Economies of scale drive unit profits growth
There’s a key point when you are at an early-stage phase of your online business: the variable costs of each sale will decrease as your business grows, resulting in a ramp-up of unit profits.
Basically, we can say that the greater the cost reduction, the greater the benefits in terms of unit profits.
But, in finance, the basic reasoning above is not enough. We should gain a clearer picture about how much we may benefit from economies of scale.
What’s behind unit profits?
To understand how economies of scale may be beneficial to our unit profits, we need to step back for a while.
When you combine LTV and CAC in the LTV - CAC metric, the result you get is the customer-unit profit.
You can get more information about why LTV – CAC is a more compelling metric than LTV/CAC at this stage, I give it implied hereby.
The LTV is made of four components:
- the expected Average Order Value;
- the expected Repeat Purchases;
- the COGS (direct variable costs attributable to the sale);
- other fixed costs we want to load the LTV with.
So, unit profits rely on COGS.
When you have just launched your business, such costs are probably the highest you can pay because, for example, you lack negotiation power with suppliers.
Image you launch a product-based e-commerce shop: the price you pay for shipping and packaging at the day one is much higher than the price you pay if you can commit 10K orders/month.
For this reason, unit profits are going to be better and better as your business grows.
May economies of scale apply also to other costs than COGS?
Economies of scale do not apply just to COGS. But, in this crack, I just focus on such costs because it’s easier to build-up a case to get straight to the point: the impact economies of scale may have on your business.
LTV % improvement through economies of scale
As said at the beginning, I want you to have a clearer view about the benefits of economies of scale to your unit profits.
To do it, I’m showing you how economies of scale may improve your customer LTV.
In the chart above, we can see how a 10% COGS reduction may improve the customer LTV.
When COGS are 50% of the AOV, a 10% reduction in COGS (i.e: 45% instead of 50%) leads to a 10% improvement in the LTV.
When our COGS are greater than 50% the AOV, a 10% reduction brings more benefits. When they’re lower than 50% the AOV, the impact is marginally less significant.
What does it mean? It means that the greater the impact of COGS on AOV, the greater the marginal impact from a COGS reduction.
And, of course, the greater the COGS reduction, the greater the benefits we have.
Reaching economies of scale is a key drive of profitability. So, take it into account when you’re planning your growth strategy.
But, do not rely on economies of scale to be profitable.