Metafocus: Serious Games: Three Questions About Unit Economics

If you’re thinking of making a serious game or educationalexperience, you need to understand the unit economics to see if it’sfinancially feasible to build it. Unit economics is a tool that will help youanswer three basic questions about any opportunity:

• What is my breakeven?
• What is my pre-tax cash flow?
• How long until payout?

We’ll explain what each of these questions means, and why eachis important, later in this article. For now, understand that these are threemain financial questions you’ll need to answer when analyzing entrepreneurialopportunities, whether you’re launching a whole new business, investing in aventure or project, or simply creating a new product for your currentorganization.

Unit economics also prevents you from improperlycategorizing or combining variable costs, fixed period costs, and primary sunkinvestments, allowing you to budget for the project or venture more accurately.Lastly, if you build a simple spreadsheet that performs the calculations foryou, you can do a sensitivity analysis, changing assumptions until you’veidentified the best business model for proceeding. Don’t worry—the formulas arequite simple, even though few entrepreneurs and managers know how to do them. We’llwork through a simplified case study to illustrate the critical elements of uniteconomics.

Unit economics always matter

Even if you’re not a for-profit business looking to makemoney from your game, the unit economics are still important to calculate.Budgets still matter, no matter what kind of organization you are. I guaranteethat, at minimum, someone at the top of your organization very much cares howmuch your game will cost to make, how much it will increase overhead, how muchrevenue it can bring in, and so on. I’ll write this article assuming that youplan to sell your own game or experience for a profit, but the same rules ofunit economics apply to any kind of organization. Even if you’re only buildingthe experience for internal use within your own organization, some sort ofvalue is likely to change hands from department to department, even if only atthe accounting level. Further, you can still calculate the unit economicsformulas even if you set the price to $0.

Also, many successful software companies got their start asa spin-off from a larger corporation or government entity. As in, theparent company or agency develops the software for its own internal uses, thenrealizes other companies could benefit from the same software, and so decidesto sell licenses to outside parties to generate a new revenue stream. If youdevelop highly valuable games for your organization’s internal use, don’t besurprised if you’re suddenly the head of a division selling your games to theopen market. If you do your unit economics now, you’ll be better prepared if andwhen you find yourself in that situation.

Now you know why to calculate unit economics, so let’s setup our fictional but realistic case study.

Case study

Let’s say you were a technical trainer working for a largecorporation. You decided you wanted to make a game that teaches a skill that’sfundamental to the work completed by many of your company’s employees. You alsorealized that a game that teaches this particular skill would be valuable tocompanies and workers outside your organization, too.

You pitched your manager on the idea that you’ll build thegame and sell it on the open market as an additional revenue stream for thecompany. She asked you how much the game would cost to build, how many copiesof the game you would have to sell to cover costs each month, how much money it’slikely to make, and how long before the company recouped its invested capital.Fortunately, you had already calculated the unit economics, so you had theanswers ready. The numbers made sense, you sounded confident and organized, andso she agreed. She allocated a small budget your way, and you were off to theraces.

After some initial planning and organization, you hired fivecontract game developers and designers to help you build the game. The salariesfor the six of you totaled about $40,000 per month, and it took you four monthsto build the game. Once the game was finished, you let most of the team go. Youretained two full-time employees plus yourself to fix bugs, take customerservice calls, market and sell the game, and handle any other tasks. Yourcombined salaries cost only $20,000 per month moving forward. You also spent $5,000to build a website and $15,000 on marketing your game for launch. Game licenses(GLs) are priced at $20 each, meaning that each person who buys your game paysyou $20.

The game was a success. Your company loved it, and you werepromoted to VP of the company’s newest division: training and development software.Further, the game did fairly well outside the company. Almost immediately, salesreached 2,500 units (i.e., unique game licenses and downloads) each month. You’realready planning what games to build next.

Amazingly, all the revenues, costs, and cash flows turnedout exactly as you predicted in your original unit economics calculations. Let’stake a closer look.

Assumptions

Unit economics uses several assumptions (aka variables) inthe formulas. These assumptions include units, price, three types of costs, andunit sales. Figure 1 shows all the assumptions and formula calculations asdescribed in our case study. Throughout the rest of this article, we’llreference this figure one section at a time.

Figure 1: Case study assumptions and formula calculations

Units

A unit (i.e., a single unit sold) can be many differentthings, but for our purposes, a unit will be one GL or download of your game.Every time a person, company, school, etc., buys and downloads a single copy ofyour game, that’s one unit. If someone buys two licenses for two differentcomputers or devices, then that counts as two units. If you’re a pizzarestaurant, a unit is probably going to be a single pizza. If you’re a T-shirtcompany, a unit will be a single T-shirt. In your venture, a unit is a single gamelicense. 

