Unlocking growth: Understanding Unit Economics in SaaS

Unlocking growth: Understanding Unit Economics in SaaS

In the realm of Software as a Service (SaaS), you’ll hear the term "unit economics" getting thrown around… but what does it really mean? Unraveling this concept and the important metrics behind it is pivotal for any SaaS founder or startup aiming for sustainable growth, profitability, and investor appeal. Let's delve into the core of unit economics, including its definition, components, and more.

TL;DR: Unit economics in the SaaS world involves calculating the financial impact of signing up new customers. It determines long-term growth, profitability, and investor appeal. Key components include:

  1. ARPA (Average Revenue Per Account): Customer payment per product.
  2. Gross Profit: Revenue after subtracting Cost of Goods Sold (COGS).
  3. Gross Revenue Retention (GRR): Customer revenue retention rate.
  4. CAC (Customer Acquisition Cost): Expenses to acquire new business.
  5. CLTV/CAC Ratio: Relationship between customer lifetime value and acquisition cost.

Understanding unit economics

Unit economics can be complicated, but here’s the layperson’s definition — unit economics is essentially figuring out how much money you make or lose every time you sign up a new customer. It's about discerning the monetary outcome of every new sign-up, a fundamental factor shaping the trajectory of a business.

That’s because a business' unit economics determine its long term growth potential, profitability, and sustainability. Investors evaluate unit economics to determine the overall health and invest-ability of a business. Let’s take a look at a few granular factors that unit economics is based on. 

Average Revenue Per Account (ARPA)

Average Revenue Per Account (ARPA) is the amount each customer pays for your product. For instance, if you have 100 customers and a total of $100k in ARR, then your ARPA is $1,000. 

Gross Profit

Gross profit is the amount of revenue left over after the cost of sales. Note that "cost of sales" in this case isn't sales and marketing costs. It's Cost of Goods Sold, or COGS. In SaaS, COGS includes product infrastructure and hosting costs, as well as the salaries of post-sales support, services, and customer success teams.

Gross Revenue Retention (GRR)

Your GRR is the rate at which you retain a cohort of customer revenue over a given period of time, typically a quarter or a year. 

Customer Acquisition Cost (CAC)

Customer acquisition cost is the amount you spend on sales and marketing to acquire each new dollar of ARR/MRR.

Understanding the CLTV/CAC ratio

A classic measure of unit economics, CLTV/CAC is a ratio that describes the relationship between the lifetime value of a customer relative to the cost of acquiring them. And it's built on all of the metrics that we discussed above. On the surface it's a simple formula: CLTV/CAC Ratio = CLTV/CAC. But underneath, there's some complexity. Let’s unpack it…

Customer Lifetime Value (CLTV)

The formula for CLTV is as follows: CLTV = (ARPA * Gross Margin) / (1 - Gross Retention Rate). CLTV is calculated on the Gross Profit generated by customers. To get gross profit per customer, you’ll simply multiply Average Revenue Per Account (ARPA) by Gross Margin

If you think about selling a physical good rather than software, Gross Profit is easier to understand. For instance, if you buy widgets wholesale for $1 and sell them to customers for $5, Gross Profit is $4 and Gross Margin is 80%.

Once you have Gross Profit, you divide it by gross churn rate to get lifetime value. You’ll often see churn rate expressed as [1 - Gross Retention Rate], the inverse of gross retention. Assuming a gross retention rate is 85%, you would divide by (1-.85), or .15.

Here's a full example where ARPA is $1000, Gross Margin is 75%, and gross churn rate is 15%: CLTV = (1000 * 75%) / (1 - .85)CLTV = 750 / .15CLTV = $5,000. In this example, the annual Gross Profit per account is $750. When we divide it by the churn rate, the average Gross Margin-adjusted lifetime value is $5,000. This can also be expressed in terms of time by dividing $5,000 by the $750 annual Gross Profit per customer, giving us an average tenure of 6.7 years. 

