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:

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

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

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

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:

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

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

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

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

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

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

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

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

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

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

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

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).

Written by Obaidullah Jan, ACA, CFA and last modified on