 1 of the nearly prominent verticals in the on-demand infinite was nutrient delivery. Some companies (DoorDash, Postmates, Caviar) delivered food from restaurants that didn't accept their ain couriers. Some (Spoonrocket, Sprig) made the meals themselves. Others (Munchery, Blueish Apron) delivered repast kits that were either ready to be heated, or had to be cooked by the client. Whatever the spin, the concept was elementary: Permit customers to society nutrient via an app, deliver it (relatively) fast, sit back, and watch the business scale.

But equally is often the instance, the hype wore off, and soon many of the well-funded startups started to close down. The New York Times proclaimed the "cease of the on-demand dream" while Pandodaily chronicled the coming "food-pocalypse". In a May 2017 article, Quartz quipped "For years now, nosotros accept been living in a gilt era of VC-subsidized meals. As startups piled into the nutrient delivery space, they showered customers with coupons and promotional offers made possible by generous investor financing…[But] It seems that in the finish people were less excited about the speed, convenience, and slick interfaces…than they were nearly having their meals delivered for absurdly low prices. In that sense the last iii years take been less an innovation than a giant wealth transfer, from the VCs and startups they funded to the lucky consumers who got a costless lunch along the way."

What happened? Unremarkably, the reasons why startups close down are many and varied, but in this case it seems fairly clear that i reason stood out above them all: poor unit economics. On-demand nutrient delivery startups were simply not profitable and couldn't make their business models work, even at scale.

In an age when profitability is almost a muddy word amongst startup founders, the fate of the food commitment market should serve as a useful reminder that profit margins, even in Silicon Valley, still matter. Legendary venture capitalist Bill Gurley said and then himself, in an ominous interview in 2015: "Ane thing that happens in Silicon Valley—and this has been highly cyclical—the more we go into peak-y [valuations] territory, the more than optimistic we get about business models that are lower margin."

But investing in and scaling unprofitable businesses doesn't make sense. If a concern loses money on every auction, and so growing that business will only increment the corporeality of money that is lost. And yet I am continuously surprised by the number of founders who fail to internalize this. Having founded and sold an eCommerce company, and then moved over to the investing side, I encounter time and fourth dimension again how startup founders embrace the "scale it first, arrive profitable afterward" mentality without spending whatsoever time thinking about whether their business can really e'er be profitable.

The betoken of this article is to phone call attention back to this, and in item to i of the nearly useful ways startup founders can think about their business organization' potential profitability: unit economics. By running through some of the biggest issues I've encountered, I hope to impart some useful information, not just then founders can improve their prospects of fundraising, merely more importantly and then that they tin brand informed decisions most whether they should really be investing years of their lives at farthermost personal and fiscal cost into businesses that might never make any coin.

What Are Unit Economic science and Why Are They Important?

Simply put, unit of measurement economic science are a measure of the profitability of selling/producing/offer ane unit of your product or service. If yous're a widget company selling widgets, the unit economic science will be a human relationship betwixt the revenue you receive from selling a widget and all the costs associated with making that sale. For companies offering a service, for instance Uber, the unit economics volition exist the human relationship betwixt the revenue from their service (e.g., ane taxi ride) vs. the costs associated with offer and servicing the customer.

At a high level, the signal of unit of measurement economic science is to understand how much profit a business makes before fixed costs so that i can estimate how much a business needs to sell in gild to comprehend its fixed costs. Unit economic science are thus a fundamental role of breakeven analysis.

For startups who are still in growth mode, this sort of analysis is crucial. It charts a path that the visitor tin follow in order to wean its way off external disinterestedness funding. Effigy 2 below displays this graphically. As volumes increment, profits before stock-still costs (named "contribution" in the nautical chart) tick upward and to the correct, eventually crossing paths with the stock-still price line. The point in which they cantankerous is the breakeven point.

Going deeper, there are two ways one can approach the adding of unit economics, and the key differentiating factor is how one defines a unit. If 1 were to define a unit of measurement as one detail sold, and then the unit of measurement economic science becomes a calculation of what's unremarkably referred to as the contribution margin. Contribution margin is a measure out of the amount of revenue from one sale that, once stripped out all the variable costs associated with that auction, contributes toward paying fixed costs.

