This is the second part of a series covering unit economics and its importance when evaluating business health:
- Should You Acquire that Company? It Depends on the Unit Economics
- Applying Unit Economics to Cafe Acquisition
- Productizing Unit Economics
Suppose your company is thinking of acquiring a chain of coffee shops. You might be another coffee company, a hospitality company, a venture capital fund, or a private equity firm. While this might seem entirely hypothetical, you would in fact be at least the sixth (6th) to join the cafe acquisition party in the past six years.
In the interest of simplicity, let’s assume the following:
- The cafe serves only one size and precise type of coffee, with no food options
- The existing espresso machines can handle current and future demand
- The existing size, layout, and furnishings of each coffee shop can meet demand
- Barista tips are not included in unit economics, as tips go to the baristas
Let’s walk through the unit economics analysis step-by-step.
Step 1: List Out the Drivers of Unit Costs and Revenues
Understanding the business model of a cafe, we write out the drivers of costs and revenues at the unit level. In this case, 1 unit = 1 cup of coffee.
Revenue:
- Price per coffee
Cost:
- Milk: 1 gallon, which is enough for multiple coffees
- Coffee Beans: 10 pound bag, which is enough for multiple coffees
- Coffee Cups: Packages of 1,0001
- Milk, coffee beans, and coffee cups each have an associated shipping cost
- Staff wages per hour of work, in which multiple coffees can be made
Step 2: Determine Profitability Equations, No Data Nor Forecasts Required
Equipped with our drivers of unit profitability, we can craft revenue and cost equations. These equations are conceptual representations of input factor relationships rooted in business understanding. They are the “physical laws of profitability.” Therefore, these equations require no data nor projections of any kind. In fact, equations determined by a method other than domain knowledge would not make sense.
The equations step does not involve fitting data, statistical regression models, or predictive modeling.
To some this might be a counterintuitive assertion, but allow me to elaborate. Indeed, modeling techniques such as linear regression were designed to discover an equation that describes the relationship among several variables. But these techniques are only necessary when that relationship is non-deterministic and variable. For example, would you use statistical modeling to determine that Revenue = Price x Quantity? I sure hope not.
Clearly, the governing equations must come from understanding the underlying forces of profitability.
Data and forecasting are applied to unit economics in later steps, which will be covered in later blog posts in this series.
The equations in this cafe acquisition example are left as an exercise for the reader.2
Step 3: Set Revenue = Cost → Assess Break-Even Conditions
Take your revenue and cost equations, and set them equal to one another. Substituting values for each input reveals conditions under which one coffee sale is break-even. Of course, there are many break-even scenarios - as it turns out, there are infinitely many.3
Knowing the break-even point for a particular scenario means that we also know its corresponding profit and loss conditions. Specifically, a price below break-even means every coffee is sold at a loss. Similarly, a price above break-even means every coffee is sold for a profit.
But manually computing break-even scenarios would become quite cumbersome quite quickly. Additionally, comparing and contrasting scenarios would be unintuitive. The effect of each factor on profit would not be clear. For unit economics to be practically useful as an operational due diligence approach, a full tool makes sense.
The next post in this series will showcase a decision tool that productizes this scenario analysis of break-even conditions.
Footnotes
I prefer non-disposable cups for environmental and experiential reasons, though many cafes serve their coffee in disposable cups.↩︎
If you are actually contemplating a coffee shop chain acquisition, feel free to reach out.↩︎
In the lemonade stand example of the previous blog post, our break-even condition equation is p = (c + l). Using this equation, two examples would be p = $1.25, c = $0.25, l = $1.00 and p = $0.75, c = $0.30, l = $0.45. There are infinitely many scenarios that satisfy this equation.↩︎