When Losing Money Is Strategic — and When It Isn’t

The bike-sharing company Ofo was founded in 2014 by members of a Peking University bike-riding club without much fanfare. They initially focused on bike tourism but swiftly switched to what they saw as the bigger prize: a bike-sharing app. In the next three years, the company’s growth exploded. By 2016, Ofo had a fleet of 85,000 bicycles in China, and it soon began to open locations around the world, including India, Europe, Australia, and the United States. The company would eventually raise a staggering $2 billion in funding. But by 2018, facing stiff competition and cash flow stress, its leaders considered filing for bankruptcy several times. A year later, Ofo was out of business.

What went wrong?

Ofo, like many new ventures — especially those backed by venture capital — focused on growth in its early years. Often, that means a venture will lose money. That’s not unexpected in a startup, of course, but the key question is whether such losses are healthy or unhealthy.

If the business model anticipates both creating and capturing value, the losses occur purely because the entrepreneurs are investing in growth and scale. Over time and with scale, the losses should take care of themselves. These are healthy losses.

But if the business model is fundamentally flawed and fails to capture a part of the value it creates, then scale is not going to convert the losses into profits. Contrary to conventional thinking, the approach of absorbing losses year after year to drive revenue growth will not work for most entrepreneurs. As Ofo found out, it can be a path to certain failure.

There is, however, a simple but often overlooked analysis that can help entrepreneurs determine early on whether they are driving for healthy or unhealthy losses: unit economics (UE), or the contribution margin per unit. This is calculated by taking the expected revenue of the unit under consideration and subtracting the costs the company incurs from offering that unit. The key insight is that if the company sets the price above avoidable costs, larger volumes will likely lead to business profitability; if the price is below avoidable costs, even high revenues will often fail to prevent high losses.

It may seem like an obvious assessment, but UE analysis is not typically part of many new business ventures, which are often focused on growth in revenues or the number of users, app downloads, or unique daily visitors. But careful consideration of UE is particularly beneficial for high-growth entrepreneurial ventures that are investing heavily in growth and losing money at the company level. It is difficult in such ventures to assess the business’s underlying health because it is hard to distinguish between losses that may be arising due to upfront investments to generate future growth and those that may be arising due to fundamental problems with the business model. UE is also critical for managers of established companies who aim to renew and expand their business units through business model innovation. Even for those ventures that are applying UE analysis in their decision-making, the majority do not do so systematically and often do not define their units with sufficient granularity to garner the real insights that UE can provide.

With a good understanding of UE, it will be clear if the business is simply burning cash on a short-term basis in order to scale but will eventually become profitable or if the business model is fundamentally flawed. A UE analysis can stop the venture from scaling until its leaders have determined how and when they will be able to capture a part of the value they are creating with their product or service. In this article, we will explain how entrepreneurs, investors, and managers can think systematically about using UE to assess the long-term viability of the business model using three tests: the scale test, the sources of revenue test, and the value proposition test. Through these tests, UE can help clarify the profitability of the business at the unit level, which in turn can provide crucial insights on whether, when, and how to scale the business. A thorough understanding of UE can go a long way toward ensuring the successful rollout of innovative business models.

The Problem

Unfortunately, the story of the rapid rise and fall of a once promising new venture such as Ofo is not uncommon. A number of prominent startups with innovative business models have made poor pricing and resource allocation choices due to a fundamental misunderstanding of the long-term consequences of their business model. Had they had a better understanding of UE and the long-term implications of having negative UE values early in the life of the venture, they might have avoided that fate.

Consider MoviePass, a subscription service for cinema fans founded in the U.S. in 2011.1 Few startups have generated the kind of buzz that MoviePass enjoyed in its early years. The company offered an “all you can eat” movie pass: For $50 per month, subscribers received vouchers that they could present for unlimited admission to movie theaters.

After subscribers complained that the vouchers were not being accepted by theaters, the company swiftly issued them debit cards. But it failed to secure either discounts or a commission on ticket sales from major movie theater chains and thus ended up paying full price for tickets. MoviePass’s goal was to build a large subscriber base and then sell data to film studios and other advertisers, such as restaurants located near movie theaters. It reduced the price of the service, which allowed subscribers to see one 2D movie per day, to between $25 and $40 per month, depending on the location. With that pricing, MoviePass assumed that some customers would use the subscription infrequently, thus enabling the company to make a contribution margin on their subscriptions. But in reality, subscribers had to see only one movie per week on average for the company to lose money.

