Financial projections involve determining what level of profit you want from a business. Profit is often assumed to be the end result, a natural consequence of setting revenue and expense levels in the financial projections. However, the correct course of action in planning a new start up business is to set the level of profit required, and then using the target profit formula work backwards to determine whether and how this target profit can be achieved.
Revenue Needed to Achieve Target Profit
A variation on the use of the break even formula can be used to determine the revenue needed to achieve a profit target level.
For example, if the target profit level is 7,000, fixed costs 36,200, and the gross margin percentage is 60%, then the revenue needed to achieve the target profit is given as follows.
Revenue = (Fixed costs + Target profit) / Gross margin % Revenue = (36,200 + 7,000) / 60% Revenue = 72,000
Furthermore at this level of revenue, the income statement is as follows.
|Gross margin (60%)||43,200|
Finally using the formula below the number of units it needs to sell to achieve the target profit level is as follows.
For example, if the selling price of each unit is 12.00, then the number of units needed to reach the target profit level is 72,000 / 12.00 = 6,000
Extending the Target Profit Formula
Furthermore the target profit formula above can be extended and rearranged using the formula for the gross margin percentage.
This profit target formula now expresses the number of units which the business needs to sell in order to achieve a given target profit level in terms of the fixed costs, the selling price per unit and the cost price per unit.
Target Profit Formula Example
As an illustration, suppose a start up manufacturing business wants to target a profit of 15,000 in its financial projections. Additionally its product sells for 15.00 and costs 6.75 to produce, and it has fixed costs of 60,000. The number of units it needs to sell to reach its profit target is as follows.
Units = (Fixed costs + Target profit) / (Selling Price - Cost) Units = (60,000 + 15,000) / (15.00 - 6.75) Units = 9,091
So the business needs to sell 9,091 units in order to make the targeted profit of 15,000.
Allowing for Available Production Capacity
Generally the above calculation is fine providing the business has the production capacity to produce 9,091 units and the target market is large enough accommodate them. If not, then the formula can be used to change any of the three parameters fixed costs, selling price, or product cost in order to reduce the number of units to an appropriate level.
As an illustration, suppose the business estimates the market in the first year will be 8,000 units and is has the production capacity to accommodate this. Additionally it decides that it can’t reduce the fixed costs or the production cost per unit, and needs to know the revised selling price to achieve the same target profit of 15,000. So using the formula the selling price can be calculated as follows.
Units = (Fixed costs + Target profit) / (Selling Price - Cost) 8,000 = (60,000 + 15,000) / (Selling price - 6.75) Selling price = 16.125
The selling price needs to be increases from 15.00 to 16.13 in order to achieve the target profit of 15,000 with unit sales of 8,000.
However, perhaps the market will not accept a price increase and the selling price has to be maintained at 15.00. In this case either the fixed or variable (product) cost needs to change, and again the target profit formula can be used to calculate the revised product cost needed to achieve the level of profit required.
Units = (Fixed costs + Target profit) / (Selling Price - Cost) 8,000 = (60,000 + 15,000) / (15.00 - Cost) Cost = 5.625
The product cost will need to be reduced from 6.75 to 5.63 per unit in order to achieve the required profit level of 15,000 with 8,000 units
In summary the table below shows each of these scenarios.
|Item||Original||Scenario 1||Scenario 2|
Of course in practice it is not sufficient to simply amend one of the parameters. Generally it will be a case of adjusting the number of units, selling price, product cost, and fixed costs by small amounts. In this way the business can achieve the desired target profit level taking into account its production capacity and its target market.
In summary the target formula can be used to quickly calculate various scenarios to produce estimates for the number of units, selling price, unit cost price and fixed costs which achieve the target level. Once the process of using the profit target formula has been completed, the results can be used as the basis for starting the financial projections for the business plan.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.