Cupcake Economics

As the New York Times noted a few days ago, cupcakes are hot. I’ve seen shops sprouting around the DC area, and according to the article we are not alone: New York, Los Angeles, Denver, and other cities are also enjoying cupcake boomlets.

I must admit that I don’t know what’s driving the rise of the cupcake. Did Americans finally realize that Krispy Kreme doughnuts are over-rated at best (one man’s opinion)? Was there a technological breakthrough in cupcake production? Has the weak economy lowered rents and labor costs so much that cupcakery is now economically viable?

What I can tell you is that the new cupcake entrepreneurs have a tough road ahead of them. Competition is heating up–good news for cupcake consumers, but bad news for entrepreneurs.

So what is the cupcake entrepreneur to do? Well, the experience of Porche Lovely, who owns a shop in Denver, is instructive:

For each cupcake she sells, Ms. Lovely figures she spends 60 cents on ingredients, 57 cents on mortgage payments and utilities, 48 cents on labor, 18 cents on packaging and merchant fees, 16 cents on loan repayment, 24 cents for marketing, 18 cents for miscellaneous expenses and 4 cents for insurance. That totals $2.45, leaving a potential profit of 55 cents on each $3 cupcake.

So far, the per-cupcake margin is going to pay down start-up expenses. She’s been selling the 2,800 cupcakes a month she calculates she needs to sell to cover her costs — she’s taking only a small salary for now — but she says it’s too early to predict when the store will turn profitable, in part because of the economy and in part because she fears losing business to rival cupcake entrepreneurs.

Ms. Lovely is in the process of rebranding the shop to overcome what she calls “a typical rookie mistake” of underestimating “the power and importance of branding and marketing.” She said she had to do more to tell customers that her cupcakes were made from organic, local and natural ingredients.

Ms. Lovely’s overview of cupcake economics provides a fine illustration of three main points in the economics of competition, which I taught my students a few weeks ago:

  • If you want to stay in business in a competitive market, you’ve got to keep a close eye on costs. You absolutely have to cover your costs to stay in business. (And eventually one of those costs should be a real salary for you, the entrepreneur.)
  • Rivals will eat into your profits. If cupcakes are a good idea, other bakers will follow.
  • To have any chance of making profits in the long run, you’ve got to differentiate yourself. Build a brand and maybe, just maybe, customers will keep coming despite all your rivals.

10 thoughts on “Cupcake Economics”

  1. Donald, I’m disappointed. You didn’t teach your students the most important lesson of all:

    The best way to make money in the cupcake market is to make friends with investment bankers.

    Then, when increasing competition finally drives all the margin out of the business, you can swoop in and buy up distressed or bankrupt cupcake outlets at liquidation prices in a roll-up play, consolidate the market behind the most successful brand and/or product, and use your instant economies of scale to keep out new market entrants and drive the stragglers out of business.

    Without significant competition, you get healthy sustainable margins, in high enough volume to pay yourself a healthy salary, and your investment banker friends get a good return in interest and fees for helping you out.

    Then, after a short while, you list your cupcake empire, cash out, retire early and go helicopter skiing in Telluride.

    Safe to say Mrs. Lovely won’t be going helicopter skiing anytime soon.

  2. Donald,

    Someone should tell Ms. Lovely that she is making a BIG mistake that is, unfortunately, quite common (particularly among small business owners/managers) in the way she is viewing costs. Essentially, she is viewing all costs as if they were variable costs, and that is likely to royally screw up her decision making on pricing, promotional investments, etc.

    I can best explain by illustration, and believe me, in my consulting career I’ve had this conversation with many a small business owner/manager. Suppose I asked Ms. Lovely how many more cupcakes she could sell on an ongoing basis if she lowered her price from $3.00 to $2.45, and she said she’s confident she would sell at least twice as much (even net of any reaction among competitors). Leaving aside any other possible strategic considerations (e.g., if she’d want to expand the product line beyond these cupcakes), if her goal is profit-maximization over whatever time horizon she has in mind, I would advise her to lower the price to $2.45. She would react with surprise (they usually do) and say, wide-eyed, “No way! That would completely wipe out my profit margin because my product cost per unit is $2.45. It would make it impossible for me to make a profit.”

    No, it wouldn’t. Let’s tally up what her variable costs are. I’ll use a little guesswork on some items.
    $0.60 Ingredients
    $0.10 Variable utilities (mainly oven usage, I assume)
    $0.40 Variable labor
    $0.12 Packaging
    $0.04 Misc. Variable costs

    $1.26 Total Variable Costs

    So Price (i.e., marginal revenue) is now $3.00, Variable Costs are $1.26, yielding $1.74 Contribution Margin per unit. That is, for each unit sold, $1.74 goes to covering fixed costs and then to profit once fixed costs are covered.

    Now, lowering price to $2.45 reduces Contribution Margin per unit to $1.19, which is only 68% of the prior Contribution Margin per unit. That means that breakeven sales quantity (quantity that must be sold to yield the same Contribution to Profits as was yielded at the prior price and quantity) is 146% of the prior quantity (a 46% increase in quantity), calculated as 1/0.68 = 1.46. Therefore, doubling sales (200% of the prior quantity, a 100% increase) would significantly increase Contribution to Profits, and since fixed costs are, by definition, fixed*, that means significantly increasing bottom line profit.