Contribution margin = Cost per unit - variable costs per unit of measurement

If instead one defines a unit as one customer, then the commonly calculated metrics are client lifetime value (CLV) and its relationship with customer conquering costs (CAC). In essence, these are the same every bit contribution margin, in that they limited the profitability of one customer vs. the cost of acquiring said client. But the main difference is that they are non fixed in time. Rather, CLV measures the total profit generated by a customer throughout the lifetime of that client's relationship with the company. The reason this is of import is that startups naturally take to invest in acquiring customers, often at a loss on the kickoff sale. Simply if the customer makes multiple transactions with the company in fourth dimension, the visitor will exist able to recoup, and hopefully brand a substantial return on the initial investment.

A more than detailed explanation/tutorial of what unit economics are and how to calculate them are beyond the scope of this article. But for those who are new to unit economic science and how to summate them, here is a good introductory post on contribution margin, and here are two on CLV and CAC. The latter are admittedly more focused on eCommerce, but the general principles stand up for any business. And in whatsoever case, the web is awash with tutorials on how to calculate these metrics. For those who want to actually nerd out near unit economics, I recommend reading Peter Fader'southward work, widely considered the guru on the subject (and incidentally, my erstwhile business organization school professor).

Common Mistakes Founders Make with Unit of measurement Economics

To be fair, most founders practice have a basic understanding of unit of measurement economics and usually include this as function of their conversations with investors. Many startups in fact focus their entire value proposition around improvements in the unit economic science of their vertical, common examples existence the direct-to-consumer startups that we recently covered in a fascinating commodity on the mattress manufacture.

Just what has often surprised me is the level of superficiality with which founders in many cases approach the subject. They practise the assay because they have to, but don't really internalize what unit economics aim to appraise and why they are important. In particular, I've encountered three common sets of mistakes that founders brand, and I've chosen to accost these in greater item in this article. (northward.b., There are a surprisingly loftier number of investors who besides don't understand these principles.)

Understanding Which Costs Are Truly Fixed vs. Variable

Past far, the biggest fault people brand when performing unit of measurement economic analysis relates to the cost side of the equation. Equally nosotros saw to a higher place, whether y'all're just calculating your contribution margin or whether you're doing a more ROI-based CLV/CAC analysis, a vital function of the equation is what costs yous choose to discount from your acquirement. In principle, the dominion is simple: Unit economics just considers variable costs, not fixed costs. But in practice, the distinction betwixt fixed and variable costs is often non so straightforward.

The textbook definition of a variable cost is that variable costs are those directly associated with sales. Variable costs therefore vary according to the volume of output. Common examples of variable costs are cost of goods sold (COGS), things like aircraft and packaging costs for eCommerce startups, or sales costs for enterprise/B2B startups.

But while some costs are obviously variable, others aren't quite as articulate-cutting. The price of providing client service is a common area of confusion. For many startups, the ability for customers to speak to a customer service rep is crucial, and thus becomes a vital role of the sales procedure. In such situations, customer service should be accounted for as a variable cost, especially since the size of the customer service squad will naturally expand every bit sales volumes aggrandize. The growth in customer service may not be 1:i, but the relationship is in that location, making this a variable price that must be deemed for in unit economics analysis.

At that place are a multitude of other "quasi-variable" costs that often go mistakenly archived as fixed. For eCommerce companies, for case, the cost of returns is a proficient example. Since many eCommerce companies offer free returns, and since all will take some level of returns per X number of sales, this therefore becomes a variable cost that again must be included. Technology costs are some other case. In that location are many types of technology costs (east.g., server costs, software costs) that vary as sales and output increment.

