Target Income and Margin of Safety

At the break-even point, sales and costs are exactly equal. However, the goal of most companies is to make a profit. When a company decides that it wants to earn more than the break-even point of income, it must define the amount it thinks it will realistically make. By modifying the break-even equation, the sales required to earn a target or desired amount of profit may be computed.

Complete the following: If a company makes $5 off of each unit it sells and has a target operating income of $5,000, then it must sell _____________ units. Similarly, if a company has a target operating income of $75,000 and knows that total expenses for the period will be $75,000, how much revenue must it earn to reach its target operating income? $__________________

Units sold or revenue earned above and beyond the break-even point contributes to the margin of safety for a company. Margin of safety is a crude measure of risk, in that it serves as the padding between profit and the break-even point.

Complete the following: Expressed in terms of units, if a company hits its break-even point in units (say, 100 units) and actually sells 400 units, then the margin of safety is _______________________________ units. Similarly, if the break-even point in sales revenue is $200,000, and it actually has sales revenue of $400,000, then its margin of safety is $ _____________________________.

APPLY THE CONCEPTS: Target income (number of units sold)

Suppose a business has pricing and cost information as follows::

Price and Cost Information	Amount
Selling Price per Unit	$10.00
Variable Cost per Unit	$2.50
Total Fixed Cost	$600

For the upcoming period, the company wishes to generate operating income of $900. Given the cost and pricing structure for the companys product, how many units must the company sell to attain its target income?

Remember that the basic equation for calculating operating income is as follows:

Operating Income

=

(Unit Price x Units Sold)

-

(Variable Cost per Unit x Units Sold)

-

Fixed Cost

Step 1: Replace the operating income in the equation with your companys target income, and insert your cost and pricing information into the equation, as well:

$___________

=

($ __________ x Units Sold)

-

($_____________ x Units Sold)

-

$____________

Step 2: Rearrange the equation to isolate units to one side of the equation:

Number of Units to Earn Target Income =	Fixed Cost + Target Income
	Unit selling price - Variable Cost per Unit

Number of Units to Earn Target Income =	$_________ + 900
	$_________ - $__________

Number of Units to Earn Target Income = units

Step 3: Create a contribution margin income statement to check your previous work. Enter all amounts as positive numbers.

Sales		$_________
Total variable expense		__________
	Total contribution margin	$_________
Total fixed expense		__________
	Operating income	$_________