Target profit is the expected amount of profit that the managers of a business expect to achieve by the end of a designated accounting period. The target profit is typically derived from the budgeting process, and is compared with the actual outcome in the income statement. This results in a reported variance between the actual and target profit figures, for which the accounting staff may provide a detailed explanation. However, budgets are notoriously inaccurate, and become more inaccurate the further into a budget year that you go.
Thus, a secondary derivation of the target profit that tends to be more accurate comes from a rolling forecast, where the target information is updated regularly, based on a company's short-term expectations for the next few months. This tends to result in relatively small differences between the target and actual profit.
Yet another alternative is formula-based. This approach, known as cost-volume-profit analysis (or CVP analysis) following this calculation:
- Multiply the expected number of units to be sold by their expected contribution margin to arrive at the total contribution margin for the period.
- Subtract the total amount of expected fixed cost for the period.
- The result is the target profit.
A great deal of modeling can be done using this simple calculation. For example, it can be modified for the following variables:
- Adjust the contribution margin per unit and units sold based on an expected sales promotion.
- Alter the fixed cost total and the contribution margin per unit for the effects of outsourcing production.
- Alter the contribution margin for the effects of changing to a just-in-time production system.
The target profit concept is extremely useful for cash flow planning (once modified to approximate cash flow), as well as for planning results-based bonuses, and for revealing expected results to investors and lenders. If there is continually a large unfavorable variance between the target and actual profit, it may be necessary to examine the system used to derive the target profit, and derive a more conservative budgeting methodology. The worst situation is when excessively optimistic target profits are continually released to the investment community, which eventually loses faith in the ability of management to meet its own projections.