By Yuriy Smirnov Ph.D.

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.

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 |

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 |

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

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!

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

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.

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