This is CFO Secrets. The weekly newsletter that remembers when the Big 4 were the Big 5

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In Today’s Email:

• 💰Unit Economics - Bringing it all together

• 👨‍👨‍👦‍👦 An Auditor, A 4 Year Old & The Backstreet Boys

• 💉Turnarounds, where to start

THE DEEP DIVE

Unit Economics; How to make sure profits grow faster than volumes

Note - This post assumes knowledge from the following previous posts:

• Cost Behavior

• Marginal Contribution

Unit economics.

The science of how your business makes money.

I’m lucky to have worked with a great number of business rockstars in my career. High profile CEOs, billionaire founders, brilliant finance pros.

Each of them had one skill in common.

They were jedis of unit economics.

The back of an envelope math that drives how a business makes money and generates cash.

In this post we will step through unit economics. First in theory, and then into more practical applications.

The Theory

Unit economics = incremental marginal contribution generated for each individual unit sold.

Marginal contribution per unit = revenue per unit less variable costs per unit.

Articulating this in a simple statement for your business is crucial.

Example for a DTC business selling one product; e-Scooters manufactured in house:

Note: the analysis ignores cost classification; gross margin vs opex. Instead it focuses on cost behavior (fixed vs variable).

Now you can build a profile of how operating income moves with sales volume:

This gives clean lines, and solving for different volume points is straight forward.

Once plotted against a range of unit volumes you can quickly see where the Breakeven volume is. Somewhere between 200 & 250 units per month.

This becomes a helpful maxim in the business:

“We need to sell 8 scooters per day to breakeven”.

Or

“To hit our target of $50k profit per month, we need to sell 400 scooters per month, or 14 per day.”

Feels manageable. Understood by anyone.

Calculating the breakeven point precisely is easy, once you’ve done the work above.

Breakeven Volume for Period = Fixed Cost per Period / Contribution Per Unit

Straight forward enough.

But there’s a problem…

Unit Economics in Practice

The theory assumes that your costs play fair and self identify as either fixed or variable.

As we said in Issue 6 - that is not the case. Nearly all costs are 'mixed'. They have at least some component that is fixed and some component that is variable.

This is where the science can run away a bit. Costing models can get extremely complex, and will vary by industry.

Complexity can mean more accurate outputs. But its also can be alienating for those that didn’t build it. I see lots of finance folk fall in this trap.

And these are managerial tools remember.

They are designed to drive behavior and improve profits.

They must be accessible. Actionable > perfect.

Here’s a more practical way to look at it

It's true that all costs have a fixed and variable component at some level. But there is normally a relevant range of units within which a cost can be assumed to be either fixed or variable.

Let’s say for our scooters that it is unit increments of 50 per month.

From here you can scale out the cost dynamics at each step of 50 units per month. Rather than theorizing. We can draw out exactly what we expect our cost structure to look like at each volume step.

I call this a Volume Step Cost Analysis:

Note the units on the horizontal access are units sold not time. The time period is fixed.

The assumptions that sit underneath the above example:

• Increased scale will improve the unit cost prices of materials, and conversion efficiences

• After 250 units per month we are able to yield some labor productivity efficiences

• Up to 150 units we are outsourcing assembly (no rent and utilities, but higher other variable). After 200 units we insource, incurring property costs, and reducing other variable costs

• We will need to step in more salaried cost at higher volume levels

• 500 units per month is a ‘tipping point’. To hit and service these levels of volume we need to step in much more fixed cost ($85,000 to $118,000 per month)

• For this illustration it is assumed that the net revenue per unit is flat at $500. In practice we might reduce prices to pass on some of our efficiencies and drive higher volumes.

And how do you calculate a Volume Step Cost Analysis?

For each cost step, ask yourself, how would I operate at this level of volume in the cheapest way possible? If you don’t know the answer, find out. Speak to suppliers, examine your capacities, do the math.

