Target Net Income and Margin of Safety
LEARNING OBJECTIVE 5
Determine the sales required to earn target net income and determine margin of safety.
Target Net Income
Rather than simply “breaking even,” management usually sets an income objective often called target net income. It then determines the sales necessary to achieve this specified level of income. Companies determine the sales necessary to achieve target net income by using one of the three approaches discussed earlier.
Mathematical Equation
We know that at the break-even point no profit or loss results for the company. By adding an amount for target net income to the same basic equation, we obtain the formula shown in Illustration 18.24 for determining required sales.
Sales − Variable Costs − Fixed Costs = Target Net Income
ILLUSTRATION 18.24 Formula for sales to meet target net income
Recall that once the break-even point has been reached so that fixed costs are covered, each additional unit sold increases net income by the amount of the unit contribution margin. We can rewrite the equation with contribution margin (sales minus variable costs) on the left-hand side, and fixed costs and target net income on the right. Assuming that target net income is $120,000 for Vargo Electronics, the computation of required sales in units is as shown in Illustration 18.25.
Sales − Variable Costs − Fixed Costs = Target Net Income $500Q − $300Q − $200,000 = $120,000 $500Q − $300Q = $200,000 + $120,000
$200Q = $200,000+120,000 Q =
$
200,000
+
120,000
$
200
=
Fixed Costs
+
Target Net Income
Unit Contribution Margin
Q = 1,600 where Q = number of units sold $500 = unit selling price $300 = unit variable costs $200,000 = total fixed costs $120,000 = target net income
ILLUSTRATION 18.25 Computation of required sales
Vargo must sell 1,600 units to achieve target net income of $120,000. The sales dollars required to achieve the target net income is found by multiplying the units sold by the unit selling price [(1,600 × $500) = $800,000].
Contribution Margin Technique
As in the case of break-even sales, we can compute in either units or dollars the sales required to meet target net income. The formula to compute required sales in units for Vargo Electronics using the unit contribution margin can be seen in the final step of the equation approach in Illustration 18.25 (shown in red). We simply divide the sum of fixed costs and target net income by the unit contribution margin. Illustration 18.26 shows this for Vargo.
(Fixed Costs+Target Net Income) ÷ Unit Contribution Margin = Sales in Units ($200,000+$120,000) ÷ $200 = 1,600 units
ILLUSTRATION 18.26 Formula for sales in units using unit contribution margin
To achieve its desired target net income of $120,000, Vargo must sell 1,600 cell phones.
Illustration 18.27 presents the formula to compute the required sales in dollars for Vargo using the contribution margin ratio.
(Fixed Costs+Target Net Income) ÷ Contribution Margin Ratio = Sales in Dollars ($200,000+$120,000) ÷ 40% = $800,000
ILLUSTRATION 18.27 Formula for sales in dollars using contribution margin ratio
To achieve its desired target net income of $120,000, Vargo must generate sales of $800,000.
Graphic Presentation
We also can use the CVP graph in Illustration 18.23 to find the sales required to meet target net income. In the profit area of the graph, the distance between the sales line and the total-cost line at any point equals net income. We can find required sales by analyzing the differences between the two lines until the desired net income is found.
For example, suppose Vargo Electronics sells 1,400 cell phones. Illustration 18.23 shows that a vertical line drawn at 1,400 units intersects the sales line at $700,000 and the total-cost line at $620,000. The difference between the two amounts represents the net income (profit) of $80,000.
Margin of Safety
Margin of safety is the difference between actual or expected sales and sales at the break-even point. It measures the “cushion” that a particular level of sales provides. It tells us how far sales could fall before the company begins operating at a loss. The margin of safety is expressed in dollars or as a ratio.
The formula for stating the margin of safety in dollars is actual (or expected) sales minus break-even sales. Illustration 18.28 shows the computation for Vargo Electronics, assuming that actual (expected) sales are $750,000.
Actual (Expected) Sales − Break-Even Sales = Margin of Safety in Dollars $750,000 − $500,000 = $250,000
ILLUSTRATION 18.28 Formula for margin of safety in dollars
Vargo’s margin of safety is $250,000. Its sales could fall $250,000 before it operates at a loss.
The margin of safety ratio is the margin of safety in dollars divided by actual (or expected) sales. Illustration 18.29 shows the formula and computation for determining the margin of safety ratio.
Margin of Safety in Dollars ÷ Actual (Expected) Sales = Margin of Safety Ratio $250,000 ÷ $750,000 = 33%
ILLUSTRATION 18.29 Formula for margin of safety ratio
This means that the company’s sales could fall by 33% before it operates at a loss.
