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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.