To combat its losses, the company renewed its focus on growth, and in 2017 it launched its most aggressive pricing: $9.95 per month for one 2D movie per day. Rapid growth resulted, as the number of subscribers increased from 12,000 to 400,000 within a month. However, depending on the location, MoviePass was paying between $8.97 and $12 every time a subscriber saw a movie. It perhaps should have assumed that frequent moviegoers (those who see more than one movie in a theater per month) would account for a significant portion of its subscriber base. Although these film fans represent only 12% of the population of the U.S. and Canada, they account for 49% of the movie tickets sold.2 Over the next three years, MoviePass experimented with multiple pricing schemes but was unable to settle on one that was both attractive to customers and profitable for the company. Without a clear UE analysis as a guide, MoviePass couldn’t find the right balance between growth and profitability.

Three Critical UE Tests

MoviePass started hemorrhaging money and racked up cash losses exceeding $20 million. In September 2019, the company threw in the towel, permanently shutting down its service. With such unfavorable UE, this was all but inevitable. Careful analysis would have revealed that MoviePass’s approach to business did not pass any of the three critical UE tests:

• Scale test: Given enough volume, economies of scale/experience, or bargaining power with suppliers, we will have sufficiently low unit costs.
• Sources of revenue test: With enough volume, we will unleash additional sources of revenue.
• Value proposition test: With increased volume, our offering will become more and more desirable to customers, thus allowing for improved monetization.

Here’s what those three tests could have revealed to MoviePass:

• Scale test: The key assumption here seems to have been that if MoviePass could bring in a sufficiently large number of viewers, operators would be willing to sell unoccupied seats to MoviePass at a substantial discount below their standard prices. Additional subscribers were attractive to operators, since they had seats available to be used at nearly zero marginal cost. However, it was not difficult for operators to create their own versions of MoviePass and reap these benefits directly, without an intermediary. Also, operators likely feared losing control of their relationships with moviegoers and the ability to shape transactions with them (such as experimenting with price discrimination).
• Sources of revenue test: MoviePass appears to have assumed that the data gathered about viewers would eventually become sufficiently valuable for advertisers to be willing to pay substantial amounts to access them. However, a large volume of subscribers did not, per se, increase the willingness to pay for data on a particular subscriber. Therefore, for the most part, volume gains due to low prices did not help increase the data revenue per subscriber.
• Value proposition test: In the case of MoviePass, there were no network effects or obvious lock-ins that would lead to possible price increases in the future.

In sum, unfavorable UE early in the life of MoviePass was unlikely to translate into a future sustainable competitive advantage, and the company could not find a path for converting the negative into positive UE. Thus, it was doomed to fail.

How Managers Can Use UE

Unit economics can help guide the critical decisions that can make the difference between success and failure, but there is no cookie-cutter approach for all companies. At a simple level, we are defining UE as the expected revenue of the unit under consideration minus the costs the company incurs from offering that unit. Note that we distinguish between fixed costs (not sensitive to volume) and avoidable costs (costs the company would avoid if that unit was not offered or served). We discuss some of the best practices below, but managers must consider the right approach for their particular company and product.

Define the unit in UE carefully. Picking the right unit to analyze is key. A company can consider UE on new or existing products, customers, or operating units (such as a restaurant or retail outlet) or some combination of them. The analysis can be particularly useful where growth depends on network effects. (See “Unit Economics in Multisided Platform Businesses.”)

The right unit to consider and costs to be included in the calculation depend on the question under consideration. For example, if management is considering whether to continue offering an existing product to a particular customer segment, the correct unit to examine is the average customer in that segment. The calculation should include revenue derived from that customer over the expected lifetime of the relationship minus the costs the company would avoid if it chose to stop serving that customer. On the other hand, when considering the launch of a new product, the cost calculation should also include customer acquisition costs, since those are avoidable before the product is launched. Or, when an on-demand business such as Washio (an app-based laundry service) is considering launching in a new region, the correct unit for analysis is the target city: expected revenue in the city, minus all the costs involved in setting up business and offering services in that location.3

You can also consider profitability per outlet for businesses that need a geographical presence in every local market; this is calculated as revenue for that outlet minus all the costs (both fixed and variable) incurred at that outlet.

Triangulate. It is helpful to look at the viability of a business from the perspective of multiple units. For example, NephroPlus, an India-based company that provides dialysis to patients with end-stage renal disease, has more than 270 centers located within hospitals in 160 cities across four countries. NephroPlus may want to consider profitability per patient (over the lifetime of that patient), per treatment (an individual dialysis session), and per center. If the message from the analysis of the profitability of multiple units is consistently positive, then management can be more confident of the robustness of the business model. If a particular unit has negative UE, then this exercise helps pin down corrective actions to convert it into positive UE.

