Economics of a cupcake factory Economics of a simple business leading up to a discussion on inflation/deflation. Touching on income statements.
Economics of a cupcake factory
- All the talk today is about are we going to see inflation or deflation.
- And before we do that, I think it's really important to get a microeconomic level understanding of
- why do prices increase or decrease.
- We'll do a little example of me starting a business and
- when do the prices increase or decrease in that market?
- So let's say I wanted to start a cupcake factory.
- And then actually in the process of this video,
- even though this isn't the intent of this playlist.
- The intent of this playlist is eventually for you to be able to go to your econ professor and say,
- no, we won't or we will have inflation or deflation for reasons x, y, and z.
- But in the process you might learn a little bit about accounting and starting a cupcake factory.
- So let's say I want to start a cupcake factory. It costs a million dollars to build.
- And just the economics of the factory is it costs $500,000 a year to operate.
- So that's literally to pay the electric bills,
- to have people sitting there ready to make cupcakes,
- and I have accountants and all the rest. I have to pay people to clean the place.
- Let's say the economics of the cupcakes themselves-- The cost per cupcake is $1.
- Let me do that in red. I'll do all of these in red because these are-- I'll do that later.
- So the cost per cupcake is a dollar, one dollar cost per cupcake.
- And where does that cost? Some of it is the incremental,
- Let's assume that I had a completely automated, robotic factory.
- Let's say there's very little labor at my factory.
- And this is just the cost of ingredients: cream, and sugar,
- and butter, and those little wax paper things that the cupcake is held in,
- and the electricity to run my robots,
- and then overtime to kind of maintain the robots that make my factory.
- Let's say I think that I can charge $2 per cupcake.
- This is just an exercise and let's think about. Oh and one other thing,
- my $1 million factory can produce 1 million cupcakes per year.
- So this is a couple of exercises.
- Because I'm a businessman, I'm not just going to plunk down a million dollars
- before I figure out how much money I can make.
- Let's think about how much money we can make in different scenarios.
- Let's call this scenario one, which is kind of the best scenario.
- So call this the optimistic optimist-- is that I sell a million cupcakes.
- So my factory can produce a million cupcakes and I sell a million cupcakes.
- If I sell one million cupcakes-- And I'll take a side here
- because this is an issue that I want to bring up a lot. I am fully utilized.
- My factory can produce one million cupcakes and, in this scenario, I'm producing a million cupcakes.
- So we would say we're 100% utilized.
- How much are you producing relative to what you can produce? 100%
- So, if I sell a million cupcakes, what would be my revenue?
- And I won't go into the details of accounting.
- Let me make revenue in green because that's a good thing. So what is my revenue?
- If my background weren't already black, I would make that in black.
- That's why people say being in the black or being in the red.
- Because being in the black means you're positive and being in the red means you're negative.
- But my background is black so I'll use green. So we'll say being in the green.
- So what would be my revenue?
- Well, I'm selling one million cupcakes and this is my optimistic scenario.
- Let's say I actually am able to charge $2 per cupcake.
- Obviously the whole discussion is: what happens to this price over a bunch of different scenarios?
- So I am able to charge $2 per cupcake, so my revenue is equal to $2 million per year. Right?
- This is a million cupcakes per year. What are my cost of goods?
- And I'll write the common acronym in there, COGS.
- And this is what you'll see if you actually look at income statements for public companies.
- You'll see something like cost of goods or variable costs.
- Usually, actually, cost of goods or cost of services is what you'll see most often.
- So if I have a million cupcakes-- let me do this in red, I said I would do this in red.
- So I have a million cupcakes times-- what's my cost per cupcake?-- times $1 cost per cupcake.
- So it's $1 million per year.
- And so what is my profit just from selling the cupcakes?
- Before I think about how much does it cost for me, all of the overhead expenses.
- Just kind of the money I'm getting from selling the cupcakes, and
- that term is called gross profit.
- And that's essentially how much am I bringing in from the cupcakes?
- And then how much are just those cupcakes costing me?
- So I'll do a line here. I'll subtract that from that.
- So gross profit, I'm making $1 million. Two minus one.
- You might say, oh that's great! You're making a million dollars on your cupcake factory in this scenario,
- and oh no, we're not done yet. This is just the gross profit.
- This is just the money directly from the cupcakes.
