Cupcake economics 2 | Inflation | Finance & Capital Markets | Khan Academy

Summary

The video script discusses the process of starting a cupcake factory, emphasizing the importance of financial planning and analysis. It introduces an Excel spreadsheet available at khanacademy.org to calculate investment returns, cost per cupcake, and pricing strategies. The script explores the impact of price changes on sales volume and profitability, illustrating how to use Excel for sensitivity analysis and 3D graphing to understand break-even points and optimal pricing. The narrative also touches on market competition, showcasing how new entrants can affect profitability and the need for strategic pricing to maintain market share.

Takeaways

• 😀 The speaker is considering starting a cupcake factory, which involves a significant investment.
• 📊 They have created an Excel spreadsheet to calculate the financial aspects of the business, including investment, costs, and revenue.
• 💼 The initial investment for the factory is $1.1 million, with an annual capacity of one million cupcakes.
• 📈 The cost per cupcake is variable, and in the example, it's $1.05, while the price per cupcake can be set by the owner, starting at $2.
• 💰 The spreadsheet computes revenue, cost of goods sold, operating income, capacity utilization, and return on asset based on user inputs.
• 🔍 The speaker explores different pricing strategies and their impact on sales volume and profitability, highlighting the importance of price elasticity.
• 📉 At a lower price of $1.50 per cupcake, the business would operate at a loss, while at $1.75, it's close to break-even.
• 📈 By increasing the price to $3 per cupcake and selling 750,000 cupcakes, the return on asset reaches an impressive 88%.
• 🤝 The introduction of competition, represented by 'Imran' entering the market, affects the original business's profitability and market share.
• 💡 The video script illustrates the use of Excel for sensitivity analysis and the impact of market dynamics on business performance.

Q & A

What is the main topic discussed in the video script?

The main topic discussed in the video script is the financial analysis and decision-making process involved in starting a cupcake factory, including investment, pricing, sales, and competition.

What is the initial investment cost for the cupcake factory mentioned in the script?

The initial investment cost for the cupcake factory is $1.1 million.

What is the annual capacity of the cupcake factory in terms of the number of cupcakes?

The annual capacity of the cupcake factory is one million cupcakes per year.

What are the variables that can be adjusted in the Excel spreadsheet provided in the script?

The variables that can be adjusted in the Excel spreadsheet include the cost per cupcake, the price charged per cupcake, and the number of cupcakes sold.

How does the script suggest using Excel to analyze the business?

The script suggests using Excel to perform a sensitivity study, calculate revenue, cost of goods sold, operating income, capacity utilization, and return on assets under different pricing and sales scenarios.

What is the significance of the break-even curve in the 3D graph discussed in the script?

The break-even curve in the 3D graph represents the combination of pricing and sales volume at which the business neither makes a profit nor incurs a loss.

What strategy does the script suggest for entering the market with a new product?

The script suggests starting with a low price to attract customers and gain market share, as exemplified by the strategy of selling cupcakes at $1.75 per cupcake.

How does the script illustrate the impact of competition on business profitability?

The script illustrates the impact of competition by showing how the entry of a competitor, in this case, Imran, affects both his and the original business's return on assets, leading to a decrease in profitability for the original business.

What is the role of capacity utilization in the financial analysis of the cupcake factory?

Capacity utilization is used to determine how efficiently the factory is operating, calculated as the ratio of the number of cupcakes sold to the number of cupcakes that could be produced.

How does the script use the concept of return on asset (ROA) to evaluate the success of the cupcake factory?

The script uses return on asset (ROA) to evaluate the success of the cupcake factory by comparing the operating income to the initial investment, showing the profitability and efficiency of the business.

What is the potential consequence of a high return on investment in the cupcake business as described in the script?

The potential consequence of a high return on investment is that it attracts competition, as seen when Imran enters the market with a new factory, leading to a decrease in the original business's profitability.

Outlines

00:00

📊 Financial Planning for a Cupcake Factory

The speaker discusses the financial planning for starting a cupcake factory, emphasizing the importance of investment analysis. They mention creating an Excel spreadsheet available at khanacademy.org to aid in calculations. The spreadsheet includes inputs for the factory's investment cost, annual capacity, cost per cupcake, and price per cupcake. It calculates revenue, cost of goods sold, operating income, capacity utilization, and return on assets. The speaker explores the impact of changing the price per cupcake and the number of cupcakes sold on the financial outcomes, highlighting the importance of understanding different scenarios to maximize profits and return on investment.

05:03

📈 Sensitivity Analysis and Market Strategy

The speaker delves into a sensitivity analysis using the Excel spreadsheet to understand how different pricing and sales volumes affect the return on investment. They illustrate the use of a 3D graph to visualize the relationship between price, quantity, and return on assets. The speaker also discusses a hypothetical scenario where they initially set a low price to capture market share and then gradually increase the price to maximize profits. The narrative includes a humorous twist, suggesting the addition of nicotine to the cupcakes to create addiction, and explores the impact of competition entering the market, leading to a decrease in returns due to market saturation.

