Economics of a cupcake factory | Inflation | Finance & Capital Markets | Khan Academy

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.

39 thoughts on “Economics of a cupcake factory | Inflation | Finance & Capital Markets | Khan Academy

  1. The adherance to the 10 minute clips is really helpful for digestion of material.

    Also, when used as a refresher, 10 minutes is not a long time investment.

  2. In a way I am glad Sal is not running it, otherwise he couldn't do this videos. 🙂

    awesome videos, you make it seem so easy and down to earth.

  3. @gamehero77 It's not "non profit". No rational company would keep operating if they weren't earning profit. Especially, something like a cupcake factory. Also, just because the operating profit is 0, doesn't mean its non profit. It must foresee profits in the future, which is why it doesn't shut the factory down. If the profit continues to remain 0, it will stop running business.

  4. @BlairSantos Because this is ground level economics. Something that they probably teach you in the 9th or 10th grade. Actual economics is way more complicated.

  5. Where r u man since 10 or 15 years, if u and the youtube were exist since that period I could be someone else now. I consider you as a treasure to me and my kids. Ahmed from Egypt

  6. This video is bullshit – NOT economics! Economic analysis in no way involves making arbitrary assumptions about the operating costs to running a business. Economic analysis has nothing to do with accounting principles such as calculating unit costs of production (or making blind assumptions as to those numbers).

    Economic analysis uses calculus to determine the optimal level of production given the COSTS of capital (K – machinery/tools used by workers) and the COSTS of labor (the wage rate).

  7. So I'm guessing you made a video to educate people on 'real' economics? No? At least this guy is doing something positive, you're just being a jerk.

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