Target Income Analysis

Target income analysis is a management accounting technique used to identify a company’s target income sales, the sales level that must be achieved to earn a target net income.

Target income sales depends on a company's fixed costs, target operating income and contribution margin per unit and/or contribution margin ratio. The target operating income in turn depends on the target net income and applicable tax rate.

Calculating target income sales is an important part of the cost-volume-profit analysis. Every business must earn enough revenue not only to cover its variable and fixed costs, but to be able to generate a decent return on its investment. It is useful to have a number in mind when preparing a sales budget or assigning sales targets.

Formula

We start with a target net income and use it to work back to the sales level. First, we need to work out the target operating income which is effectively the income before taxes:

$$ \text{Target Net Income}\ =\ \text{Target Operating Income}\ \times(\text{1}\ -\ \text{Tax Rate}) $$

A bit of rearrangement gives us the formula for target operating income:

$$ \text{Target Operating Income}\ =\ \frac{\text{Target Net Income}}{\text{1}\ -\ \text{Tax Rate}} $$

Target income sales in units can be calculated by dividing the sum of total fixed costs and target operating income by the contribution margin per unit:

$$ \text{Target Income Sales}\ (\text{in Units})\\=\frac{\text{Fixed Costs}\ +\ \text{Target Operating Income}}{\text{Contribution Margin per Unit}} $$

Contribution margin per unit equals contribution margin (excess of revenue over variable costs) divided by total output i.e.

$$ \text{Contribution Margin per Unit}\\=\frac{\text{Sales}\ -\ \text{Variable Costs}}{\text{Total Units Sold}} $$

Target income sales in units can be converted to target income sales in dollars by multiplying it with price per unit.

$$ \text{Target Income Sales in Dollars}\ \\=\text{Target Income Sales in Units}\times \text{Price per Unit} $$

Alternatively, we can use the following formula to calculate target income sales in dollars:

$$ \text{Target Income Sales}\ (\text{in Dollars})\\=\frac{\text{Fixed Costs}\ +\ \text{Target Operating Income}}{\text{Contribution Margin Ratio}} $$

Contribution margin ratio equals the difference between sales and variable costs divided by sales.

$$ \text{Contribution Margin Ratio}\\=\frac{\text{Sales}\ -\ \text{Variable Costs}}{\text{Sales}} $$

Contribution margin ratio can also be calculated by dividing contribution margin per unit by price:

$$ \text{Contribution Margin Ratio}\\=\frac{\text{CM per Unit}}{\text{Price}}=\frac{\text{Price}\ -\ \text{Variable Cost per Unit}}{\text{Price}} $$

Contribution margin ratio also equals 1 minus variable cost ratio.

Example

Orange Juices Inc. is a company engaged in packaging and distribution of fresh orange juices. Its revenue per liter of juice is $10. Its manufacturing costs are as follows:

Costs of raw oranges used per liter $2
Direct labor costs per unit 1
Fixed manufacturing overheads 200,000
Fixed administrative and distribution costs 300,000

The company wants to generate net income of $150,000 at least. If the company's tax rate is 30%, determine how many liters the company should be able to sell and the amount of total sales.

Solution

Target operating income
= $150,000 ÷ (1 − 30%)
= $214,286

Contribution margin per unit
= $10 − $2 − $1
= $7

Contribution margin ratio
= $7 ÷ $10
= 70%

Target income sales in units
= ($200,000 + $300,000 + $214,286) ÷ $7
= 102,041 units

Target income sales in dollars
= ($200,000 + $300,000 + $214,286) ÷ 70%
= $1,020,410

Target income sales can also be determined as product of per unit sales revenue and target income sales in units i.e. ($10 × 102,041 = $1,020,410).

by Obaidullah Jan, ACA, CFA and last modified on

XPLAIND.com is a free educational website; of students, by students, and for students. You are welcome to learn a range of topics from accounting, economics, finance and more. We hope you like the work that has been done, and if you have any suggestions, your feedback is highly valuable. Let's connect!

Copyright © 2010-2019 XPLAIND.com