10:03

🏭 Market Entry and Competition Dynamics

In this section, the speaker introduces a competitive scenario where a new entrant, named Imran, enters the cupcake market with a more efficient factory and lower costs. Imran undercuts the speaker's pricing, leading to a shift in market dynamics. The speaker discusses the impact of competition on their sales and profitability, highlighting the decrease in return on assets for both parties. The narrative concludes with the speaker considering raising prices to maintain profitability among their loyal customer base, reflecting on the broader economic principle that high returns attract competition, which can lead to a normalization of returns over time.

Keywords

💡Cupcake Factory

A cupcake factory refers to a business establishment that specializes in the mass production of cupcakes. In the video, the concept is central to the discussion around starting a business and the financial analysis involved in such a venture. The script explores the investment required to start a cupcake factory, its operational costs, and potential revenue, illustrating the complexities and considerations of running a food production business.

💡Spreadsheet

A spreadsheet is a digital document used for organizing, analyzing, and storing data in a grid of rows and columns. In the context of the video, the speaker uses an Excel spreadsheet to calculate the financials of the cupcake factory, such as investment costs, operational income, and return on assets. The spreadsheet is a tool for conducting a sensitivity analysis, helping to understand how changes in variables like price and sales volume impact the business's profitability.

💡Investment

Investment in the video refers to the initial capital outlay required to start the cupcake factory, which is mentioned as $1.1 million. It's a crucial concept as it sets the baseline for calculating returns and assessing the financial viability of the business. The video discusses how different operational strategies and market conditions can affect the return on this investment.

💡Annual Capacity

Annual capacity is the maximum output a factory can produce in a year, which in the video is stated as one million cupcakes. This term is significant as it sets the upper limit for production and influences the scale of operations and potential sales. The script uses this concept to discuss capacity utilization and how it affects the business's efficiency and profitability.

💡Cost Per Cupcake

Cost per cupcake represents the variable expenses associated with producing each cupcake, including ingredients and labor. In the video, this cost is given as $1.05. Understanding and controlling this cost is essential for the business's financial planning and profit margins, as it directly impacts the cost of goods sold and the operating income.

💡Price Charged Per Cupcake

The price charged per cupcake is the amount at which cupcakes are sold to customers, set at $2 in the video's initial scenario. This price is a key determinant of revenue and is a strategic decision that influences customer demand and market positioning. The video explores how changes in this price can significantly affect sales volume and overall profitability.

💡Revenue

Revenue in the video refers to the income generated from selling cupcakes, calculated by multiplying the price per cupcake by the number of cupcakes sold. It is a fundamental financial metric that reflects the top line of the business's income statement. The script demonstrates how revenue changes with different pricing strategies and sales volumes.

💡Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS) is the direct cost attributable to the production of the goods sold by a company, which includes the cost per cupcake. In the video, COGS is calculated based on the number of cupcakes sold and is a critical component of the income statement, as it helps determine the gross profit and operating income.

💡Operating Income

Operating income is the profit a business earns from its operations, calculated by subtracting operating expenses (including COGS) from revenue. In the video, operating income is used to evaluate the financial performance of the cupcake factory at different price points and sales volumes, providing insights into the business's operational efficiency.

💡Return on Asset (ROA)

Return on Asset (ROA) is a financial metric that shows how efficiently a company is using its assets to generate profit, calculated by dividing the operating income by the initial investment. The video uses ROA to assess the financial success of the cupcake factory, highlighting how different business strategies can lead to varying returns on the initial capital invested.

💡Sensitivity Study

A sensitivity study is an analysis that assesses how different variables impact a particular outcome. In the video, the speaker conducts a sensitivity study using Excel to understand how changes in cupcake price and sales volume affect the business's return on investment. This study is instrumental in strategic planning and decision-making, as it helps to identify the most influential factors on business performance.

Highlights

Discussing the potential of starting a cupcake factory as a major investment.

Mentioning the availability of an Excel spreadsheet for financial modeling at khanacademy.org/downloads/cupcakes.xls.

Detailing the factory's investment cost of $1.1 million and an annual capacity of one million cupcakes.

Exploring variable costs per cupcake, starting at $1.05, and price points, initially set at $2.

Demonstrating how the spreadsheet calculates revenue, cost of goods sold, and operating income based on user inputs.

Analyzing the impact of changing the price per cupcake on total revenue.

Calculating capacity utilization and return on asset based on sales and initial investment.

Highlighting the importance of price as a lever for the business owner to influence sales volume.

Presenting a scenario where lowering the price to $1.50 leads to a loss of $275,000 per year.

Discussing the break-even point when selling cupcakes at $1.75 and selling 700,000 units.

Using Excel to conduct a sensitivity study on price and sales volume to determine profitability.

Encouraging users to explore the spreadsheet for educational purposes, such as school projects.

Visualizing the relationship between price, quantity, and return on asset with a 3D graph in Excel.

Identifying the break-even curve on the 3D graph and its significance for business planning.

Strategizing a business launch with a low price to attract customers and understanding the potential for addiction to the product.

Exploring the effects of raising prices incrementally and observing the change in sales volume and profitability.

Considering the impact of competition entering the market and how it affects both market share and return on investment.

Discussing the economic principle that high returns attract competition, which can lead to a decrease in profitability.

Transcripts

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