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.
About Donald Marron 294 Articles

Donald Marron is an economist in the Washington, DC area. He currently speaks, writes, and consults about economic, budget, and financial issues.

From 2002 to early 2009, he served in various senior positions in the White House and Congress including: * Member of the President’s Council of Economic Advisers (CEA) * Acting Director of the Congressional Budget Office (CBO) * Executive Director of Congress’s Joint Economic Committee (JEC)

Before his government service, Donald had a varied career as a professor, consultant, and entrepreneur. In the mid-1990s, he taught economics and finance at the University of Chicago Graduate School of Business. He then spent about a year-and-a-half managing large antitrust cases (e.g., Pepsi vs. Coke) at Charles River Associates in Washington, DC. After that, he took the plunge into the world of new ventures, serving as Chief Financial Officer of a health care software start-up in Austin, TX. After that fascinating experience, he started his career in public service.

Donald received his Ph.D. in Economics from the Massachusetts Institute of Technology and his B.A. in Mathematics a couple miles down the road at Harvard.

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