Target Profit analysis

Very often businesses face situation where they are required not only to recover their fixed production, marketing and administrative overheads but also some profits after tax to provide return to shareholders and build retained earnings. Such retained earnings can be used to finance future projects.

We have already studied the formula of break but for the sake of ease of understanding, the formula is reproduced below.

Break-even units = Fixed costs / contribution margin per unit

Targeted Profit without tax effects

When company is required to earn the targeted profit, the above formula must be modified to include effects of such profit. Contribution margin will now need to cover not only fixed costs but also the targeted profit.Therefore, the simple break-even formula will now look like this.

Units to sell to earn desired profit = (Fixed costs + Targeted Profit) / contribution margin per unit

I would again resort to the same example as used in Simple Break-Even Analysis to explain the application of this concept.

Q # Mr. A manufactures a machine AS-1000. AS-1000 sells for Rs. 1,000. It's variable cost of production is Rs. 700. Variable selling and distribution costs is Rs.75 per unit. Fixed cost is Rs. 10,000,000. Fixed cost covers shop rental and depreciation of plant used to manufacture machines. Determine the break-even units and sales value if the Mr. A desires to earn targeted profit of Rs. 800,000 ?

contribution margin per unit = 1,000-700-75 => 225

Units to sell to earn desired profit = (10,000,000+800,000)/225

Units to sell to earn desired profit = 48000 units

Required sales value to earn desired profit = (10,000,000+800,000)/22.5%

Required sales value to earn desired profit = 48,000,000

Let's check answer.

Targeted Profit with tax effects

When tax is given in question, our above desired profit formula needs a little modification i.e. the amount of desired profit is required to be grossed up by tax percentage. For example if tax rate is 35%, then the profit will be as follows.

Profit = 800,000 x 1/(1-tax%)
Profit = 800,000 x 1/(1-0.65)

Profit = 1,230,769.23

Our targeted profit will now be Rs.1,230,769.23 instead of Rs.800,000. This is because after deduction of 35% tax, we will have 65% profit after tax which is Rs.800,000. Now desired units to sell to earn Rs. 800,000 profit after tax are:

Units to sell to earn profit after tax of Rs.800,000 = (10,000,000 + 1,230,769.23)/225

Units to sell to earn profit after tax of Rs.800,000 = 49914.5 units

Sales value to earn desired profit of Rs.800,000 = (10,000,000 + 1,230,769.23)/0.225

Sales value to earn desired profit of Rs.800,000 = 49,914,529.9

Let's check our answer.

Friends, please let me know if you have any questions regarding the topic.