Definition and Explanation of Target Profit:
Target profit is the amount of net operating income or profit that management desires to achieve at the end of a business period. Management needs to know the required level of business activities to get target profits.
Cost volume profit (CVP) equations and formulas can be used to determine the sales volume needed to achieve a target profit. The explanation of target profit analysis requires an example.
- Sales price per unit = $250
- Variable cost per unit = $150
- Total fixed expenses = $35,000
- Target Profit = $40,000
- Q = Number (Quantity) of units sold
How many units will have to be sold to earn a profit of $40,000?
The CVP Equation Method:
Under CVP equation approach, we can find the number of units to be sold to obtain target profit by solving the equation where profits are equal to target profit (that is $40,000).
Sales = Variable expenses + Fixed expenses + Profit
$250Q = $150 + $35,000 + $40,000
$100Q = $75,000
Q = $75,000 / $100 per unit
Q = 750 Units
Thus the target profit can be achieved by selling 750 units per month, which represents $187,500 in total sales ($250 × 750 units). This equation is also extensively used to calculate break even point. When break even point is calculated the value of profit in the equation is taken equal to ZERO.
The Contribution Margin Approach:
A second approach involves expanding the contribution margin formula to include the target profit.
[Unit sales to attain target profit = (Fixed expenses + Target Profit) ÷ Unit contribution margin]
This approach gives the same answer as the equation method since it is simply a short cut version of the equation method. similarly the dollar sales needed to attain the target profit can be computed as follows:
Dollar sales to attain the target profit = [(Fixed expenses + Target profit) ÷ CM ratio]
= ($35,000 + $40,000) ÷ 0.40
No. of units to be sold = $187,500 / $250
Voltar Company manufactures and sells a telephone answering machine. The Company’s contribution margin format income statement for the most recent year is given below:
Management is anxious to improve the company’s profit performance. Assume that next year management wants the company to earn a minimum profit of $90,000. How many units will have to be sold to meet the target profit figure?
Sales = Variable expenses + Fixed expenses + Profits
$60Q = $45Q + $240,000 + $90,000
$15Q = $3330,000
Q = $3330,000 / $15 Per unit
Q = 22,000 Units
Contribution Margin Method:
[(Fixed expenses + Target profit) / Contribution margin per unit]
[($240,000 + $90,000) / $15 Per unit]
You may also be interested in other articles from “cost volume profit relationship” chapter
- Contribution Margin and Basics of CVP Analysis
- Difference Between Gross Margin and Contribution Margin
- Cost Volume Profit (CVP) Relationship in Graphic Form
- Contribution Margin Ratio (CM Ratio)
- Importance of Contribution Margin
- Change in fixed cost and sales volume
- Change in variable cost and sales volume
- Change in fixed cost, sales price and sales volume
- Change in variable cost, fixed cost, and sales volume
- Change in regular sales price
- Break even point analysis (calculation of break-even point by contribution margin and equation method)
- Target profit analysis
- Margin of safety
- Sales Mix and Break Even with Multiple Products
- Cost Volume Profit (CVP) Consideration in Choosing a Cost Structure
- Operating Leverage and degree of operating leverage
- Assumptions of Cost Volume Profit (CVP) Analysis
- Limitations of Cost Volume Profit Analysis
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