Price

Price is what you’ll charge to sell one unit. Game pricesvary greatly. However, for the purposes of this case study, you’re charging $20per GL.

Costs

Unit economics requires you to differentiate between threedifferent kinds of costs: variable costs per unit (VC), overhead or fixedperiod costs per month (FPC), and primary sunk investment (PSI). It’s veryimportant that you categorize costs correctly. For example, if you list an FPC,such as an employee’s salary, under VC or PSI, then your monthly budget will beway off, as will your VC or PSI. 

Variable costs per unit

VC are costs that you incur each time you sell a single unitof your game. These typically include:

• The cost of the raw materials required to makeone unit
• Sales commissions
• Credit card fees
• Sales taxes
• Delivery costs

VC can be a percentage of the price or a set dollar amountper unit. When adding up the VC, make sure to convert any percentages to anactual dollar amount so all VC can be added together.

In the case of a game that’s downloaded via the Internet,your VC will typically be limited to:

• Credit card fees of about 2% – 3% of the unitprice
• Sales taxes, varying depending on your locationbut generally around 7% – 8% of the unit price
• Any fees (aka revenue splits) charged by theplatform or marketplace that markets and distributes your game, often around30% of the unit price (this is what Steam is purported to charge)

The total VC for your game will thus be 40% of the price. Ifyou charge $20 for your game, the VC will be $8/unit. If you sell one unit in agiven month, you incur the $8 just once that month. If you sell two units, youincur the $8 twice, totaling $16 in VC for that month. If you sell 1,000 unitsin a month, you’ll incur $8,000 in VC that month.

Note: Alwaysinclude the full label or mathematical units (e.g., %, $, per unit, per month)for every number used in unit economics so you don’t mistakenly add two numberstogether with different mathematical units or labels.

Fixed period costs per month

FPC (aka overhead) are costs that you incur each month nomatter what, such as:

• Salaries
• Rent
• Insurance
• Utilities

If you sell zero units in a given month, you still have topay your employees’ salaries and the rent payment. The landlord doesn’t carehow many units you sell, as long as you keep paying rent on time. However, ifyou sell 1,000 units, your employee salaries and rent payments stay thesame. 

For the purposes of this case study, we’ll assume your onlyFPC will be salaries because your rent, insurance, utilities, and other overheadcosts will already be covered by the other business activities of your parentcompany. An accountant could certainly allocate some of these other costs tothis project, but realistically, the business will go on whether your game issuccessful or not. Further, your small team is not likely to increase rent,insurance, or utilities by launching your game either. Therefore, salarieswill be our only FPC.

The number of full-time employees you’ll need depends on thescope and complexity of your game and the speed at which you’re going todevelop it. A team of two or three people can build and launch a very simplegame perhaps within a few months, maybe as long as a year. A team of 15developers can launch a larger and more complex game in 6 – 12 months. Majorgame development companies require hundreds of people to launch each big-budgettitle over the course of a year, or sometimes over several years. As mentionedabove, you decided to hire five people plus yourself, and it took you fourmonths to build the game.

However, once the game was built, you didn’t need all thosepeople anymore, just the small crew of two full-time employees plus yourself.The larger original team of five developers was an up-front cost that you onlyincurred one time to build the game. Thus, that team won’t be considered anFPC. Only the new, smaller team that’s staying on indefinitely will beconsidered an FPC.

Primary sunk investment

PSI are costs that you incur one time at the very beginningof a venture. These costs are required to get the business and productlaunched. These often include:

• Development costs
• Signs, logos, and other branding
• Website and app
• Office or location build-out
• Equipment
• Operating losses incurred until the product islaunched and breakeven is reached

Just like with some of the variable and fixed period costs,many of these PSI will not apply to your serious game development project. Forexample, in our case study, you already had all the computers and equipment youneeded.

The biggest PSI to consider here is the original team ofdevelopers. This team costs $40,000 per month, and it took you four months tobuild the game. $40,000 X 4 months = $160,000. Add in the $5,000 you spent forthe website and the $15,000 for marketing the launch, and that puts your PSI at$180,000.

Unit sales

The final assumption or variable in unit economics equationsis unit sales. How many units do you estimate you’ll realistically be able tosell each month? I can’t answer that for you, because it depends on the size ofyour market, the demand for your particular game, how good your game is, howheavily you market and promote the game, how much competition it has, anypartnerships or business development you have lined up, a little bit of luck,and so on. In our case study, however, you sold 2,500 units per month.

Formulas and analysis

Now that we’ve decided values for all our variables orassumptions, we can calculate the unit economics formulas. The four formulasare as follows:

• Contribution = price – variable costs
• Breakeven = fixed period costs / contribution
• Pre-tax cash flow = contribution X unit sales –fixed period costs
• Payout = primary sunk investment / pre-tax cashflow

Let’s walk through each of them, in order, using theassumptions in our case study.

