Cupcake Economics 2 More analysis of the cupcake business.
Cupcake Economics 2
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- In the last video we talked a little bit about, at least potentially, starting a cupcake factory.
- But this is a major investment that I'm thinking about making,
- so at minimum, I made a spreadsheet here in Excel
- and it's available at khanacademy.org/downloads/cupcakes.xls.
- If you just click slash here, you'll see everything in the download directory,
- but I'm going to start putting more stuff there.
- So I encourage you to play with it.
- But this is essentially-- it'll do all the math for us
- that we did in the last video, --the investment in the factory.
- Let's say in the real world, once I actually got bids from contractors and things like that,
- it ends up costing $1.1 million.
- The annual capacity is a million cupcakes per year.
- The cost per cupcake is-- let's say, I don't know, input costs went up for whatever reason.
- Now that I have a computer doing the math for me, I can deal with a little bit funnier numbers.
- So let's say it's $1.05.
- The price charged per cupcake is $2.
- Well, actually, it can be anything, right?
- And so this is going to be an input field and right now it says $2.
- Let's say this is what we assume is how many cupcakes we sell. In this scenario,
- this is the income statement, at least as far as we get to the operating income line.
- And so it calculates that you have $2 million of revenue.
- Notice what happens when I change it.
- If I sell my cupcakes for a $1.50 per cupcake, then I only have $1.5 million.
- So it actually computes what we need it to compute.
- It computes the cost of goods sold.
- If I change the number of cupcakes, let's see,
- if instead of a million, I sell 500,000, it calculates everything accordingly.
- And in all these scenarios it tells me my operating income.
- And if you go a little bit lower, it tells me capacity utilization.
- That's just how many cupcakes I sold, divided by how many I could make.
- So it's 50% utilization and then,
- my return on asset is my operating income divided by my initial investment, right?
- So this is 275,000 divided by 1.1, it was a minus 25.
- So this is actually a bad outcome.
- So in the last one, I touched on a little bit that
- the real lever that I, as the owner of my cupcake factory, can change is price.
- And then, obviously, if I charge a lower price more people are going to want to buy my cupcakes
- and if I charge a higher price, fewer people.
- Although, there are some things that when you charge a higher price people think it must be better
- so maybe they want it, or they want to show off to their friends,
- and look at this expensive cupcake that I eat, and it's kind of a status symbol.
- But for the most part the lower the price, the more you sell.
- And now we can actually figure out under what combinations am I going to make certain amounts of money.
- So if I charge $1.50 per cupcake and I'm only able to sell 500,000 cupcakes,
- I'm going to take a loss per year of $275,000.
- If I sell them for $1.75 and if I sell, I don't know, 700,000 cupcakes,
- I'm almost at break-even.
- So, let's see, you have to do $1.85.
- Here in this situation, I actually make money.
- I have a 5% return on asset.
- And, just so you know, this is a major investment that I'm making, $1.1 million.
- I actually want to make sure I understand all of the scenarios of price and sales.
- So what I did is actually used Excel to do a sensitivity study.
- So what I did here is I put all of the-- let me just go to that part of the spreadsheet.
- And I encourage you to play with this, because it's interesting.
- It shows you that even in a fairly simple business, you can do a lot of analysis.
- And, if you're in high school or in middle school, this could actually be a fun--
- I don't know if they allow this type of thing for science projects.
- But go to a local business and kind of analyze the business in a hundred different ways.
- And actually, if you watch the probability videos,
- I do all those things on Poisson processes and things like that.
- You can analyze the business and do Excel spreadsheets and
- you'll probably end up winning soon the state science fair.
- Call it a math project or engineering project.
- But anyway, here I want to figure out what is my return on asset?
- So essentially my operating profit divided by my initial investment,
- depending on the different prices I might charge and the different quantities.
- And here it's kind of hard to visualize, so I graphed it as a three dimensional surface. 3D.
- So as you see here, if I charge $2.80 and I only sell 300,000, then this is my return on asset right here.
- This curve is actually the zero curve, right?
- So this is actually my break-even right here.
- So any point along this curve right here I'm at break-even.
- So if I'm at $2.80 per cupcake and I only sell 300,000, I'm at break-even.
- Let's see, what is this right here?
- If I sell $1.60 per cupcake and if I sell 900,000, then I'm also at break-even.
- So this is my break-even curve. This is what I want to avoid.
- Everything here is in the negative, right, according to the legend, minus 50% to zero percent return.
- So here I'm losing money and I would color it in if I wasn't in Excel mode.
- If I charge $1.60 per cupcake and I only sell 400,000 cupcakes,
- I'm going to have a negative return.
- And we can figure it out in that little worksheet I just did.
- But anyway this is fun to look at and I encourage you to play with it.
- And it actually shows you that it's a fairly interesting and sophisticated thing,
- that you have these two variables that change.
- And this is about as simple as a business can get.
- You can only imagine what happens when you start varying the other parameters,
- but these are the two big ones.
