The Application Factory Pattern in Flask means we write a function called create_app that builds and configures the Flask app. When we call this function, it creates the app instance, sets configuration like DEBUG mode, registers routes such as '/' with their handlers, and then returns the app. After that, we assign the returned app to a variable and run it. This pattern helps us create the app only when needed, making it easier to configure differently for testing or production. The execution steps show calling create_app, creating the app, setting config, registering routes, returning the app, assigning it, and running the server. Variables like 'app' change from undefined to a Flask instance with config set. Key points include why the app is created inside a function and when the server starts running.