The higher the margin of safety in dollars or the percentage, the lower the risk that the company will operate at a loss. Management evaluates the adequacy of the margin of safety in terms of such factors as the vulnerability of the product to competitive pressures and to downturns in the economy.
Service Company Insight Rolling Stones
How a Rolling Stones’ Tour Makes Money
Computations of break-even and margin of safety are important for service companies. Consider how the promoter for the Rolling Stones’ tour used the break-even point and margin of safety. For example, say one outdoor show should bring 70,000 individuals for ticket sales of $2.45 million. The promoter guarantees $1.2 million to the Rolling Stones. In addition, 20% of ticket sales goes to the stadium in which the performance is staged. Add another $400,000 for other expenses such as ticket takers, parking attendants, advertising, and so on. The promoter also shares in sales of T-shirts and memorabilia for which the promoter will net over $7 million during the tour. From a successful Rolling Stones’ tour, the promoter could make $35 million!
What amount of sales dollars are required for the promoter to break even? (Go to WileyPLUS for this answer and additional questions.)
DO IT! 5 | Break-Even, Margin of Safety, and Target Net Income
Zootsuit Inc. makes travel bags that sell for $56 each. For the coming year, management expects fixed costs to total $320,000 and variable costs to be $42 per unit. Compute the following: (a) break-even point in dollars using the contribution margin (CM) ratio; (b) the margin of safety and margin of safety ratio assuming actual sales are $1,382,400; and (c) the sales dollars required to earn net income of $410,000.
ACTION PLAN
Apply the formula for the break-even point in dollars.
Apply the formulas for the margin of safety in dollars and the margin of safety ratio.
Apply the formula for the sales in dollars.
Solution
a. Contribution margin ratio = [($56 − $42) ÷ $56] = 25%
Break-even sales in dollars = $320,000 ÷ 25% = $1,280,000
b. Margin of safety = $1,382,400 − $1,280,000 = $102,400
Margin of safety ratio = $102,400 ÷ $1,382,400 = 7.4%
c. Sales in dollars = ($320,000 + $410,000) ÷ 25% = $2,920,000
Related exercise material: BE18.10, BE18.11, BE18.12, DO IT! 18.5, E18.14, E18.15, E18.16, and E18.17.
USING THE DECISION TOOLS | Amazon.com
Amazon.com faces many situations where it needs to apply the decision tools presented in this chapter, such as calculating the break-even point to determine a product’s profitability. Amazon’s dominance of the online retail space, selling other company’s products, is well known. But not everyone may realize that Amazon also sells its own private-label electronics, including USB cables, mice, keyboards, and audio cables, under the brand name AmazonBasics. Assume that Amazon’s management was provided with the following information regarding the production and sales of Bluetooth keyboards for tablet computers for 2022.
Cost Schedules
Variable costs
Direct labor per keyboard
$ 8.00
Direct materials
4.00
Variable overhead
3.00
Variable cost per keyboard
$ 15.00
Fixed costs
Manufacturing
$ 25,000
Selling
40,000
Administrative
70,000
Total fixed costs
$135,000
Selling price per keyboard
$25.00
Sales, 2022 (20,000 keyboards)
$500,000
Instructions
(Ignore any income tax considerations.)
a. What is the operating income for 2022?
b. What is the unit contribution margin for 2022?
c. What is the break-even point in units for 2022?
d. Assume that management set the sales target for the year 2023 at a level of $550,000 (22,000 keyboards). Amazon’s management believes that to attain the sales target in 2023, the company must incur an additional selling expense of $10,000 for advertising in 2023, with all other costs remaining constant. What will be the break-even point in sales dollars for 2023 if the company spends the additional $10,000?
e. If the company spends the additional $10,000 for advertising in 2023, what is the sales level in dollars required to equal 2022 operating income?
Solution
a.
Sales
$500,000
Less:
Variable costs (20,000 keyboards × $15)
300,000
Fixed costs
135,000
Operating income
$ 65,000
b.
Selling price per keyboard $25
Variable cost per keyboard 15
Unit contribution margin $10
c. Fixed costs ÷ Unit contribution margin = Break-even point in units: $135,000 ÷ $10 = 13,500 units
d. Fixed costs ÷ Contribution margin ratio = Break-even point in dollars: $145,000* ÷ 40%** = $362,500
*Fixed costs $135,000
Additional advertising expense
10,000
Revised fixed costs
$145,000
**Contribution margin ratio = Unit contribution margin ÷ Unit selling price: 40% = $10 ÷ $25
e. Sales = (Fixed costs + Target net income) ÷ Contribution margin ratio
$525,000 = ($145,000 + $65,000) ÷ 40%