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