Understand the hierarchy of units. For practical purposes, entrepreneurs and managers often equate company-level contribution margin to UE. On the surface, this sounds reasonable, but contribution margin as reported in the P&L is a misleading indicator of true UE. Contribution margin should be computed at the relevant unit level; average contribution margin for the entire line of business or company is often too aggregated a statistic to be helpful in guiding strategic decision-making at the product-market level.

At the most basic level, there is the product — for instance, the meal in a restaurant. If UE is not favorable at the product level, the company may hope to earn positive returns from ancillary services (such as MoviePass hoping to earn a profit from advertising or from data while losing money on tickets), but more often than not, it will get into financial trouble: Additional volume will almost surely just bring additional losses. Next, assuming that UE is favorable at the mean product level, management must ensure that it is favorable at the customer level. This can be achieved by finding ways to have the customer conduct more transactions (eat more meals, for example) or to have a lower churn rate, or by decreasing customer acquisition costs. More volume per customer may lead to favorable UE at this level. Finally, there may be situations in which both the meal and the customer have positive UE, but the individual restaurant has negative UE. This will likely be due to additional fixed costs, such as insurance, rent, utilities, and the salaries of store-specific personnel. To make these unit economics positive, the restaurant will need to generate additional volume. If UE indicates a likely long-term poor financial performance at the level of the company, a clear understanding of UE at different levels (meal, customer, outlet) can be used as a guide for managerial action. If a particular unit’s UE value is less than zero and this is expected to continue in the future, it will be clear that the company is better off not offering that unit at all.

Make your assumptions explicit, and test them with small-scale experiments. As the discovery-driven approach to business models suggests, entrepreneurs and managers make a number of assumptions when they design business models in situations of uncertainty, such as prices customers are willing to pay for the product or service offering; their cost structures (both fixed and variable) to deliver the offering to customers; and the possible reactions of competitors and other organizations in the ecosystem (such as movie theater chains, in the case of MoviePass).4 In highly uncertain situations that are characterized by limited information, entrepreneurs and managers inevitably start small-scale actions (we can call them experiments) on the basis of assumptions, because they often do not have the luxury of waiting to have all the relevant information. Further, new information will emerge with every action. We strongly urge entrepreneurs to be explicit about their assumptions, document them, and use every experiment to test one or more of them.

Consider dynamic scenarios. In many modern industries, particularly those that are technology-intensive, circumstances can change rapidly. Any UE analysis is valid only at a particular point in time, in a particular context. Prices can fluctuate over time due to increased competition, costs can increase due to scarce resources, and customers can migrate to newer offerings. Any of those scenarios would affect a UE analysis. For example:

• The costs of electronic hardware can drop steeply as production volumes increase. Xiaomi, the Chinese mobile phone brand, often prices its new models below cost and relies on proven economies of scale to kick in as customers respond favorably to its price-competitive phones.
• As e-commerce grows all over the world, the increasing competition for delivery personnel is driving up their compensation. This is putting pressure on fulfillment costs, which are already high because of the high cost of last-mile delivery. Entrepreneurs and managers who do not take into account this dynamic scenario might be surprised by lower-than-expected profits or even losses.
• There can also be significant uncertainty as some organizations push regulatory boundaries. For example, ride-hailing companies have been prohibited from operating in some jurisdictions, or they may face significant restrictions that drive up their costs.

How UE Reveals Implications for Strategy

Careful consideration of UE helps a company develop an understanding of the long-term viability of its business model and suggests necessary changes. An assessment of UE is particularly useful when the venture experiences high growth accompanied by significant losses. For example, after Amazon was founded in 1994, it experienced losses for many years (until the fourth quarter of 2001), in part because founder Jeff Bezos subsidized fulfillment costs by not charging customers for delivery. However, Bezos had a deep understanding of the economics of the business and knew exactly why the company was losing money and how to ensure its survival until it could become profitable. Essentially, the losses were the result of highly competitive pricing, subsidies on deliveries, and huge investments to cater to aggressive growth. Once Amazon started to partially recover delivery costs and make fuller use of its assets as a result of higher volumes, it transitioned to profitability.

Here are some of the ways that applying UE can provide strategic insights to managers:

UE helps managers forecast the volume needed for the business to be profitable. It is important to note that in order to grow volume to break even, a company may have to add to its fixed costs (such as by increasing advertising, investing in logistics and warehousing, or spending more on IT). These fixed costs may be so substantial that the company is unable to generate a profit even with the additional volume that results from them. Sometimes the profit decreases due to these volume-boosting investments.

