How do you know if your product is going to be successful?
How do you know if your product IS successful?
When I ask product managers this question, I get answers like these:
“We regularly ask our customers for feedback on our product.”
“We have a customer satisfaction metric that we measure.”
“We look at usage — customers who are logging in and using the system.”
“We measure conversions from free/trial to paid users.”
Those are very valuable data points. Good things to measure and track.
But none of those things tell you if your product is actually going to be successful.
Because they don’t answer the most fundamental question about the success of your product:
Is your product PROFITABLE?
Can you make more profit from your customers than it costs to acquire them?
And that’s what unit economics is about.
Unit economics makes it possible to project whether your product will be profitable.
Because, quite simply, you could have great customer satisfaction, high usage, lots of positive feedback…
But if your product isn’t profitable, you won’t have a business.
So as a product manager, in order to truly measure the success of your product, you need to understand the underlying unit economics of your product.
What are unit economics?
Unit economics are the direct revenues and costs associated with a particular business model expressed on a per unit basis.
What’s the basic unit for your product?
For a SaaS product, it’s usually users, customers or accounts. And the unit economics are:
- Lifetime Value (LTV): The average revenue a customer will bring in during the entire duration of using your product. Sometimes also called Customer Lifetime Value (CLTV or CLV).
- Customer Acquisition Cost (CAC): How much it costs to acquire a customer. Sometimes also called Cost per Acquisition (CPA).
LTV and CAC are critical drivers of a SaaS product’s growth and success.
To the extent that LTV exceeds CAC, your product will be successful and you will have a business.
So LTV is a measure of your product’s sustainability: will it make a profit and continue making a profit.
In other words:
LTV is a prediction of all the value a business will derive from its entire future relationship with a customer expressed as net profit.
As a very simplistic example, let’s say on average your customers stay with your product for 24 months and pay $50/month. Then your average LTV is 24 * $50/month = $1,200.
If customer lifetime increases to 28 months, LTV at the same monthly recurring revenue is 28 * $50/month = $1,400. Nice.
If average monthly recurring revenue increases to $75/month, LTV at the same customer lifetime is 24 * $75/month = $1,800. Even better.
But in any of those cases, if it costs $100 to acquire a customer, your product will die.
(Note: This overly simplistic example doesn’t consider churn, which is a critical factor in the sustainability of your product’s profitability. We’ll get to that in another post.)
So ideally, LTV is way more than CAC.
This balance is INCREDIBLY important for a SaaS product, and good product management involves being mindful of the competing forces that affect this balance.
So how can you, as a product manager, affect this balance?
Let’s first talk about how to calculate LTV. There are several formulas, each of which is just a different approach to do the same calculation:
LTV = ARPU * Gross Margin * (1 / Monthly Churn)
LTV = ARPU * Average Customer Lifetime – Cost to Serve
- ARPU = Average recurring revenue per user (or customer or account) = Total Net MRR ÷ number of customers
- Gross Margin = (Revenue − COGS) / Revenue
- Customer Lifetime = average number of months we expect a customer to use the product (i.e., before they churn)
- Cost to Serve is basically COGS (i.e., cost of goods sold), and typically can include hosting and monitoring costs, infrastructure costs, licenses and royalties for 3rd party embedded apps, credit card fees, commissions to affiliates and partners, support, etc.
Driving up LTV can have a significant impact on your product’s success.
Let’s say Customer A is on a $100 monthly plan. We expect them to churn after 1 year.
LTV = $1,200.
Customer B is also on a $100 monthly plan and expected to churn after a year, but upgrades to a $150 monthly plan in month 4 and then again to a $200 plan in month 8.
LTV = $100 * 3 + $150 * 4 + $200 * 5 = $1,900 — a significant difference!
BTW, customer B upgrading is called expansion revenue, and it’s pretty sweet!
And understanding the LTV formulas makes it really easy to pinpoint which areas need improvement. (Because math.)
As a product manager, you may have little control or influence over CAC (because you don’t control sales or marketing).
But there ARE a number of ways you can impact LTV:
- Increase average revenue per user (ARPU).
- Increase customer lifetime — i.e, get customers to “stick” with your product longer.
- Drive expansion revenue from existing customers.
You have a number of levers to impact these numbers.
The obvious one is to identify new features, experiences, and improvements to your product that will help increase these numbers.
You can look at offering different feature mixes in various pricing packages, or build “upgrade incentives” into the product itself, etc.
You can also segment your customers by LTV and double down on the more profitable ones or the faster growing segments by targeting them with specific features, pricing options, or other valuable services.
Let’s look at a couple of examples that bring these concepts together.
Let’s say you manage a project management SaaS product that caters to two customer segments:
|Customer Segment||MRR||Customer Lifetime||LTV|
|Smaller teams||$50/month||24 months||$1,200|
|Larger, enterprise teams||$500/month||36 months||$18,000|
To keep things a bit simple, we’ll assume churn and the cost to serve each segment is the same.
Now, on the surface, looks like enterprise customers are the more valuable ones. They pay more and stay longer.
But on further analysis, you find the cost to acquire an enterprise customer is $6,000, while the cost to acquire a small team is just $240.
CAC for enterprise customers is a third of their LTV, whereas CAC for smaller customers is just 1/5th of their LTV.
This means it costs 25 times more to acquire an enterprise customer but they’re only 15 times more profitable.
So turns out smaller customers are actually the more profitable segment!
LTV for enterprise customers would need to increase to at least $30,000 to be just as profitable as smaller customers (assuming no change to CAC or churn).
It would seem to make sense to direct your product strategy toward pursuing features and experiences for smaller teams that could minimally protect their lifetime value and ideally increase it and/or their MRR.
Alternatively, you may believe it’s better to focus on increasing LTV for enterprise customers. You could define a product strategy that targets increasing LTV to at least $30,000 by increasing either their customer lifetime to 60 months (maybe they’ll sign 5-year contracts?) or your price to $833/month (will they pay that much?). You can then craft a product roadmap that identifies features and services that will justify the longer contract commitment or higher price point.
Let’s take another example.
Again, you manage a SaaS project management product. Customer lifetime is 24 months, and LTV is $1,200 on an MRR of $50/month.
Because you’re a smart, intrepid product manager, you do some digging and discover the following:
|% of customers||Lifetime||LTV|
Wow — half your customers are actually churning in just a year and a half! Your product’s profitability is actually being propped up by just 20% of your customers.
So maybe you should double down on the 20% segment, encouraging sales and marketing to focus their efforts on acquiring more of the same kinds of customers, and define a product roadmap that delivers features and capabilities that could help acquire more of them.
Alternatively, or in addition, you could try to identify any gaps in your product portfolio that are causing customers in the 50% segment to churn so quickly, and get the relevant solutions prioritized on your product roadmap.
I’ve talked about how MRR and ACV bookings are key metrics for a product manager to measure the demand and growth of their SaaS product.
In other words, the key question of will it be successful?
So if all you’re doing is gathering qualitative feedback or measuring usage, customer satisfaction, or things like that, you’re NOT getting the true measure of whether your product is successful.
Those ARE important to measure. But they are NOT the ultimate measure of your product’s success, which is simply:
Is your product PROFITABLE?
Unit economics help you understand this.
By analyzing the unit economics of your product, you can highlight opportunities, expose gaps, and identify optimal strategies for maximizing the profitability (= success) of your product.
BTW, I’ve created this helpful 2-page SaaS Metrics Quick Reference Guide for Product Managers that you can download totally for free. Print it out, post it on the wall of your cube or office so that way you have it conveniently available as a reference at all times.