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Target Profit Analysis

By Yuriy Smirnov Ph.D.

Definition

Target profit analysis is part of cost-volume-profit analysis, with the main objective being to determine the sales level covering fixed costs and variable costs that would allow a certain amount of profit called target profit to be earned during the relevant accounting period. In other words, it indicates the amount of revenue necessary to earn a target profit.

Target Profit Analysis Methods

Equation Method

The equation method can be applied to compute a sales volume that allows a target profit to be earned.

Sales = Fixed Costs + Variable Costs + Target Profit

The equation above can be transformed as follows:

n × Unit Price = Fixed Costs + n × Variable Cost per Unit + Target Profit

where n is a number of units to be sold to earn a target profit.

Thus, the number of units to be sold to earn the target profit can be calculated as follows:

Target Sales in Units Fixed Costs + Target Profit
Price per Unit - Variable Cost per Unit

In turn, the dollar amount of target sales can be computed by multiplying target sales in units by the sales price per unit as shown here.

Target Sales in Dollars Fixed Costs + Target Profit  × Sales
Sales - Variable Costs

Contribution Margin Method

The contribution margin method of target profit analysis is a modification of the equation method. The formula used to calculate in units target sales is as follows:

Target Sales in Units Fixed Costs + Target Profit
Contribution Margin per Unit

where the contribution margin per unit is the sales price per unit less the variable cost per unit.

The dollar amount of target sales can be calculated as shown below.

Target Sales in Dollars Fixed Costs + Target Profit
Contribution Margin Ratio

where the contribution margin ratio is

Contribution Margin Ratio =  Sales - Variable Costs
Sales

or

Contribution Margin Ratio =  Price per Unit - Variable Costs per Unit
Price per Unit

Calculation Examples

Equation Method

EstroZ Inc. management plans to earn a profit of $250,000 in the next quarter. Expected fixed costs are $700,000, the variable cost per unit is $500, and the sales price per unit is $900.

Target Sales in Units $700,000 + $250,000  = 2,375 Units
$900 - $500

EstroZ Inc. needs to sell 2,375 units in the following quarter to cover its costs and earn a target profit of $250,000. The dollar amount of target sales can be calculated by multiplying the number of units of 2,375 by the sales price of $900.

Target Sales in Dollars = 2,375 × $900 = $2,137,500

Contribution Margin Method

Target profit analysis can also be made using the contribution margin method. Using data from the example above, the contribution margin per unit is $400 ($900 - $500).

Target Sales in Units $700,000 + $250,000  = 2,375 Units
$400

We need to calculate the contribution margin ratio first to find the dollar amount of target sales.

Contribution Margin Ratio =  $900 - $500  = 0.444
$900

Target Sales in Dollars $700,000 + $250,000  = $2,137,500
0.444

As you can see, both methods of target profit analysis bring the same result!

Graph

Target profit analysis results can also be presented graphically. Let’s consider the graph below using the data from the example above.

Graphical method of target profit analysis

The break-even point is on the intersection of the total costs line and the sales line. In turn, target sales exceed total costs by the amount of target profit of $250,000.