    * As a note, outside of some range of quantity, a fixed cost becomes variable (e.g., a decision to expand capacity via new/expanded facilities), but that doesn’t diminish the value of the point above.

    1. Brooks,

      Good analysis, but I’m going to have to go with Donald on this one.

      In a competitive market, an equilibrium market-clearing price will emerge. You can’t simply assume, as you do above, that your price reductions won’t be matched by your competitors, and consequently have no impact on volume (“price war”).

      In a mature competitive market, the market participants in the strongest position are those that achieve operational efficiencies that allow for greater net operating margins at the equilibrium price, or achieve competitive differentiation that allow them to charge a premium over the market equilibrium price.

      So, that is a useful lesson from microeconomics, and kudos to Donald.

      However, I’d submit that more of his students are likely to end up consumers, investors, and voters than cupcake entrepreneurs, so maybe it would make more sense to focus on rent-seeking, unpriced negative externalities, information asymmetry, principle-agent problems, regulatory capture, provision for public goods, etc. in the first-year econ curriculum, and leave the supply-demand curves for advanced studies.

      1. Michael,

        In my hypothetical, the increase in volume was “net of any reaction among competitors”. You are correct in seeing in this hypothetical an implication that it is possible that not all competitors will react with fully comparable price cuts (“comparable” in terms of price elasticity of demand for each competitor’s cupcakes). But you are incorrect in thinking that such a competitor reaction — all competitors reacting with a fully comparable price cut — will necessarily occur*. There are a number of reasons why one supplier may be able to cut prices and gain volume. Just a few off the top of my head:

        – She may be currently priced higher than whatever you would consider this equilibrium price. More broadly, your implication seems to be “No supplier should ever reduce its price in hopes of increasing volume”. Well where did Ms. Lovely’s price come from in the first place? Ms. Lovely picked it. Are all cupcakes currently priced at $3.00? Probably not. But even if so, are all the cupcakes on the market exactly same size? Same quality in the eyes of every consumer/segment (however “quality” is defined — taste, aesthetics, retail environment [e.g., buying coffee at Starbucks vs. McDonald’s or Dunkin Doughnuts], total experience, etc.)? Etc. “Perfect competition” is a useful abstraction for some purposes, but it shouldn’t be confused with reality.

        – Some/most/all competitors could have different cost structure, meaning a comparable price cut could adversely impact their profits even with a similar percent volume gain.

        – Some/most/all competitors could have different price-elasticities. Maybe Ms. Lovely’s customers are more price-sensitive and/or the demand curve for her particular cupcakes is just different (e.g., some competitors position their cupcakes as “high end” and a price cut would tarnish that image).

        – A small competitor can increase market share very substantially in percentage terms without it affecting other competitors much and sparking market-wide competitor price-cutting. This can be the case in a highly fragmented market of equal size competitors, but even more so when some competitors are substantially larger than others. If I have 30% of the market and you have 1%, and you cut your price such that you double market share to 2%, even if we assume that I lose my “fair share” to you, I’m only down to 29.7% market share, i.e., 99% of my prior volume. If a comparable price cut for me would mean losing 1/3 of my contribution margin to try to get back that 1% of volume, am I necessarily (or even likely) going to do so? It’s true that I should take into account if some other competitors will do so, and what the total impact on my share will be, and it’s possible it could amount to enough to justify my cutting my price accordingly, but it’s very, very far from a given.

        – Even if all competitors do lower price comparably, there is the chance that lower prices will grow the product category — i.e., Ms. Lovely increases volume not by increasing her size of the pie (her market share) but by growth of the pie, probably at the expense of substitutes (e.g., doughnuts), but perhaps to some extent at the expense of saving (i.e., incremental consumption).

        The above are all off the top of my head. I’m sure I could add more if I took Michael Porter off the shelf.

        * As a note, some competitors who do react may do so not with a price cut but with some other means of building awareness and perceived value and driving action (e.g., via advertising, higher quality, etc.).

      2. Michael,

        Also, I mentioned in my initial comment that, in addition to pricing, promotional investments are among the types decisions that are likely to get screwed up by Ms. Lovely’s view of costs. Here’s what I mean:

        Suppose Ms. Lovely thinks that placing a $1,200 ad in the local paper would result in her selling an incremental 1,000 cupcakes over a given period of time. Per her (incorrect) view of product cost, doing so would lower profit by $650 (calculated as $0.55 X 1,000 less the cost of the ad $1,200), and she might forego the ad on that basis. In reality, her profit would increase by $540 (calculated as $1.74 X 1,000 less the cost of the $1,200 ad), meaning the ad is a much more attractive promotional investment than she thinks.

  3. Michael Robinson is spot on.

    Why would anyone bother doing anything terribly well? The goal is to corner the market. Easiest way to do that is with power.

  4. Michael Robinson & Brooks,
    Please help, I am in the process of opening my Cupcakery and I do not want to be another “Ms. Lovely” any advice other than whas above??? Please help…

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