Customer Acquisition Cost (CAC)

CAC is the total of all sales and marketing expenses you incur to win new business during a given period. It includes marketing and sales team salaries and commissions, as well as paid ads, event sponsorships, and any other expenses related to marketing and selling your product. Often, CFOs will also allocate a portion of customer success team expenses to CAC based on the percentage of their time spent generating sales. 

For example, if you spend $1 million on Sales and Marketing to acquire 1000 new accounts during a period, your CAC would be $1,000 per customer ($1,000,000 / 1,000 = $1,000).


In our hypothetical examples above, the lifetime Gross Profit of a customer is five times the cost to acquire it. The math is simple: CLTV = $5,000 CAC = $1,000 CLTV/CAC Ratio = $5,000 / $1,000 CLTV/CAC Ratio = 5. In SaaS, this ratio should ideally be 3:1 or higher.

Drawbacks and shortcomings of CLTV:CAC

While CLTV/CAC is a well-worn SaaS metric, it has many drawbacks to be aware of. First of all, it's a compound metric. Compound metrics can obscure nuances of your business, since one metric is stacked upon another. This is especially true of CLTV/CAC given the numerous metrics that make it up. SaaS companies that serve different customer segments and industries will find this figure too generic. However, we can solve for this by calculating CLTV/CAC on a product or market segment basis

Second, CLTV/CAC is based on historical results, and it doesn’t adjust for historical shifts in market conditions and go-to-market tactics. As a SaaS company evolves, so do its selling motions. Ideal client profiles change, pricing plans are reworked, and staffing models change over time as the product and company grow. All of these changes can impact GTM effectiveness, and a simple CLTV/CAC calculation largely ignores these dynamics. 

Third, CLTV/CAC focuses on gross retention, but expansion plays a massive role in unit economics. A company with net revenue retention (NRR) greater than 100% grows despite its new customer acquisition performance. These companies are often more profitable and have higher enterprise value than their counterparts with NRR less than 100%.

And, finally, the basic CLTV/CAC calculation doesn’t discount future cash flows to account for the time-value of money. Despite all these drawbacks, CLTV/CAC is a good "gut check" metric that investors will continue to use when determining a company's prospects for sustainable growth and profitability. 

How to improve unit economics

While CLTV/CAC is a useful investor metric, it's not very helpful on a day-to-day operational basis.  That said, SaaS operators can impact unit economics by focusing on the atomic components of the CLTV/CAC Ratio as described above: increasing ARPA, reducing COGS, and increasing gross retention. 

We can improve Gross Margin by raising prices while keeping Cost of Goods Sold constant. We can also improve it by maintaining price points while increasing delivery efficiency. To do that, you can try using some of the strategies and tactics below:

  • Optimizing cloud hosting costs
  • Using AI to increase support efficiency and reduce headcount 
  • Reducing the number of professional services headcount required to onboard new customers
  • Increasing the amount of ARR assigned to each customer success manager Each of these examples results in lower COGS

Reducing customer churn has the obvious impact of increasing gross retention, which directly impacts lifetime value. Using our example above, improving retention by just one percentage point, from 85% to 86%, adds five months to the average lifetime of a customer. That’s a 6%+ improvement.

We can also improve unit economics by reducing CAC relative to each new dollar of new ARR/MRR we bring in. Here are some tactics you could use to accomplish this:

  • Generating high-intent, inbound leads 
  • Spreading sales targets across fewer, stronger account executives
  • Eliminating go-to-market programs that aren't working (e.g., SDR teams, event sponsorships, etc)
  • Scrutinizing paid media, lead generation, and search placement programs


As you can see, managing unit economics is a team sport. It involves everyone from sales, marketing, product, support, services, and customer success.  Managing and improving unit economics is a matter of focusing on the measures that lie beneath the CLTV/CAC Ratio: revenue per account, gross profit, gross retention, and sales and marketing costs. 

If you want us on your team, we’re ready to help. Churnkey's suite of churn reduction solutions, including dunning management, cancel flows, and reactivation strategies, is tailored to fortify unit economics for SaaS companies. By seamlessly integrating these tools, you can optimize your company’s CLTV/CAC ratio and propel sustainable growth.

Check us out to see how Churnkey helps SaaS businesses reduce churn and retain more customers.