Unit Economics in the times of Auction Marketing Models

Unit Economics is all we hear these days in the consumer technology world. Unfortunately for many start-ups seeking venture funds, this is the biggest hurdle they need to cross to build a strong case for their business.

What is the concept of Unit Economics

I will not go into the definition and relevance of Unit Economics. That’s well documented here and here. Or just Google it.

Lets refer to Microeconomics 101 for our discussion – Marginal Costs(MC) and Marginal Revenue(MR). We all know that its a healthy sign if Marginal Revenues are higher than Marginal costs. And this delta (MR-MC) is what is unit economics.

On the other hand, if we are losing money on each transaction, either we see the losses reducing or we stop growing transaction volumes.

At least rational individuals would choose to do so. Or so goes the basic Economics assumption.

Unit Economics in web/mobile start-ups

1. Marginal costs are volatile

A big chunk of a start-ups costs is the customer acquisition cost. ( I am excluding businesses with very high repeat volumes in early days where the operating costs contribute heavily to the overall transaction costs).

Most start-ups need to market their products and services. They are in a continuous state of transaction ramp-up along with concurrent improvements in experience or efficiency.

And in a world where most advertising/marketing channels are bid/auction model driven – this translates into the marginal costs being highly volatile. How volatile?

• In the early days when you don’t have the luxury of brand-pull or of time, almost 60-70% of transactions may be coming from Google Adwords/Facebook/Ad-networks. Meaning 60% of your business is not insulated from pricing shocks.
• Bid-rates may vary as much as 30-40% to maintain the same positioning. Maybe more, if there is a competitor who has just raised a round. Also, if you are competing in a category where big brands play, anything can happen. E.g. At Deal4Loans, we had seen bid-rates on our key-words jump significantly every time a competitor raised venture money or a bank launched a new digital campaign.
• Add to this that the conversion-rates of your campaigns have not yet stabilized. Remember, these are early days, you are experimenting on your landing pages, and funnel optimization is still underway. So the final cost per account gets even more volatile.

2. Customer Pricing is relatively in-elastic

Theoretically, if you could pass on the burden of increased bid-rates and hence the ups/downs in marginal costs on to the consumer, your unit economics would be safe. The neighborhood vegetable vendor who has daily-prices does exactly this and is hence able to retain his margins.

But this is rarely possible. Pricing is just not that elastic.  Most mobile/web start-ups can not /do not change prices so frequently.

3. Marginal Cost CURVE is UNPREDICTABLE AND NOT SMOOTH

We know that the bid-rates can inflict wild fluctuations(as seen in pt1) in the cost of acquisition, thereby making it unpredictable. But a bigger challenge is that the Marginal Cost curve is not smooth.

One rarely finds gradual changes in marginal costs with increasing through-put. It happens in unpredictable steps. Here’s why

• Each fluctuation in effective bid-rate leads to drastic ups/downs
• As a start-up you are experimenting with multiple channels. Success in any one will bring down the blended MC immediately.
• Referral/Viral coefficient and % of in-bound of the campaigns can impact the costs significantly. e.g. One PR mention may bring in huge self-select traffic.
• SEO traffic which is typically very predictable can also swing wildly with a new Google update as we saw with Penguin and Panda.

So what do we do?

• Keep Experimenting. Do know that customer-acquisition at optimal price is a moving target. You are never really truly there. It can always be better.
• Invest early in content. In-bound has significant ripple effects.
• Raise money but don’t throw it all on branding. Consumer memory is short lived. Discover and test more channels, unlock access to more segments.

I would love to hear from bootstrapped ventures as to how they are/have handled the customer acqui costs. What worked, what didn’t?