Cupcake economics 2

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