Contribution

Contribution per unit (aka contribution or gross profit perunit) is how much each new unit sale contributes to the company. Knowing thecontribution per unit is somewhat useful in its own right, but its biggestimportance comes from its role in the remaining three formulas that arecalculated after calculating contribution.

The higher the contribution, the better, because you want tomake as much profit on each sale as possible. In our case study, thecontribution is:

Breakeven

Your breakeven is the number of unit sales you need to selleach month in order to pay for all your FPC. If you sell fewer units than thateach month, the company loses money. If you sell exactly the number of unitsneeded to break even each month, the company neither loses nor profits. If yousell more units than that, the company makes a profit. Obviously, knowing howmany units you need to sell to break even is critically important to anyentrepreneur, executive, or manager.

The lower the breakeven is, the better, because that reducesthe risk of losing money each month. In our case study, the breakeven is:

Pre-tax cash flow

Pre-tax cash flow is exactly what it sounds like: how muchmoney the company will make before paying taxes. This is roughly analogous toEBITDA (earnings before interest, taxes, depreciation, and amortization) on anincome statement. Obviously, being able to estimate how much monthly cash flowa new product is likely to create is also critically important toentrepreneurs, executives, and managers.

The higher the pre-tax cash flow, the better, because we allwant to make more money. In our case study, the pre-tax cash flow is:

Payout

Payout is how many months (or years) it will take for theventure to earn enough pre-tax cash flow to pay back the full amount of capitalinvested to build and launch the project.

The sooner the payout, the better, because it’s less riskyto get any invested capital back as quickly as possible. In our case study, thepayout will be:

Sensitivity analysis

While the assumptions above are fairly realistic for manysmall game-development projects, your actual assumptions may be quitedifferent. That’s OK. Similarly, you may not even know what your price, costs,and unit sales will be yet. That’s OK, too. Just build a spreadsheet that calculatesthe formulas above. Make sure you can easily change any of the variables. Thenput your own numbers in and see how the results change. Make a note of theresults. Then change one or more of the assumptions, and make a note of thoseresults. Do this again and again until you have a deep understanding of howeven small changes to any of the variables—whether the price, VC, FPC, PSI, orunit sales—will impact your breakeven, pre-tax cash flow, and payout.

Don’t just make up numbers, however. Instead, do yourhomework. You must research as best you can what your costs will likely be,what price point you can likely sell at, and how many units you canrealistically sell at that price point. If you can’t find any information onthese assumptions, you’ll have to make educated guesses, but the better theinformation you feed into the unit economics formulas, the more accurately they’llpredict breakeven, pre-tax cash flow, and payout.

Once you’ve tested out every realistic scenario in yourspreadsheet, and not a moment before, you will finally be well enough informedto decide whether the project is even worth doing, or whether it’s too small ortoo risky to proceed.

Note that unit economics analyses are highly subjective.While some opportunities are clearly bad—perhaps because the contributionmargin is close to zero, they have a negative pre-tax cash flow, they’ll neverreach breakeven, or payout is absurdly far in the future—the analyses of otheropportunities are less clear. For example, take our case study’s calculationsof:

• $12 contribution per GL
• 60% contribution margin (i.e., $12 contribution from$20 price)
• A breakeven of 1,667 GL per month
• $10,000 pre-tax cash flow per month
• An 18-month payout

Are they good or bad? Risky or safe? Is this opportunityworth pursuing or not? Frustratingly, the answer to all these questions is, “Itdepends.” It depends on your (or your organization’s) balance sheet, liquidity,current profitability, operational focus, strategic plan, competition, markettrends, and more. The same opportunity and unit economics might be a perfectinvestment for one company and a disaster for the next.

Only you and your team can decide what these numbers mean inthe context of your own company and circumstances. That said, you’ll make farbetter decisions about whether to proceed with this or any opportunity if youhave the unit economics numbers in front of you than if you don’t.

Summary

After you’ve built the spreadsheet—and it should only takeyou five minutes if you’re proficient in Microsoft Excel, Apple Numbers, GoogleSheets, or other spreadsheet programs—then you can use it to analyze theviability of any new opportunity, no matter what the product or service.

For example, what if you’re considering building game-basedeLearning experiences for big corporate clients? No problem. Just use your uniteconomics spreadsheet. Your unit could be selling, building, and delivering onetraining game to one client. Your VC will be way higher, but so will the price.The number of units sold will be way smaller. FPC and PSI could be high or low,depending on the size of your team and how much you spend before closing yourfirst deal.

The unit economics will look very different for every singleopportunity, but the formulas will work just the same, and the results willalways be incredibly informative and useful.

Additional resources

You can find several in-depth articles about uniteconomics on my blog. If you email me, I’ll happily send you a unit economics spreadsheet template at no cost.