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Ashley thought she understood break-even analysis from Chapter 21 but then she started over-thinking it. “Why did those stupid old men accountants a long time ago invent a way for companies to PLAN to break even? It doesn’t make sense because in real life companies don’t want to break even; they want to make a profit!”
One of Ashley’s brave classmates tried to offer an explanation but Ashley responded that we should just learn about target profit instead and it would save us all a lot of time. The classmate gave up arguing because Ashley suddenly got a mean look on her face and began angrily balling up her fists.
(1) What is target profit and how does it differ from break-even? Is Ashley on the right track at all or could she possibly benefit from the student’s correction? Please explain.
(2) Please also discuss margin of safety. How is it calculated and how can that information be useful to managers?
Expert Answer
Answer to question no.1
Target Profit:
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. Target profit is a decision, rather than a calculation. It is a goal for how much money a company wants to make.
Breakeven:
It is a point or situation where profits are equal to costs. You can start by calculating the breakeven point, and then decide how much profit you want to make in addition to breaking even.
As per the aforesaid information Ashley is not on the right track at all and she possibly benefit from the student’s correction.
Analysis:
In given question Ashley feels that “Why did those stupid old men accountants a long time ago invent a way for companies to PLAN to break even? It doesn’t make sense because in real life companies don’t want to break even; they want to make a profit!. Break even is possible in real life also and whatever the amount which excess more than the breakeven point shall be consider as a profit , they can be consider as a target profit also.
Comment:
Intention of the Ashley is not correct.
Answer to question no.2
Margin of safety:
The term margin of safety means the difference between total sales and breakeven sales. It means sales in excess of breakeven point,
- Margin of safety can calculated as follows:
- In Units: Profit/Contribution per unit
- In Amount: Profit/ PV ratio
- Uses to manager:
- Companies use the margin of safety in management accounting to establish the strength and potency of the business.
- The higher the margin of safety, the sturdier it deems business.
- Companies attempt to place their selling price at such a point in order to cover fixed and variable costs.
