The better your grasp of your MSP’s unit economics, the better you’ll execute.

The best MSP CEOs have an intuitive feel for their unit economics. They can predict whether a business decision will improve or hurt their unit economics with simple math.

That means the best MSP CEOs can make faster decisions. Their speed of execution is top of class.

MSP owners face many business decisions that can have a positive or negative impact on unit economics:

• When should we hire another technician?

• When should we hire our first dedicated salesperson?

• Is this new tool worth including in our stack?

If you understand how your unit economics work, you'll be able to answer these questions with confidence. And you'll make money.

Make the wrong decision, and your unit economics suffer. You'll work longer hours, while paying yourself smaller distributions.

This post will help you get your unit economics right.

What are unit economics?

Your MSP's unit economics are your MSP's profitability on a per-unit basis, which could be per recurring customer, per project, or per sale. It's the science of how your business makes money.

First, some key terms for unit economics:

• Variable costs grow and shrink with sales volume.

• Fixed costs stay the same, regardless of sales volume.

• Contribution margin is sales less variable costs, i.e. the profit we make from all our sales. Contribution margin per unit is the incremental profit earned from one unit of sale.

• The breakeven point is how many units you need to sell for your revenue to match your costs; selling less than your breakeven means you're losing money, and selling more than your breakeven means you're profiting.

Let's illustrate unit economics with a couple graphs:

1. Contribution margin

The first step at understanding unit economics is contribution margin, i.e. what you make after you subtract variable costs.

This graph has a couple takeaways for MSP owners:

1. Each client should add contribution margin. If you're not making money on each client, increase your prices or pick different clients.

2. Each upsell or cross-sell should add contribution margin. This includes break/fix or any project-based work. If project-based revenue isn't profitable, increase your project-based prices or stop offering this project-based work.

3. Each distribution channel should add contribution margin. The CAC vs LTV equation still applies, with LTV being another way to think about contribution margin.

4. You should be looking to preserve or expand your contribution margin at all times. Grow your prices faster than you grow your expenses, especially technician payroll and vendor costs.

2. Breakeven analysis

Since contribution margin only considers variable costs, we can introduce fixed costs to our unit economics analysis with a breakeven graph.

In this graph, while contribution goes up and to the right, we aren't making a profit until we sell enough units, when the contribution margin exceeds the fixed costs. Some business decisions that a breakeven analysis can help you with include:

• How many new clients do we need to close before we cover our costs?

• If we change our prices, how does that affect how many units we need to sell before we break even?

• A key supplier just changed their pricing, which impacted our cost structure. How much do we need to sell to break even? Is it worth changing to a different supplier?

Here's another breakeven graph, but with total revenue and total cost lines instead of contribution margin and fixed cost lines. The y-intercept of the total cost line is the fixed cost, and the slope is the variable cost. This latter graph might be more helpful for the rest of your team than the former graph, especially for your teammates who are accountable for revenue generation.

3. Stepped costs

The above breakeven graphs assume that fixed costs will remain constant even at scale. In practice, all fixed costs will become variable if you zoom out enough. For instance:

• One technician could handle multiple clients. But there's a max limit. Eventually you'll need to hire another technician if you keep closing new clients.

• Let's say you have an on-prem data center that supports all your clients. But there's a max limit here too, and eventually you'll need another data center if your first data center reaches max capacity.

This graph illustrates how you can convert variable costs to fixed costs as volume goes up, keeping the fixed cost per unit under control as you scale up sales.

4. Stranded fixed costs

What happens if you convert variable costs to fixed costs too soon, before your volume can justify it? Worse, what happens if your revenue declines to a volume too low to have justified the fixed cost investment in the first place?

This is an unfavorable turn for your unit economics, due to incurring stranded fixed costs.

You incur a stranded fixed cost if you're not selling enough to justify your cost structure. For instance, you rented a large office in anticipation of a historical sales year… but your primary marketing strategy suddenly stopped working, sales slowed to a crawl, and you couldn't justify sticking with your original plan to hire enough people to fill out your new office. So now you're paying office rent for extra employees that you didn't hire.

It's much easier to convert variable costs to fixed costs than it is to reduce fixed costs and convert them back to variable costs. This introduces a couple interesting business decisions as you consider your unit economics:

• Since stranded costs make your unit economics suffer, how much stranded cost risk are you willing to stomach? How likely is sales volume to decline?

• How badly do you want to protect your unit economics from declining sales volume?

• How much are you willing to invest in your MSP's value chain resilience, to maintain your unit economics across increasing or decreasing sales volume?

If you want to answer these questions for your own MSP, I'd recommend having cashflow forecasting in place first.

5. Unit economics vs. gross profit

Lots of MSP pundits argue for certain gross profit benchmarks that each MSP should strive for. Gross profit is related to, but not the same as, unit economics.

I must admit… I can't stand gross profit. Can't stand it!!! I find it the most frustrating accounting metric to evaluate businesses, since each business calculates gross profit differently. Business-by-business differences in gross profit are due to judgment calls on how to classify different costs, and these judgment calls are so subjective that my default expectation is that gross profit is just not a useful metric for MSP owners.

On the flipside, contribution margin calculations don't rely on subjective judgment that can vary business-by-business. Contribution margin relies on understanding the actual behavior of each cost, i.e. how each cost changes with volume. So each business should calculate contribution margin the same.

The above chart shows the difference between gross profit and contribution margin, or "marginal contribution" in the chart. The key difference is that both cost of sales and gross profit can contain both fixed and variable costs, while contribution margin is only concerned about whether a cost is fixed or variable.