Being thorough most including all variable costs in an assay of unit economics is vital because this can make a very cloth difference to the breakeven scenarios. Permit's look at an instance to illustrate the betoken. Sofas.com is a fictional company selling sofas online. Their contribution margin calculation is shown in the table beneath. Equally 1 tin see, sofas.com has a fairly straightforward business. For each sofa it sells, the visitor incurs four standard variable costs: COGS, shipping and packaging costs, and the payment processing costs of the payment provider it uses (e.thou., Stripe or PayPal). With these variable costs, sofas.com seems to have a very healthy contribution margin of 38%. Assuming fixed costs of $50,000 per year and a linear growth trajectory, they would break even somewhere in Yr 2. Not bad.

But if nosotros at present include other variable costs such as client service, returns, and server costs, the picture changes substantially. The company's breakeven moves out by 2 years!

My proposition to founders, when in doubt, is to err on the side of caution. Include as many costs as yous can in your unit economics. That mode, you'll only receive positive surprises rather than the other way effectually. It likewise forces you to pay attention to costs that you lot'd otherwise never recollect about since in the first ii to iii years you'll spend footling fourth dimension thinking near stock-still costs. If you lot mistakenly account for certain costs every bit stock-still, yous'll find yourself further down the line struggling to understand why you're cash fire isn't looking similar what your business concern plan was projecting (trust me, I'k speaking from experience).

Accented Numbers Matter

Another common mistake founders make in their unit of measurement economics analysis is forgetting that absolute numbers affair. Information technology tin be tempting to focus exclusively on contribution margins every bit percentages or on CLV to CAC ratios. Just the bespeak is that larger accented numbers tend to be very helpful! A large share of a pocket-sized number may terminate upward being less than a small share of a large number, and that matters when the fixed costs involved are the same in either scenario.

Let'due south stick with sofas.com as our example to illustrate the point further. Imagine that sofas.com is but getting started, and has decided to only sell one type of sofa to brainstorm with. The first option is a compact sofa made with cheaper fabrics that retails at $500. Direction believes this volition retail well with younger professionals who are just moving into their offset apartment. The alternative would exist to sell a much larger L-shaped sofa made from premium fabric which retails at $900 but only appeals to a smaller set of wealthier customers. The compact sofa has gross margins of 55% because the supplier is based overseas, whereas the larger sofa has much lower margins of 40% because the supplier is local and much of the work is done by hand. Given the larger margins and the bigger addressable marketplace, sofas.com may exist tempted to choose the compact sofa to start. But what they're forgetting is that their stock-still cost base is going to be exactly the same in both scenarios: they're going to need the aforementioned size of office and the same size of squad. Even accounting for a larger volume of initial orders and higher growth for the compact mass-market sofa, sofas.com may be better off selling the larger, more expensive sofa.

The overarching point well-nigh absolute numbers being important matters particularly because in reality, in that location is no such thing as a stock-still toll. Over the long term, all costs are variable. They just vary at unlike rates and on dissimilar schedules. Consider the cost of an function, the about commonly cited fixed cost: while the function may exercise for several years, as a businesses grows, it will at some betoken demand to expand to larger offices. Same thing with supposedly fixed costs such as the size of your tech squad. Just compare the size of the tech team at a large, Series C funded tech company versus a small Serial A funded i. I guarantee you lot that the Series C funded company will have a considerably larger tech team.

So if stock-still costs are never really stock-still, selling products or services with large ticket sizes and therefore larger accented profit numbers helps add more cushion to back up the fixed toll base, making the promise of profitability that much more tangible.

Non All Cash Burn Is Created Equal

The third big result I see related to unit economics is more than fundamental, and pertains to a misunderstanding of the principles behind cash burn in startups and growth businesses. Taking a step back, why is it acceptable to burn cash? Why would VCs fund unprofitable businesses? Why would founders invest their time and free energy into businesses that don't brand money?

In that location are fundamentally two reasons why it makes sense for both parties (direction, investors) to back an unprofitable business.

Level up: The first acceptable scenario is when there has been an investment into a fixed asset (say, a slice of expensive machinery or the salaries of an expensive team) that makes the business organisation unprofitable at its current output levels just allows the business to abound to a much larger output level than information technology otherwise would accept been able to operate at. When the business eventually reaches this larger output level, it volition be very profitable, maybe more so than prior to the investment. In other words, you level up.