Remember what I said:

Every rockstar i’ve ever worked with can do this on a napkin. Often in extraordinary detail for their business.

Now lets look at the unit economics for this step analysis:

Notice, there are scale points at which our profitability falls despite higher unit volume. E.g. 350 to 400, and 450 to 500.

Why is this?

In this example there are three volume phases:

• 0-200 units (subscale, loss minimization is objective)

• 200-350 unit (unit economics improve with volume and convert to profit)

• 350 -500 units (unit economics mature)

The business is sub-scale at 0-200 units. The product contribution is healthy, but it’s not enough to offset the higher fixed cost per unit.

There aren’t enough units to divide out the fixed costs by. Even with those much lower assumptions at small volumes.

Then from 200 to 350 units you see the unit economics working their magic:

• The product contribution per unit remains flat (ish)

• But the fixed costs per unit crash down as the $ value remains relatively fixed, despite volumes growing

• the difference between the two passes through to an increased operating income per unit

Then as the business hits 350 units and more, the fixed cost per unit starts to flatten and even increase. It’s clear that 350 units is the capacity of that profitable cost structure.

After that point there is a step in fixed costs to access the capacity needed to support the higher volumes.

You can see the increased fixed cost $ fighting against the volume increases in the grey line.

For a business at 350 units this asks some interesting existential questions:

1. Do you want to grow?

2. How do you grow? What is the right level of fixed cost to step in? And when?

3. How do you avoid the risk of stranded costs? What happens if volume falls

4. How does the above inform your pricing and sales strategy?

The above assumes a single product business

It gets more nuanced as you overlay many products, revenue streams, operating locations, etc.

Big retailers (tens of thousands of products) look at contribution per square inch of shelf space. And use that as a way determining product range and location within a store.

But it all starts with a robust view of contribution margin and fixed costs at each relevant level.

Key takeaways

1. Perform a simple breakeven analysis. Using your current cost structure, and current volume level:

   1. Using the contribution grid form last week, convert this into ‘per unit’ analysis

   2. Understand the different breakeven points in your business, for your relevant unit of analysis; (i.e. product, customer, location)

2. Build out a Volume Step Cost Analysis

   1. Identify the different steps of volume and model the cost structures for those units

   2. Identify the key inflexion points in volumes that will need decisions on the business economics

   3. Consider how you can underwrite the volume levels to protect from stranded cost

   4. Aggressively pursue discounts on variables cost per unit as volumes grow

   5. Think about your pricing strategy, and how that will change with volumes. Does it stack up against the movement in costs?

   6. Put formal flags in to manage those inflexion points

3. Set parameters that would need to be met to add extra fixed cost. For example:

   1. X consecutive months at XX units or more

   2. Contribution per margin to remain above $XXX throughout that time

   3. A worst case future volume is no lower than XX per month

This brings us to the end of this series on managing the Income Statement.

We’ll revisit the science of Income Statements again, as there is more ground to cover here, but for next time we’ll move on.

MEME OF THE WEEK

From one of my favorite Twitter accounts The Big 4 Accountant

BOOK CLUB

I love turnarounds. It’s the best way to learn business fast, especially in finance.

Corporate Turnaround by Slatter & Lovett is the best book on turnarounds I’ve read.

I first read it 15 years ago, and applied the ideas from the book in my day job of the time. This helped me get a shot as the CFO of a struggling business unit. Turning round that business unit gave me the resume for a Group CFO job.

And from there i had a seat at the table…

Hands on turnaround CFOs are some of the best paying jobs in the profession, but its hard to break into. Boards want people who have a track record.

For me it started with this book, I hope it helps you too.

FEEDBACK CORNER

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POACHED GREG

Way to pick the losing team Cousin Greg.

I’m taking a one week break next week, so CFO Secrets will be back on March 17.

I will be more active on twitter over the coming weeks, so come join me.

In the meantime …

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend. But I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need to make the right decisions.