Target net income
/Target income is the profit that the managers of a company expect to attain for a designated accounting period. It is a key concept in a corporate control system that drives corrective management actions. The term is used in the following situations:
Target Net Income in Budgeting
Managers may structure the expenditures of a business to attain a certain target income. This requires advance planning for expenditure levels through a periodic budgeting process. The target income figure may be based on a variety of factors, such as a desired rate of return on capital, a necessary cash flow level, or a certain amount of earnings per share.
Target Net Income in Compensation Planning
The human resources staff can use target income levels to set bonus goals for senior managers, or as the basis for a bonus pool for all employees. This figure is typically based on the budgeted profit level for the profit center for which a manager is directly responsible.
Target Net Income in Investor Relations
The investor relations officer or chief financial officer using ongoing guidance to keep the investment community appraised of the target income that a business expects. Investors then use this information, along with an array of other information about a business, to estimate what its stock price should be.
Target Net Income in Loan Agreements
A lender may mandate that a borrower attain a certain minimum income level for as long as a loan is outstanding, or else the lender has the right to call the loan. This is not especially common, since net income does not necessarily relate to the amount of cash flow that a borrower generates - and which is much more relevant for determining whether it can repay a loan.
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Derivation of Target Net Income
Target net income can be derived with cost-volume-profit analysis, which uses the following 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 net income level.
Problems with Target Net Income
There are several disadvantages associated with using the target net income concept, which are as follows:
Potential for short-term focus. Managers may prioritize achieving short-term profit targets over long-term business growth. This can lead to cost-cutting measures that hurt product quality, employee morale, or customer satisfaction.
Risk of earnings manipulation. To meet target net income, managers might engage in aggressive accounting practices, such as recognizing revenue early or deferring expenses. This can distort financial statements and mislead investors or stakeholders.
Ignores market and economic factors. External conditions like economic downturns, supply chain disruptions, or changing consumer preferences can impact profitability. Rigid adherence to target net income may not allow for necessary adjustments in business strategy.
Pressure on employees. Unrealistic profit targets can create excessive pressure on employees, leading to burnout, unethical behavior, or decreased job satisfaction. In extreme cases, employees may manipulate sales figures or delay necessary expenses to meet targets.
Limited flexibility in decision-making. A strict focus on achieving target net income may discourage investments in innovation, research, or expansion, even when they are beneficial in the long run. This can limit the company’s ability to adapt and grow in a competitive market.
Can lead to underinvestment. To meet profit targets, managers may reduce capital expenditures on equipment, technology, or employee development. This underinvestment can weaken the company’s long-term competitive advantage.
May not reflect true business performance. Target net income does not account for non-financial factors like customer loyalty, employee engagement, or brand strength. A company may hit its profit goal but still face declining market share or operational inefficiencies.
Encourages cost-cutting at the expense of quality. Companies may cut costs excessively, such as using cheaper materials, reducing customer service, or delaying maintenance. These actions can damage the brand reputation and lead to future revenue losses.
Creates unrealistic expectations for investors. If a company consistently meets target net income by using non-sustainable tactics, investors may develop unrealistic expectations for future growth. When the company eventually fails to meet targets, stock prices may drop significantly.
Not always aligned with cash flow. A company can achieve its target net income while still facing cash flow problems if earnings are based on accrued revenue rather than actual cash received. This can lead to liquidity issues and difficulty in paying obligations like salaries or debts.