Careful consideration of UE guides resource allocation within the company. Consider Exec, founded in 2012 in San Francisco with the aim of providing on-demand personal assistants and cleaning services.5 Exec hired errand runners at significant costs. In the end, Exec’s business model proved unsustainable, with very high variable costs. The company paid out 80% of the hourly fee that it billed for the errand runners’ time on the job. This led to a situation in which customer service and customer acquisition, among other costs, had to be funded from the remaining 20% of the hourly fee. Moreover, refunds for mistakes quickly consumed profits. The company was eventually acquired by Handy in 2014. An understanding of UE might have led the company to shy away from providing errand runners for all types of errands and instead focus on the subsets that were most profitable: those that were less prone to error; that required less specialized — hence cheaper — runners; or that required more specialized runners, for which it could charge higher prices. Changing the product range and/or the target customer segments might also have implications for IT, HR, advertising, promotions, and after-sales services, among others. A better understanding of UE could have led to a refocusing of Exec’s business model.

Understanding UE allows managers to get a good sense of how low they can go if they must respond to a price war initiated by a rival company. For example, San Francisco-based Prim offered a laundry service with pickup and delivery, charging a set price per bag. However, fierce competition in the local laundry services business led to price wars. Prim’s price did not allow it to earn a decent margin, and the company was shut down. A good understanding of the per-bag UE would have been essential in determining how much Prim could have lowered its prices in response to competition.

A consideration of how one’s own UE compares with those of competing business models informs management of how aggressive they can be in their attempts to gain market share. Investors’ eagerness to see rapid growth often results in entrepreneurs setting prices and providing discounts and promotions that lead to negative UE. Unfortunately, it often becomes difficult to transition away from negative UE. Consumers grow addicted to the low prices and promotions, and rivals respond by lowering their prices and also operating with negative UE. Lack of profitability forces weaker competitors out. Stronger competitors feel the need to transition from a strategy of growth to one of margin by raising prices and offering fewer promotions and discounts. Inevitably, volumes decrease and growth stalls. Investors’ appetite for the industry diminishes, and investments dry up. Entrepreneurs behind companies that had been growing rapidly lose their willingness to continue to push hard. This leads to additional closings and companies exiting the industry. Survivors are often those organizations that paid close attention to UE from the beginning and operated with a positive UE value, even if that meant slower growth than that of more aggressive, and often better financed, rivals.

An excellent example of a company that waited to get to positive UE before scaling and did so steadily is GoPuff, the online snacks, beverages, and toiletries delivery service that competes with convenience stores rather than with grocery retailers. Founded in Philadelphia in 2013, it started selling convenience products to students and stayed committed to this “instant needs” niche for several years, which meant that it was carrying a relatively small number of SKUs. It also focused on a vertically integrated, hyperlocal distribution model, with 500-plus microdistribution centers in the U.S., in order to have full control of the customer experience. During the first two years, it achieved positive UE; it expanded into three cities with large numbers of universities, without resorting to external funding, and raised its first institutional funding round only in 2016. As of October 2021, it had raised more than $3.4 billion in multiple rounds, from a large number of investors, with the most recent round valuing the company at $8.9 billion.

GoPuff focused on achieving positive unit economics from the very beginning. The founders ensured that every new warehouse or microdistribution center broke even within six months. Here, it was looking at the warehouse as a unit. Further, it purchased the products it offered directly from brands, which offered better terms with increasing volumes than distributors would have. This approach helped with the economics of two units: an individual customer order and an individual customer (both of whose profitability increased with increasing volumes).

For established companies, understanding UE is helpful in deciding when to renew a legacy business model or when to exit a business threatened by entrants whose innovative business models have superior UE. Netflix is a good example, given that the UE values for its streaming service are superior to those of its DVD-by-mail business: Streaming has a lower marginal cost (no postage and little handling) and better service (open 24/7, no stockouts, instant delivery, and a potentially unlimited library).6 Clearly, the DVD-by-mail days were numbered as soon as broadband became widespread and the possibility of streaming became a reality. In spite of customer outcry when Netflix forced customers to choose either a DVD or streaming subscription (and didn’t automatically offer DVD subscribers streaming as well), a UE analysis made its strategy clear. The inferiority of DVD-by-mail’s UE implied that Netflix had no choice but to adopt the new business model or die.

While value creation for stakeholders — such as customers, suppliers, and business partners — is a necessary condition for the long-term viability of a business model, entrepreneurs and managers also need to ensure value capture for their companies. We propose that unit economics — that is, profitability per unit — is an important tool for companies to assess whether they are capturing value for themselves under different business model architectures. A thorough understanding of UE can go a long way toward ensuring the right balance between value creation and value capture.