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Target Net Income: How to Set the Profit Goal in Cost Accounting

In cost accounting, target net income is the profit goal you set. (Net income and profit are used to mean the same thing.)

You compute target net income by plugging the figure into the breakeven formula [Profit ($0) = sales – variable costs – fixed costs] but with one change. The profit changes from $0 to the target net income amount. Here’s the new formula:

Target net income = sales – variable costs – fixed costs

Say you own a software company, and you’re thinking about buying a booth at a technology trade show. How much profit would make your trip worthwhile? How much profit could you produce if you decided not to go? Maybe that’s how you should answer the question. Assume your profit goal/target net income here is $2,000.

Say your application is priced at $40 per unit, your variable costs are $20 per unit, and fixed costs amount to $1,000. You can compute the sales you need to reach target net income:

Target net income = sales – variable costs – fixed costs
$2,000 = $40 x (units) – $20 x (units) – $1,000
$3,000 = $20 x units)
150 = $3,000 ÷ $20

You’ll meet target net income by selling 150 units.

You need to sell 100 more units (150 units – 50 units) to increase your profit from breakeven to $2,000. You can think about your target net income in units or dollars.

If you attend the trade show for three days, you need to average 50 sales per day to sell 150 units. If your booth is open for ten hours a day, you need to sell an average of five units per hour. Determine whether that’s reasonable. Is there enough interest in your product to reach that level of sales? That’s the real purpose of thinking through target net income.

Lower profits and margin of safety in cost accounting

The margin of safety is a cushion. If things don’t go as planned — if sales are lower than your budget — you need to know how low your total sales can go before you hit the breakeven point. The word margin, in this case, refers to the amount (in dollars or units) above the breakeven point.

Consider this example: You’re getting ready to book your tickets for the trade show. You computed a breakeven point of 50 units. To reach your target net income, you need to sell 150 units. Target net income uses your budgeted sales level. The difference between your budgeted level of sales (150 units) and your breakeven sales (50 units) is your margin of safety.

If actual sales were 30 units below your budget, your units sold would be 120 (150 – 30). You’re still way above your breakeven point of 50 units. The question always is if you don’t budget correctly, how far off can you be before your unit sales are below breakeven?

Contribution margin versus gross margin in cost accounting

Contribution margin represents the amount of money you have left after variable costs to cover fixed costs and keep for your profit. Gross margin explains how much of your sales proceeds are left after paying cost of sales.

Cost of sales is the direct costs of creating your product. If you were manufacturing denim jeans, you would have material costs for the denim and thread (and maybe a zipper), as well as the labor costs to sew the jeans. Your gross margin per pair of jeans sold might look like this:

Gross margin = sale price – cost of sales (material and labor)
Gross margin = $60 – $25
Gross margin = $35

Contribution margin (sales less variable costs) is part of the target net income formula. Try to avoid confusing the gross margin with contribution margin. The terms look similar, and both are thrown around in accounting conversations. Contribution margin is sales less variable costs. Gross margin, on the other hand, is sales less cost of sales.

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