Do you consider taxes when you make a spending or cost accounting decision? Does a bear live in the woods? The answer is “yes” to both questions. If you’re considering a major purchase, think about the income you need to earn and the tax bite. There’s going to be an impact on your profit. Cost-volume-profit (CVP) analysis can help you figure everything out.
Understanding pre-tax dollars
Assume the business needs a car. The cost is $5,000. You have to earn more than $5,000, pay tax on that amount (say 30 percent), and then pay for the car. How much do you have to earn? Here’s a formula to compute how much you need to earn, referred to as pre-tax dollars:
Pre-tax dollars needed for purchase = cost of item ÷ (1 – tax rate)
Pre-tax dollars needed for purchase = $5,000 ÷ (1 – 0.30)
Pre-tax dollars needed for purchase = $5,000 ÷ 0.70
Pre-tax dollars needed for purchase = $7,142.86
The cost of the car in pre-tax dollars is $7,142.86.
When you allow for taxes, it takes $1.43 to buy $1.00 worth of car. $7,142.86 ÷ $5,000 equals 143% (with rounding). To purchase the car, you need 143% of $5,000, or $7,142.86. The taxes paid in this example are $2,142.86, the difference between $7,142.68 and $5,000.
Adjusting target net income for income taxes
It’s a smart move to assess the impact of taxes on target net income. Assume your business, Pizza Gone Wild, earns a $100,000 profit. That profit doesn’t account for income taxes. It assumes that as the owner, you keep $100,000 in your pocket with no taxes paid. Assume a 30 percent tax rate. You can calculate the pre-tax dollars needed to earn $100,000 after taxes:
Pre-tax dollars = cost of item ÷ (1 – tax rate)
Pre-tax dollars = $100,000 ÷ (1 – 0.30)
Pre-tax dollars = $100,000 ÷ 0.70)
Pre-tax dollars = $142,857.14
The taxes paid are $42,857.14. And you’re probably saying, “Oh, I get it. To earn $100,000 after tax, I need to increase my sales to cover the taxes.” And you’re right. Ideally, sales prices and volume are sufficient to cover the burden of taxes.
Consider an example, using the same business. The plan for profitability was to sell 10,000 units at $20 each, but that won’t pay the taxes. Calculate the number of units you need to sell to cover profits and taxes ($142,857.14):
$142,857.14 = (units x $20) – (units x $8) – $20,000
$142,857.14 = units x ($20 – $8) – $20,000
$142,857.14 = units x $12 – $20,000
To finish the calculation, add $20,000 to both sides of the equation. Then divide both sides by $12.
You need to sell 13,571 units to handle the $142,857.14. That’s 10,000 units for your profit and 3,571 units to handle the taxes. You gotta sell a lotta dough to make a little dough.