Get faster: The second reason is that both parties may simply exist interested in reaching larger levels of output more quickly. The business could reach those output levels organically on its own, just it would have much longer. If management is willing to sacrifice office of their ownership in their business concern to go faster, then it's a mutually beneficial organisation for both parties.

Looking at the scenarios in a higher place, both imply investments, and consequently increases, in the stock-still cost side of P&L, rather than the variable price side. So called-for greenbacks because your business incurs larger stock-still costs than your contribution or operating profit can sustain can be acceptable so long as in that location is a realistic path of growth and that, at some point, your contribution/operating profits will exceed the fixed costs and the business organization model makes sense again.

If you wait at large public (or even private) companies, none of them do unit of measurement economics assay (at least not publicly. They may practise and then internally just for reasons that are across the scope of this article). They do fiscal analysis the old-fashioned way, using P&50 statements, cash flow statements, etc. The reason is uncomplicated: For larger, more than established companies, the distinction between fixed and variable costs is irrelevant. They demand to cover their costs, no matter what type they are.

Unit of measurement economic science analysis exists precisely because startups plough this on its caput and instead comprehend a strategy of cash burn in the initial years to reach profitability afterwards. But how practise you lot show an investor that your business, which is burning cash now, will at some point stop burning cash? Unit of measurement economics. Unit of measurement economics analysis tin can illustrate in a articulate and believable way that your visitor is intrinsically assisting, and that you lot just demand greater volume to cover your fixed costs.

With all this in listen, it baffles me when I see pitches for startups that are not profitable (or barely) on a variable cost basis. Showing a unit economics slide that omits key costs, or worse nonetheless, that is negative, completely defeats the purpose of such analysis.

To be fair, there are certain situations in which razor sparse (or fifty-fifty negative) contribution margins might make sense. Here are some:

1. Economies of scale: There are situations in which sales volumes brand a material impact on your unit costs. An case would be in COGS, where retail businesses typically receive far more favorable terms from their suppliers at larger output levels.
2. Loftier ROIs on marketing: Certain businesses reap substantial returns on the acquisition of new clients over the lifetime of such clients. Investing in marketing, and thus losing money on a unit ground at first, may brand sense so long every bit that investment returns significantly more in time. I needs to be certain about the ROI of this marketing expense, and CLV/CAC analysis is one way of assessing whether this strategy may make sense.
3. Investing in customer service/loyalty: Similar to the above, sure businesses may be able to run thin margins on their first sale to a customer, considering doing and so creates loyalty and therefore increases the ROI of that customer.

Merely the above are all much riskier strategies than if your concern had strong unit economic science. So many things can go incorrect. Customers are never as loyal as yous think. Your ability to upsell or increase prices is far more limited than you might expect, peculiarly if you've acquired customers on the basis of discounted offerings, making them more sensitive to price than you'd like. Cutting costs and replacing people with technology is much more than complicated than yous anticipate. All of the common defenses of poor unit economics are relatively weak, and building your entire concern case on these is a very risky path to take.

If you don't believe me, here are some very well-respected and knowledgeable people who call back the same.

One of the jokes that came out of the 2000 bubble was nosotros lose a picayune coin on every customer, only we make it up on book…In that location are now more than businesses than I e'er remember to explicate how their unit economics are ever going to make sense. It usually requires an caption on the order of infinite memory ('yes, our sales and marketing costs are actually high and our almanac profit margins per user are thin, but we're going to continue the client forever'), a massive reduction in costs ('we're going to replace all our human labor with robots'), a claim that somewhen the visitor can stop buying users ('we acquire users for more than than they're worth for now just to go the flywheel spinning'), or something even less plausible…

Virtually great companies historically take had good unit economics soon after they began monetizing, even if the visitor as a whole lost money for a long period of time.