Pitfalls of unit economics in practice

Most MSP owners are too familiar with how theory and practice can diverge. Protect yourself from the theory vs practice divergence by minding these common pitfalls.

Pitfall #1: You need good bookkeeping. You can't run any of these unit economics calculations without good bookkeeping. That means good systems for capturing costs and coding them correctly.

Pitfall #2: You need the ability to analyze financial data to improve your unit economics. This is a barrier to entry for most MSPs, since most owners started their MSPs because they love technology, not because they love finance.

Pitfall #3: You need to educate your team on unit economics, so you can decentralize efforts to improve them. A good MSP makes more money than it spends, but a great MSP is maintaining and expanding the gap between how much it makes and how much it spends. A great MSP makes it easy for each team member to contribute to its unit economics story.

7 strategies for MSPs to improve their unit economics

It's time for this post to help you make more money at your MSP, and help you improve your unit economics! Buckle in, yall!

1. Pricing

The absolute first place you should look is your pricing. You need to have pricing power for your MSP to earn strong unit economics. Your MSP should be competing for business on anything other than price. If price is your only differentiator, then I have some bad news… you're a commodity business.

Commodity businesses in theory aren't bad, even in spite of their poor pricing power and low margins. Popular examples of great businesses with poor margins include Amazon, Walmart & Costco.

However, the vast majority of MSPs should not be pursuing commodity businesses. There are over 60,000 MSPs in America, and over 80% of them do less than $3 million in revenue. The odds of the average MSP justifying low prices and low margins are also low. If you're a commodity MSP but you're not the leader in your market with strong net dollar retention, I recommend considering how fragmented the MSP space is, and carving out a niche with less price sensitivity.

Examples of pricing levers to impact unit economics include:

• New customer incentives.

• Retention incentives.

• Pricing strategy. Will you charge per device? Per user? How are you changing the prices and bundles in your bronze, silver & gold tiers?

2. Costs

We're not just talking about lowering costs. We want to maintain or increase the spread between unit revenue and unit cost. As you increase your sales volume, you'll want to look into building cost advantages and economies of scale. You'll want to consider making capital expenditures to convert variable costs to fixed. You can also join a buying consortium for MSPs.

3. Fill rate

Your fill rate is how much you sell vs. how much you're capable of delivering. For instance, if you have enough technicians and bandwidth to service 50 new clients, and you end up closing 40 new clients, then your fill rate is 40 / 50 = 80%. If you have 8,000 technician hours available and you bill 6,500 of them, then your fill rate is 6,500 / 8,000 = 81%.

As you look to maximize your fill rate, you'll evaluate trade-offs. For instance, you're about to hit a 100% fill rate with your existing cost structure, but you anticipate a strong quarter of sales. In this case, you might prefer to invest in your cost structure so you can add more clients, even if that means compromising on your fill rate.

I’ve heard other finance pros call this other things, like "conversion efficiency," but I prefer "fill rate" because it's more precise and useful in my opinion. But perhaps that's because I started my career as an engineer in the advertising industry, and "fill rate" is an advertising metric.

4. Mix composition

Unit economics are not equal across all units. For instance, your product mix can impact your unit economics:

• Managed services vs break/fix

• Standard managed services vs cybersecurity

• Bronze vs silver vs gold tier

Your customer mix also matters:

• Invite all your unprofitable clients to sign a new service agreement with higher prices, and offboard the ones who refuse to sign on.

• Find more clients who resemble your profitable customers.

Your channel mix is also worth your scrutiny:

• Inbound vs outbound sales

• Organic search traffic vs Adwords & other paid ads

• In-person trade shows vs online webinars

5. Fixed cost recovery rate

You should invest in fixed costs as soon as your volume justifies it. But it's a trade-off. Converting variable costs to fixed is much easier than the reverse.

Some examples:

• You started hiring technicians from a staffing agency and you pay the agency a placement fee for each hire. But now you're recruiting technicians aggressively enough to hire an in-house recruiter, converting variable placement fees to a fixed recruiter salary.

• You've been paying per-user pricing on resold software licenses, but now your volume can justify a bulk discount.

• You've been renting office space from a coworking space on a per-desk, per-month basis. But you can switch that to your own office, converting the variable cost of coworking space to fixed monthly rent.

6. Marketing & sales cost efficiency

Marketing & sales costs are typically considered fixed costs, but sometimes they behave more like variable costs or even capital expenditures. For instance:

• You're adding a cybersecurity offering for your first time, but none of your existing salespeople have experience selling cybersecurity, only traditional managed services. You're ready to invest in hiring a cybersecurity sales team, but it might not pay off until next year.

• You're investing in an SEO strategy that will expand your business in a new market, but deploying the content and building the links to execute this SEO strategy might not pay off until next year.

• You're considering investing in newsletter sponsorships, but the payoff is speculative and it makes sales attribution difficult.

7. Volume

Sales volume has a positive feedback loop with the other drivers above:

• If you operate efficiently, you'll drive up volume.

• If your volume goes up, you can operate more efficiently.

As your MSP scales and your volume increases, which lines on your P&L will increase with volume? Which will decrease? This depends on your cost structure, and how appropriate your cost structure is for your current volume.

Summary

• Unit economics matter because they're the science behind how your MSP makes money.

• Unit economics are a dance between variable costs, fixed costs, and sales volume.

• Your goal should be to maintain or increase the spread between unit revenue and unit cost, by operating more efficiently as your sales volume increases.