- So let's say, when I come out the gate, I want everyone in town to taste my cupcakes.
- Because I think, once they taste it, they'll realize that they're delicious.
- And by the way, I've also learned from the cigarette companies
- and I put nicotine in my cupcake, so I think people will become addicted to it.
- So what I do is, I want to charge a relatively low price for it.
- Let's say I do come out the gate at, I don't know, $1.75.
- And that's a very cheap price for cupcakes.
- There's actually no cupcake producers in this town right now.
- So I just sell out. I just sell out of cupcakes.
- And so I'm making $200,000 per year, that's an 18% return on asset.
- And a lot of people would be happy with that.
- but I'm like, hey, I'm leaving money on the table because I'm selling out of my cupcakes.
- So what happens if I raise my price a little bit?
- I'm fully utilized, right? I have 100% utilization.
- So it makes sense for me to see if there's any-- maybe
- there's some people who want cupcakes, who can't get them because I can't produce that many.
- So let me raise my price a little bit.
- Let me say I raise it to $1.85.
- At $1.85 it still turns out that I'm selling a million cupcakes in a year.
- Now, I was right. I was leaving money on the table.
- Now I'm making $300,000 a year. This seems like a good idea.
- I want to see how much people are willing to pay.
- So, let's say, I raise the price to $2.
- But, in that scenario, $2, it starts to get a little pricey for people.
- It's just kind of a little sticker shock. Maybe I should have done $1.99.
- And so I don't sell a million. I sell 950,000.
- There's maybe 50,000 people in the margin who said,
- hey, you know, I'd buy it at $1.85 but I'm not willing to buy it at $2.
- But this still works out, right? I'm still making more money.
- Even though I'm selling fewer cupcakes,
- because I'm charging so much more per cupcake, and I'm making a 37% return.
- Let's say I keep figuring this out.
- And let's say I figured out the optimal point is me charging $3 per cupcake.
- And at $3 per cupcake, I'm able to sell you 750,000 cupcakes.
- And I make $962,000 a year and I have a huge return on asset, 88%.
- Imagine a business or some investment where you get 88% of your money every year.
- So that's all good and I'm driving a Bentley and I have the biggest house on a hill in town and all of that.
- But other people say, hey, all Sal's doing is making cupcakes.
- I can make cupcakes too and I have some money to build a factory.
- This is a better return on investment than the stock market or anything else that I know of.
- So I'm also going to get into the cupcake factory business.
- And so, here, this is the second worksheet in this spreadsheet.
- So let's say, I was at $1.1 million. I don't know if you can see this.
- Maybe I should zoom in a little bit. There you go.
- So this is the same thing. So I said $3 and, 750,000 cupcakes and
- my cost was a $1.05.
- So I was making $962,000.
- But then Imran-- and just if you're curious why I wasn't recording videos for the last two weeks,
- actually Imran is the name of my son and he came into the world two weeks ago,
- and so, I think it makes sense to name a cupcake store after him.
- But let's say he comes in, and he's like, I'm tired of getting an allowance from dad;
- I also want to produce cupcakes.
- And he actually has more money because his grandma gave him more money
- because she likes him more than her son.
- And so he has $1.5 million to invest because he's like, wow,
- this is such a good investment, let me put more money into it. $1.5 million.
- He builds a factory that can produce two million cupcakes a year.
- And also, it's a more efficient factory, so it actually uses a little less electricity,
- and wastes less cream and frosting, and, I guess, nicotine as well.
- So the cost per cupcake is less.
- And he decides to undercut his father, so he charges $2.90 per cupcake.
- And when he charges $2.90 per-- everyone just kind of runs to him,
- because his cupcakes are just as good.
- There really wasn't much of a barrier.
- So, let's say, he sells 500,000 cupcakes.
- Then I'm only selling 250,000 at $3.
- There's just some people who like my cupcakes.
- So I'm pretty much almost break-even and I say, well, these are my die-hard fans.
- And so, to benefit them-- these guys aren't going to go anywhere else.
- I'm going to raise my prices a little bit.
- Just because I know that these guys like me.
- At least in that situation, I'm cutting a profit.
- But then I say, well, you know, this isn't a good state of affairs.
- He took all my business.
- I actually want you to notice something right here, what happened immediately.
- I was making an 88% percent return on my money, right?
- And just when this Imran comes in, and he enters into the space, all of a sudden, what is the return?
- He's only running at 25% utilization.
- But his return on asset has gone down to 20.
- and, because he's at that utilization, his return on asset has gone down to 20%.
- And then my return on asset has gone down to 1%.
- So there's a general theme here.
- When someone is doing really well and getting a really great return, it attracts competition.
- It attracts capacity, right?
- And if there's enough demand to satiate that new capacity, maybe they will get a better return.
- But in general, over time, if there's a very favorable return, more and more will enter the market.
- Actually I've run out of time in the studio.
- In the next video, I'll talk about more scenarios with competition.
- See you soon
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