Target profit is a financial metric that helps businesses determine how much revenue they need to generate in order to achieve a specific level of profit. It’s a key component of a company’s overall financial strategy, as it helps to guide decision-making and set realistic goals.
In order to calculate target profit, businesses must first determine their total fixed costs and variable costs per unit. Fixed costs are expenses that don’t change regardless of the level of production or sales, such as rent or salaries. Variable costs, on the other hand, are expenses that increase or decrease as production or sales levels change, such as materials or labor.
Once fixed costs and variable costs per unit are established, businesses can use this information to calculate their breakeven point – the point at which total revenue equals total costs, resulting in zero profit or loss. The breakeven point can be calculated by dividing total fixed costs by the contribution margin, which is the difference between sales revenue and variable costs.
To calculate the target profit, businesses need to determine how much profit they want to make above and beyond their breakeven point. This can be done by adding the desired profit to the total fixed costs, and then dividing the result by the contribution margin.
For example, let’s say a company has fixed costs of $50,000 per month, variable costs of $10 per unit, and sells each unit for $20. The contribution margin is calculated as follows:
Contribution margin = Sales price per unit – Variable cost per unit Contribution margin = $20 – $10 Contribution margin = $10
Using this information, the company can calculate its breakeven point:
Breakeven point = Total fixed costs / Contribution margin Breakeven point = $50,000 / $10 Breakeven point = 5,000 units
Now let’s say the company wants to make a profit of $20,000 per month. The target profit can be calculated as follows:
Target profit = (Fixed costs + Desired profit) / Contribution margin Target profit = ($50,000 + $20,000) / $10 Target profit = 7,000 units
This means the company would need to sell 7,000 units per month in order to achieve a profit of $20,000, taking into account both fixed and variable costs.
In summary, target profit is a useful financial metric that helps businesses set realistic profit goals and make informed decisions about pricing, production levels, and sales strategies. By understanding their fixed costs, variable costs, and breakeven point, companies can calculate the target profit needed to achieve their financial objectives.