Target Profit
Target profit is the specific amount of net income or profit a company aims to achieve in a particular period, such as a month, quarter, or year. Setting a target profit is a fundamental aspect of a company’s financial planning and strategic decision-making process. The concept is used in various business activities, from setting sales goals and pricing strategies to determining necessary cost reductions or production levels.
Understanding target profit is also vital for break-even analysis, helping businesses determine the number of units they need to sell or the revenue required to cover all costs and achieve the desired profit.
The formula to determine the number of units (XX) a company needs to sell to achieve its target profit is:
X = Fixed Costs + Target Profit / Selling Price per Unit − Variable Cost per Unit
Where:
- Fixed Costs are costs that don’t vary with the production or sales level, such as rent or salaries.
- Selling Price per Unit is how much one unit of the product sells for.
- Variable Cost per Unit is the cost that varies directly with the production or sales level, such as raw materials or direct labor.
When the company is aiming to determine the required sales in terms of revenue (rather than units), the target profit can be integrated into a break-even revenue calculation:
Target Profit Sales = Fixed Costs + Target Profit / Contribution Margin Ratio
Where:
- Contribution Margin Ratio is calculated as Selling Price − Variable Cost per Unit / Selling Price
Target profit provides a benchmark against which actual performance can be measured, helping businesses assess if they are on track to meet their financial goals.
Example of Target Profit
Let’s use a hypothetical scenario involving a company that manufactures and sells designer handbags:
Scenario: Elegance Bags, Inc. wants to achieve a target profit of $100,000 for the upcoming quarter. They are trying to determine how many handbags they need to sell to reach this profit target.
Here’s what we know about Elegance Bags’ operations:
- Selling Price per Handbag: $250
- Variable Costs per Handbag (materials, labor, etc.): $100
- Fixed Costs for the quarter (rent, advertising, utilities, salaries, etc.): $300,000
Using the formula to determine the number of units needed to achieve the target profit:
X = Fixed Costs + Target Profit / Selling Price per Unit − Variable Cost per Unit
X = $300,000 + $100,000 / $250 – $100
X = $400,000 / $150
X = 2,666.67
So, Elegance Bags would need to sell approximately 2,667 handbags in the upcoming quarter to achieve their target profit of $100,000.
To determine the target profit sales in terms of revenue:
Contribution Margin Ratio = $250 – $100 / $250 = 0.6
Target Profit Sales = $300,000 + $100,000 / 0.6
Target Profit Sales = $400,000 / 0.6
Target Profit Sales = $666,666.67
This means Elegance Bags needs to generate sales revenue of approximately $666,667 in the upcoming quarter to achieve their profit target of $100,000.
This example demonstrates how businesses use target profit calculations to set sales goals and ensure they’re on track to meet financial objectives.