- I have all of this overhead expense and often times, on a regular income statement,
- it will be called selling, general and administrative, or overhead costs, or operating costs
- or something like that. I'll just call it overhead. I'll make it red because it's an expense.
- So this should be red too: COGS. So I'll call it overhead.
- So once again, this is kind of the offices, the accountants, the bookkeepers.
- So that's going to be $500,000 a year.
- And then, how much am I making from the business now?
- And this is called operating profit.
- How much am I making from operating the business?
- And I won't go into all of the details of an income statement,
- but any income statement you look at will have this operating profit line.
- And everything below the operating profit line, just as an aside,
- will kind of cover things not related to the actual operations of the business.
- It'll be expenses related to financing the business if I took a loan for that million dollars,
- or it will be expenses related to taxes and all that.
- Or we're just assuming an ideal world that doesn't have taxes.
- And let's say, assume if I inherited this million dollars, I didn't finance it.
- So my operating profit is really my profit because I don't have to pay taxes on it.
- So let's see, I got gross profit just from selling the cupcakes: a million.
- Overhead: the accountants and the people cleaning the factory and et cetera, et cetera.
- That's $500,000 a year. So my operating profit is $500,000 and that's pretty good.
- I had a $1 million investment, one time investment.
- And I'm assuming that this $500,000 a year to operate also maintains my building.
- So this kind of $1 million investment will exist forever, right?
- And I'm making $500,000 a year in this scenario.
- So that's a 50% return, right, which is great.
- If I told you I had an investment where I could make 50% a year on your money,
- you'd say here's my money, here's a check.
- But this is, of course, an optimistic scenario. Let's think of other scenarios.
- There's actually a ton of scenarios because you can keep adjusting how much you sell
- and the price you sell it for and come up with different numbers here.
- It's actually a fun exercise to do in Excel and you could do probability distributions and all that.
- But I won't worry about that right now. Let's do a pessimistic-- actually let's do this scenario.
- What do I have to do just to make sure that I don't lose money, right?
- So to make sure I don't lose money,
- let's kind of do it backwards.
- So we're going to do a break-even analysis.
- And trust me, this will eventually lead to
- whether we're going to see inflation or deflation in this economy.
- And I think in the meantime you might learn a little interesting things about starting a business.
- So let's say I just want to know what has to happen for my operating profit to be zero.
- Right? To not be negative, what's the minimum number of cupcakes
- I need to make or what price I have to charge.
- So if my operating profit is zero, we know my overhead.
- This is fixed. This is a fixed expense.
- There's nothing I can do about it.
- If you want to have a cupcake factory,
- it will cost you $500,000. And I'll write it as a negative number
- because we're going to subtract it from the gross profit.
- So what does the gross profit have to be?
- In order for this to come out to be zero,
- the gross profit has to be $500,000.
- And so now we can think of a bunch of scenarios where we end up with $500,000 gross profit.
- We could, if we sold-- what'd we say? So how can we get to $500,000?
- So let's say we're selling, I don't know, instead of selling a million cupcakes
- we're only selling 500,000 cupcakes.
- Right, this should work out. So then our revenue will be $500,000.
- And let's say I'm still selling it for $2 a cupcake.
- Times $2.
- So that would be $1 million of revenue coming into the door per year.
- And then my cost of cupcakes, or my cost of goods sold, is what?
- I should be doing this in red, I'm not being consistent.
- My cost of goods sold is what?
- We said it was a dollar per cupcake, right?
- So that's 500,000 times $1.
- It would be silly to ever sell a cupcake for less than a dollar, right?
- Then you're just handing checks out to your cupcake eaters.
- But anyway, in this case, my cost for goods sold would be $500,000
- and everything would work out.
- So this is a break-even scenario, where I sell 500,000 cupcakes at $2 per cupcake,
- with this being the cost of goods.
- And then I'll make $500,000 gross profit and then, take out the overhead.
- At least I won't make a loss.
- This is interesting because this tells me, if I'm charging $2 per cupcake,
- I have to sell at least 500,000 cupcakes to make money.
- So you might say, oh yeah, so it would never be rational to sell anything less than 500,000 cupcakes.
- Otherwise you should not operate the business.
- And what we'll do in future videos is we'll actually explore situations in which that does happen.
- And in which people start to kind of cut prices to actually compete.
- And in the process they'll be doing very irrational things.
- But anyway, I realize I've run out of time in this video.
- I'll see you in the next one and we'll actually see what happens once I start my cupcake factory.
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