Income Taxes and Target Net Income

Learning Objective 3 Understand how income taxes affect CVP analysis

focus on net income

Net income is operating income plus nonoperating revenues (such as interest revenue) minus nonoperating costs (such as interest cost) minus income taxes. For simplicity, throughout this chapter we assume nonoperating revenues and nonoperating costs are zero. So, the net income equation is:

$Net income = Operating income - Income taxes$

To make net income evaluations, CVP calculations for target income must be stated in terms of target net income instead of target operating income. For example, Emma may be interested in knowing the quantity of units of GMAT Success she must sell to earn a net income of $1,120, assuming an income tax rate of 30%.

$\begin{array}{l} Target net income & = & (\begin{matrix} Target \\ operating income \end{matrix}) - (\begin{matrix} Target \\ operating income \end{matrix} \times Tax rate) \\ Target net income & = & (Target operating income) \times (1 - Tax rate) \\ Target operating income & = & \frac{Target net income}{1 - Tax rate} = \frac{$ 1,120}{1 - 0.30} = $ 1,600 \end{array}$

In other words, to earn a target net income of $1,120, Emma’s target operating income is $1,600.

Proof for Emma’s target operating income of 1,600 dollars.

Target operating income: 1,600 dollars

Tax at 30 percent (0.30 times 1,600 dollars): 480 dollars

Target net income: 1,120 dollars

The key step is to take the target net income number and convert it into the corresponding target operating income number. We can then use equation 1 to determine the target operating income and substitute numbers from our GMAT Success example.

(Equation 1)

$[(\begin{matrix} Selling \\ price \end{matrix}) \times (\begin{matrix} Quantity of \\ units sold \end{matrix}) - (\begin{matrix} Variable cost \\ per unit \end{matrix}) \times (\begin{matrix} Quantity of \\ units sold \end{matrix})] - \begin{matrix} Fixed \\ costs \end{matrix} = \begin{matrix} Operating \\ income \end{matrix}$

$\begin{array}{rcl} ($ 200 \times Q) - ($ 120 \times Q) - $ 2,000 & = & $ 1,600 \\ $ 80 \times Q & = & $ 3,600 \\ Q & = & $ 3,600 \div $ 80 per unit = 45 units \end{array}$

Alternatively, we can calculate the number of units Emma must sell by using the contribution margin method and equation 4:

$\begin{array}{l} \begin{matrix} Quantity of units \\ required to be sold \end{matrix} & = & \frac{Fixed costs + Target operating income}{Contribution margin per unit} \\ = & \frac{$ 2,000 + $ 1,600}{$ 80 per unit} = 45 units \end{array}$

Proof for number of units Emma must sell

Revenues, 200 dollars per unit times 45 units: 9,000 dollars

Variable costs, 120 dollars per unit times 45 units: 5,400 dollars

Contribution margin: 3,600 dollars

Fixed costs: 2,000 dollars

Operating income: 1,600 dollars

Income taxes, 1,600 dollars times 0.30: 480 dollars

Net income: 1,120 dollars

Emma can also use the PV graph in Exhibit 3-3. To earn the target operating income of $1,600, Emma needs to sell 45 units.

Focusing the analysis on target net income instead of target operating income will not change the breakeven point because, by definition, operating income at the breakeven point is $0 and no income taxes are paid when there is no operating income.

Income Taxes and Target Net Income

Proof:

(Equation 1)

Proof:

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