Silicon Valley has e'er been willing to invest in money-losing companies that may eventually brand lots of money. That's keen. I have never seen Silicon Valley and then willing to invest in companies that take well-understood financials showing they volition probably ever lose money. Low-margin businesses take never been more fashionable here than they are right at present.

– Sam Altman, President, Y-Combinator and Co-chairman, OpenAI, Unit Economics

There'south been a lot of talk coming out of silicon valley lately virtually fast growing companies with loftier valuations that are going to face problems in the coming year(due south). But how is this going to happen? The almost likely scenario is the matter that has been driving growth (and valuations) for these companies ultimately comes abode to roost. And that is negative gross margins. We have seen a tremendous number of high growth companies raising money this year with negative gross margins. Which means they sell something for less than it costs them to get in….Why would [they] take this approach? To build demand for the service, of course. The idea is become users hooked…and so…take the price upwardly…

The thing that is wrong with this strategy is that taking prices upwards, or using your volume to drive costs down, in order to get to positive gross margins is a lot harder than nearly people call up….

[M]ost of the companies out there who are growing like weeds using a negative gross margin strategy are going to find that the capital markets will ultimately lose patience with this strategy and force them to get to positive gross margins, which volition in turn cut into growth and what we volition be left with is a ton of flatlined naught gross margin businesses conveying billion dollar plus valuations.

– Fred Wilson, Co-founder, Union Square Ventures, Negative Gross Margins

It's like the old adage, [when you're] handing out dollars for 85 cents, you can go [infinitely]…Chosen unicorns are existence given hundreds of millions of dollars, but you have to ask how much margin is there. The unit economics would be very difficult, I'd think…It'southward like, the last time, all this Postmates and Shyp stuff happened [in] '99, with [the failed online delivery startup] Kozmo, [and] it'south the same shit. Information technology's the aforementioned shit…The question for all of those things has to do with core economics that'll exist proven out over time.

– Bill Gurley, General Partner, Benchmark Capital, Interview

Editor'south annotation: Shyp has since shut downwardly ($50m in funding, valuation of over $250m), and Postmates has been through severe funding struggles.

Don't Calibration an Unprofitable Business organization

Hopefully the message I'one thousand trying to pass on is articulate. If not, perhaps the story of one of the many failed on-demand nutrient commitment startups may aid drive the message home. Bento, a startup launched in 2015 that delivered customizable "bento boxes," raised $2 meg in seed majuscule after an on-stage pitch at one of the more than popular startup events in San Francisco. But but a few months later they launched, Bento realized they were burning 30-forty% more than cash than they had originally anticipated. It was strange, because the company was growing at an incredible rate of 15% per week. After looking at the numbers in greater particular, the respond became clear: Bento was selling their boxes for $12, only information technology was costing them $32 to make each box. Factoring in the costs of the kitchen staff, the equipment, the ingredients, the drivers, and so on, Bento was losing $20 on every sale.

Running out of greenbacks fast, Bento managed to cobble together $100,000, embark on a rigorous cost cutting practice which included firing all the kitchen staff and pivoting the business to a catering model. But the new model came with a new prepare of issues. "It went OK, it grew, but it didn't grow like crazy," founder Jason Demant recalled. "I think what ultimately happened is we traded ane trouble for another, while operationally and from a unit economics standpoint information technology was better for the concern, it was less appealing from a consumer perspective…Information technology still wasn't plenty. While nosotros hitting profitability toward the terminate of the year, margins were sparse, nosotros didn't have a upkeep to rent a management squad or do R&D and really burned through our upper-case letter." Bento eventually shut downwards in January 2017.

Reflecting on the experience, Demant conceded "I mean, it's well-nigh a piddling embarrassing—because I should have been watching [operation costs], especially in an operationally-intensive business like this…What nosotros have learned in the concluding year basically tells united states of america the fashion that we started the business was f***ing stupid."

Don't calibration an unprofitable business. Study your unit economics, make certain you're contribution margin positive, and go on a close centre on your variable costs.

Do Tech Startups Have High Fixed Or Variable Costs,

Source: https://www.toptal.com/finance/interim-cfos/unit-economics

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