Most business owners set prices one of these ways: look at what competitors charge, ask customers what they'll pay, or go on gut feel. We can do better.
Your unit economics tell you whether each sale is actually making money, and what you need to charge for every item on the menu.
We've talked about the ability to both zoom out and zoom in on the financials.
Zooming out means reviewing multi-year trends and forecasting years ahead. It's strategic, "what-if" scenario work.
Unit economics are the ground-floor, zoom-in view. Very tactical.
This is where you review your product and service offerings, how they're priced, and where to find cost and efficiency savings at the product level.
What are unit economics?
Unit economics are the selling price, direct costs, and profit of a product or service, measured one sale at a time.
An example helps. We just opened a coffee shop and we're trying to price our products to make money, to eventually hit break-even and target sales.
There's no universal guide listing every cost that goes into your product, so we build the list ourselves, as thoroughly as we can. And we've got a "hotdogs and buns" problem: costs don't come in clean per-unit amounts, so we estimate along the way.
Start with a basic cup of coffee. We need cups, sleeves, and lids. Our supplier quotes:
$50 for 100 cups,
$20 for 100 sleeves, and
$20 for 100 lids.
That's $0.90 per cup just for the container.
Next, a bag of beans costs $100 (good stuff). Our equipment gets 100 cups per bag, so that's $1.00 per cup.
Last, direct labor. Take total staffing cost and divide by cups sold over a period. Don't use a single hour or day, that's misleading. Use 3, 6, or 12 months and update yearly. Our payroll was $1,000 over three months, and we sold 1,000 cups, so $1.00 per cup of labor.
It isn't perfect, because some labor exists whether you sell 20 cups or 200. But it's a useful start, and over time you can separate "labor to keep the doors open" from "labor to make each additional sale."
So we have $0.90 container + $1.00 coffee + $1.00 labor, a total per-unit cost of $2.90.
What to do with this
Three good use cases for an owner:
A pricing tool: what to charge.
A product guide: where to invest.
A portfolio tool: building the right mix.
1. Pricing tool
Do a full cost buildup and hitting your desired margin becomes easy. The more thorough you are, the more accurate the number. At a minimum, review unit economics each year for your core products to see how input costs changed, and methodically raise prices to offset them.
2. Product guide
Which products make you the most money? Push those hardest. If you can't price something at a good margin because it's a commodity or the market won't bear it, that's a signal it shouldn't be a core product. Example: nobody pays more than $3 for a plain coffee, which earns little. Maybe a premium specialty drink with rotating flavors has better unit economics.
3. Product portfolio
Think of your menu as a garden. Plant seeds, water the flowers, pull the weeds.
No high-margin or high-profit-dollar products? That's a gap in your portfolio.
Low-ticket or low-margin items can be gateway products that get people in the door and up-sold to your best offerings.
Products with negative margins that don't drive other sales are low-hanging fruit to cut.
This works for service businesses too. A firm might offer a cheap one-time "quick review" to get clients in the door for higher-margin recurring work.
Back to our example
Our break-even math said we need 40% contribution margins to hit our profit target. Based on the $2.90 cost, we'd price the coffee at $4.83 to hit that margin ($2.90 ÷ 60% variable cost). Round up to $5 for buffer, or down to $4.50 if we were conservative. Then repeat annually.
Two years in, here's what our costs look like with no pricing changes:
Besides pricing, what could we improve?
We've discounted too much. Coupons and promotions climb every year while costs rise, which crushes margins.
Raw materials and labor keep increasing, good candidates to pass through in pricing.
Direct labor is its own animal. Find productivity gains that cut labor hours per unit. When McDonald's saves labor with technology, this is where it shows up.
How to implement it
Track it over time. The Profit Mastery System recommends a minimum annual review of your unit economics: analyze historic costs to see what it actually cost to make, deliver, or service each sale. Your components differ, but the process is the same:
Identify the unit.
Estimate the direct costs.
Compare them to price.
Look for margin improvement.
It sounds rigid, but really you're trying to find an economic engine that makes a lot of money and is easy to market and sell. There's more creativity here than you'd think.
Case study: the creative side
One of my favorites is the restaurant Cooper's Hawk. Restaurants are brutally competitive, but they found a unique way to add subscription income. You show up for a wine tasting, pay a per-person rate, then join the monthly wine club so the tasting is "free" plus two bottles a month. That's a profitable subscription that feeds traffic to the restaurant.
Now you're a subscriber, back every month to taste and grab your bottles, and while you're there you stay for an upscale, higher-margin dinner. A periodic visitor becomes a frequent subscriber, on top of the regular diners. A clever way to flip the script on a commodity industry.
So never assume there's nothing unique about your business, or no way to build a premium offering into what you do.
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Colin King, CPA, CFA
CEO, Profit Mastery
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