What is unit economics of a business?

In investing we often hear people say that this business has great unit economics, but what does this really mean and why does it matter? In this post I will walk you through what it means using the example of a business and simplify so that you can use it to make more informed decision when doing your own analysis.

What is Unit Economics?

In its most fundamental definition unit economics just refers to how much does a business keep for every unit of product/service they sell. 

Let's say you run a business of selling handbags. You source these handbags from a wholesaler who charges you $10 for each handbag you purchase. You now go and sell these on eBay for $35 a piece.

However you don't make the full $25 as profit. You have to still cover other expenses like shipping cost, fees charged by eBay etc.

Lets say you had to pay $8 in shipping cost and you paid $12 to eBay and that is all the costs you have.

So for selling 1 product you make: $35 - $12 - $8 - $10 = $5

In business we say your profit margin = 5/35 = 14%

So for every $100 in sales you make $14 in profit.

This is a very simple example but illustrates the point well and forms a solid foundation of how to think about stocks. Now let's apply this to a stock we all know about and understand this better.

Unit Economics for Apple

Let's take a look at 3 years of income statement for Apple to understand it's unit economics.

As you can see above For 2022, Apple sold products and services worth $394B. Lets understand the unit economics for Apples business

Sales = $394B

Cost of Products & Services = $223B

So for every $100 of product/service apple sellers they end up making $43 as gross profit viz:

(394 - 223)/394 = 43%

But they do not get to keep the $43, why because there are other fixed costs they incur in order to create their products and services other than the costs of products themselves.

For example paying salaries to their employees is such a cost that they will incur (mostly steady) regardless of if they sell 10M products or 100M products. These have to be taken out from the $43 to arrive at the final profit that apple will keep.

If we take that out, we are now left with:

Net Profit = (394 - 223 - 51)/394 =  30%

So for every $100 in sales Apple finally keeps $30, with a net profit margin of 30%.

How do you interpret unit economics?

While this is a nuanced topic and has to involve many more elements than just the income statement, I want to cover a few basic checks we should do for unit economics.

Q1. Are the unit economics sustainable?

If we do this analysis on last 3 years of data, we see that Apple's margins have been:

2020: 21%

2021: 26%

2022: 30%

Their profit margins have grown by 9 percentage points in 3 years! This is great news, suggesting that their products have a lot more demand allowing them to raise prices, reduces costs or both driving the increase in margins.

Q2. Can the business grow at these unit economics?

We see that the sales for Apple have increased by 43% in last 3 years (394/274-1). This is again a very positive sign. The business is able to grow while improving profit margins, not that easy to do in a competitive world!

Q3. Is this a monopoly ?

The reason this is important is for a monopoly, there is generally no other alternative for customers and so the business can increase margins without and impact on sales. However, these industries are subject to disruption depending on how easy or difficult it is to replicate the business.

Invariably, a good business always attracts competition sooner or later and is constantly under threat.

For Apple's case though, it is a behemoth but certainly not the only game in town. There are plenty of smartphone companies in the world. The reason Apple has an amazing business is due to the quality of its products and services and its brand value built over long periods of its existence.

Apple has been able to grow despite existing competition, and hence has what it takes to maintain and grow the business.

I'm sure there are many more ideas to consider and things to check, but I hope this was useful way to think about a business for someone that is new to learning about finance and business in general.

Let me know your thoughts and ideas in the comments below.

Wish you all Happy Holidays and a wonderful New Year 2024!