How To Calculate Target Profit in Accounting
What is Target Profit in Accounting?
Target profit is the desired level of profit a business aims to achieve within a specific period.
It acts as an objective for everyone in the business to work towards, and helps senior leaders to make informed decisions involving pricing their goods or service, managing costs and sales volume goals.
Target profit is usually determined as part of a business’s budgeting process, and is monitored over the specific period against the actual outcomes.
Target Profit Formula
There are several formulas that can be used to calculate target profit, depending on the information available and the specific context of the business.
The most popular formula for calculating target profit involves fixed costs, variable costs per unit, and the number of units needed to sell:
Target Profit = (Price x Quantity) – (Fixed Costs) – (Variable Costs x Quantity)
Where:
Price = Selling price of goods/services per unit
Quantity = number of goods/services units sold
Fixed Costs = expenses that remain constant regardless of the level of production or sales
Variable Costs = expenses that fluctuate in direct proportion to the level of production or sales
Examples of Calculating Target Profit
To further help understand calculating target profit, let’s look at some real-world examples:
Example 1 – Quantity Unknown
Let’s say a business has annual fixed costs of £65,000, variable costs per unit of £10 and a selling price per unit of £30.
The target profit for the year is £80,000.
The business wants to know how many units they need to sell annually to achieve this target profit.
Target Profit = (Selling Price x Quantity) – (Fixed Costs) – (Variable Costs x Quantity)
£80,000 = (£30q) – (£65,000) – (£10Q)
£80,000 + £65,000 = £30q – £10Q
145,000 = 20Q
145,000 / 20 = Q
Therefore, the business would need to sell 7,250 units to achieve their target profit.
Example 2 – Selling Price Unknown
Now let’s assume a business want to determine what price to sell their consultancy services at to achieve a target profit of £50,000 for the year.
It has fixed costs of £15,000 and each consultancy service delivered costs the business £1,000 each.
Based on last year’s volume numbers, the business forecasts to deliver 20 services over the year.
Target Profit = (Selling Price x Quantity) – (Fixed Costs) – (Variable Costs x Quantity)
£50,000 = (SP x 20) – (£15,000) – (£1,000 x 20)
£50,000 = 20SP – £15,000 – £20,000
£50,000 + £15,000 + £20,000 = 20SP
£50,000 + £15,000 + £20,000 = 20SP
£85,000 = 20SP
Therefore, if the business delivered 20 services as expected, they would need to charge £4,250 per service to achieve their target profit.
Example 3 – Fixed Costs Unknown
Suppose a business wants to know what their fixed costs should be, in order to hit a target profit of £250,000.
The business already knows their selling price is £150 per unit, their variable costs are £70 per unit and they expect to sell 5,000 units over the year.
Target Profit = (Selling Price x Quantity) – (Fixed Costs) – (Variable Costs x Quantity)
£250,000 = (£150 x 5,000) – (Fixed Costs) – (£70 x 5,000)
£250,000 = £750,000 – FC – £350,000
£250,000 = £750,000 – FC – £350,000
Therefore, the business knows they need to keep fixed costs at £150,000 or under to attain their target profit.
Example 4 – Variance Costs Unknown
Now consider a business wants to know what their variance costs should be, in order to hit a target profit of £1.5m.
The business already knows their selling price is £500 per unit, their fixed costs are £2.5m per year and they expect to sell 10,000 units over the year.
Target Profit = (Selling Price x Quantity) – (Fixed Costs) – (Variable Costs x Quantity)
£1,500,000 = (£500 x 10,000) – (£2,500,000) – (VC x 5,000)
£1,500,000 = £5,000,000 – £2,500,000 – 5,000VC
5,000VC = £5,000,000 – £2,500,000 – £1,500,000
5,000VC = £1,000,000
VC = £1,000,000 / 5000
Therefore, the business knows they need to keep variable costs at £200 or under per unit to hit their target profit.
Why is Target Profit Important?
There are several reasons why setting a target profit is important:
Informed Decision-Making
Target profit serves as a crucial reference point for decisions across all areas of a business.
Whether setting prices, managing costs, or planning marketing initiatives, having a predefined profit goal provides a framework for making informed and strategic decisions.
For example, let’s consider a manufacturing business that produces children’s toys.
To keep up with increasing demand, the company is contemplating investing in new machinery.
Having a target profit in mind becomes instrumental in this decision as the business is able to evaluate the potential costs of the new machinery, including purchase, installation, and maintenance.
By referencing the target profit, the business can decide whether the investment aligns with their financial goals.
In this way, the target profit acts as a guiding factor in decisions beyond pricing, influencing choices that impact the company’s overall financial health and strategic direction.
Pricing Strategies
Thinking about target profit is an important consideration when it comes to setting prices.
It’s not just about picking a number randomly, but instead finding that balance between a price that will attract customers, while also ensuring that price keeps the business profitable.
For example, imagine a new software startup that is trying to establish a competitive presence.
Setting a target profit helps the business to determine its pricing strategy.
By understanding the desired profit margin and considering the overall market, the business can lay the groundwork for sustainable growth.
Resource Allocation
By establishing a target profit, businesses gain insights into the minimum revenue required to cover costs and generate the desired profit margin.
For example, let’s say a manufacturing company with limited resources is looking to optimise their workforce.
Setting a target profit helps the management allocate resources efficiently.
If the target profit suggests a need for increased production, the company can invest in additional machinery or resources to meet the demand.
On the other hand, if the target profit suggests cost-cutting measures, the business can explore areas for efficiency improvement.
Risk Management
Setting a target profit enables businesses to identify and mitigate financial risks by being aware of the factors that could potentially cause them distress.
For example, in a volatile market, businesses face uncertainties such as fluctuating costs or unexpected economic downturns.
Setting a target profit allows companies to factor in any potential market fluctuations, providing a safety net during uncertain times.
Performance Evaluation
A clear target profit can be a powerful motivational tool for stakeholders, including employees, investors, and management.
Target profit acts as a benchmark against actual financial performance can be measured.
This allows businesses to assess whether they are on track to meet their goals, or an early warning signal if strategic adjustments are needed.
For example, think of a restaurant chain that has set a target profit for each location based on factors like foot traffic and operating costs.
At the end of each month, the restaurant chain can compare the actual profits to the targeted profits, and assess the performance of each restaurant.
This analysis can help to identify high-performing locations and areas that need improvements in order to achieve the target profit.