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Economics of a cupcake factory

Economics of a simple business leading up to a discussion on inflation/deflation. Touching on income statements. Created by Sal Khan.

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Video transcript

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. 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. Oh and one other thing, my $1 million factory can produce one 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 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. But 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 pessemistic-- 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.