Definition
The amount of profit that a business expects to achieve in an accounting period is called target profit. After setting the profit goal, sales required to achieve that profit can be worked out and the whole budget can be formulated based on target profit figure.
This concept is one of the uses of CVP analysis. You know that CVP analysis is used to find out the relation between cost, profit, and volume. This method has several uses like calculating future costs, break-even points, the margin of safety, sales required to achieve a target profit, and the determination of optimal selling price. In this article, we will consider how CVP analysis can be used to calculate the sales needed to achieve a target profit.
Sales Required to Achieve a Target Profit
Most businesses set a profit goal at the start of a period that they want to achieve. For this, they make annual budgets showing how the activities will be carried out and how much revenues and costs will be generated and incurred, respectively. CVP analysis evaluates the costs based on a marginal costing technique. It considers an important concept of contribution.
This method states that contribution is the real return of the business, and a business should be able to generate enough contribution to cover the fixed costs and achieve the desired profit. In this method, the target profit is treated as another fixed cost of the business that the business must cover by earning sufficient contribution. Let’s use this to derive the formula of target sales.
Formula – Target sales to generate target profit
To achieve a target profit, our contribution should be enough to cover the fixed costs and generate the required profit. Let’s use this logic to derive the formula of target sales.
Let us understand the concept with the help of an example.
Example – Sales required to make target profit
Consider the example of Just Baked Limited, a bakery business. A new product, croissant, is being evaluated to be included in the menu. The management of the company expects to make a profit of $350,000 for the coming period from this product. It has been estimated that the selling price of each croissant will be $15. Variable costs of $7 are to be incurred on each croissant. Total fixed costs of the new production line and other overheads amount to $250,000.
The contribution per croissant is calculated to be $8 ($15 – $7). This means each croissant will contribute $8 towards covering the fixed costs of $250,000 and achieving the target profit of $350,000. The target sales volume is calculated by using the formula mentioned above as follows:
Thus, the business has to sell 75,000 croissants generating $1,125,000 to cover fixed costs and achieve the desired profit.