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Current time:0:00Total duration:11:37

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
five 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. Allthough, 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 [UNINTELLIGIBLE] 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
one, two, three. 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 thousand
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 $1.3 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
competition 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