Profit Target

Profit Target
See also
Baumol model Differential costing Total capitalization Marginal relief Profit Look-Ahead Bias Liquidity management Held to maturity securities Depreciation of fixed assets

The profit target is the price (place) specified on the chart, which determines when a withdrawal from strategic activity on the financial market is to take place, i.e. when all financial transactions are to be closed.   In other words, it is the size of a predefined profit (P. W. Farris; Bendle N.T.; Pfeifer P. E.; Reibstein D. J. 2010,p.68).

The target profit can also be defined as the planned profit from the budgeting period, which is possible to achieve in a specific time of the settlement period. The target profit is usually analogous to the real amount of the profit and loss account (P. W. Farris, N. T. Bendle, P. E. Pfeifer, D. J. Reibstein, 2010, p. 68). For this reason, sometimes there are differences between the profit target and the actual profit amount, which require an accounting analysis. Budgets at the end of the budget year are characterized by discrepancies and inaccuracies in settlements, so it is necessary to use rolling forecasts, allowing for current updates of data on expected profits. This enables a more accurate and probable determination of the profit target and reduces significant differences between the real and the target profit (P. W. Farris, N. T. Bendle, P. E. Pfeifer, D. J. Reibstein, 2010, p. 68).

Methods for determining the profit target

Cvp analysis

Cost-Volume Profit Analysis allows you to plan your cash flow and model your profit target. The CVP algorithm is as follows (B. Sorin, C. Scorte, 2011, p. 479):

To complement the profit target, multiply the expected number of units to be sold by their expected contribution margin to get the total contribution margin in a given period. Then subtract the total amount of the expected fixed cost for the period. This modified algorithm may be used to identify the following variables (B. Sorin, C. Scorte, 2011, p. 479):

• Changes in the amount and extent of the contribution for the effects of the transition to lean management
• Changes in fixed costs and outsourcing margins
• the determination of an adequate margin
• modelling the contribution per unit and units sold based on expected sales promotions.

Profitability threshold analysis

Profitability threshold analysis shall also be used in the method for determining the target profit. In this case, the company sets a price that allows it to achieve the target rate of return on capital employed (ROI, return on investment) (R. D. Stewart, R.M. Wyskida, J. D. Johannes,1995 p. 472-473). This method is used by enterprises whose activities require incurring high investment outlays, e.g. in the case of tourist activity it is mainly hotel industry, recreation services such as: bathing beaches, aquaparks, Thematic parks, transport services or gastronomy(A. Hing-Ling Lau, Hon-Shiang Lau, 2007, p. 392-408).

Applicability of profit target

The setting of a target profit allows to achieve the sales profitability expected by the company. In this case, it is also necessary to consider whether the product being introduced is a novelty or a mere modification of an existing product on the market (A. Hing-Ling Lau, Hon-Shiang Lau, 2007, p. 392-408).

When the product being introduced is new, the target profit shall be estimated either on the basis of the profitability rate determined for the company or on the basis of the average level of profit margin for the sector/industry in which the company operates (A. Hing-Ling Lau, Hon-Shiang Lau, 2007, p. 392-408).

${\text{ROS}}={\frac {Target\ profit}{sales\ revenue}}$

${\text{Target profit}}={{\text{ROS}}\cdot {\text{Revenue from sales}}}$

where:

• ${\text{Sales revenues}}={{\text{Target price}}\cdot {\text{Planned quantity of sold products}}}$
• ROS - Profitability on sales

When the input product is a modification of an existing product, the target profit is determined on the basis of the ROS calculated using the previous method adjusted for additional costs (e.g. research and development costs).

${\text{Target profit}}={{\text{ROS}}\cdot {\text{Proceeds from sales}}}$

Examples of Profit Target

• A simple, fixed-dollar profit target is the most common type of profit target. This target is defined by a trader as the amount of money that they hope to gain on a trade. Once the trader reaches this amount, they will close out their position and take the profits.
• A percentage-based profit target is another type of target used by traders. This target is based on the amount of money that the trader wants to gain relative to their starting capital. The trader sets a percentage target and will close out their position if they reach this figure.
• Some traders use trailing profit targets, which are designed to ensure that the trader remains in a profitable trade for as long as possible. These targets adjust upwards to follow the rising price of the asset and lock in more profits for the trader.
• Some traders also use time-based profit targets. This target is based on the amount of time that the trader wants to remain in a trade. Once the target is reached, the trader will close out their position.

Advantages of Profit Target

A profit target is a financial goal set by a trader or investor to ensure that they will realize a certain amount of gain from a trade. It is a way of controlling risk and ensuring that a trade will be profitable. The following are the advantages of using a profit target:

• First, profit targets help traders and investors to optimize their returns by setting a specific goal to aim for. This allows them to maximize their profits while limiting their losses.
• Second, profit targets provide traders and investors with a clear exit strategy. Knowing when to exit a trade is important for risk management, as it helps traders to manage their losses and protect their investments.
• Third, profit targets help traders and investors to stay disciplined. By setting a specific target, traders and investors are less likely to be tempted to overtrade and increase their risks.
• Finally, profit targets can help traders and investors to measure the performance of their trades. By setting a specific target, traders and investors can track their progress and assess their success.

Limitations of Profit Target

A profit target is a valuable tool for financial market strategists, but it does have some limitations that should be taken into consideration. These include:

• Unrealistic goals – Setting a profit target that is too high can lead to frustration and disappointment when it is not achieved.
• Unforeseen market conditions – Unforeseen market conditions such as an unexpected economic downturn or a significant shift in currency rates can make it impossible to achieve the set profit target.
• Changing dynamics – Profit targets can become outdated if the underlying investment dynamics change. This can lead to investors holding onto investments too long and missing out on potential profits.
• Emotional bias – Investors may be tempted to set unrealistic profit targets out of fear or greed, which can lead to them making irrational decisions.

Ultimately, profit targets should be used as a guide rather than a strict rule, as they are subject to the limitations outlined above.

Other approaches related to Profit Target

• A profit target can also be set in terms of a percentage return on the original capital invested. For example, if a trader sets a 20% profit target, it means that when the return reaches 20%, the trader will close the position and take the profits.
• A profit target can also be set in terms of a certain number of pips. For example, if a trader sets a 50 pip profit target, it means that when the currency pair reaches a 50 pip profit, the trader will close the position and take the profits.
• A profit target can also be set in terms of a certain number of trades. For example, if a trader sets a 10 trade profit target, it means that when the trader has achieved 10 winning trades, the trader will close the position and take the profits.

In summary, a profit target is a price or point determined by the trader to indicate when the position should be closed and the profits should be taken. Depending on the trading strategy, the profit target can be set in terms of a percentage return, a certain number of pips, or a certain number of trades.

References

• Farris, P. W., N. T. Bendle, P. E. Pfeifer, D. J. Reibstein, (2010), Marketing Metrics: The Definitive Guide to Measuring Marketing Performance
• Lau Hing-Ling A., Lau Hon-Shiang., (2007), Maximizing the Probability of Achieving a Target Profit in a Two-Product News Vendor Problem, 19(2), June
• Palia A. P., (2008), Profit Pricing With The Web-Based Breakeven Analysis Package, Developments in Business Simulation and Experiential Learning, Volume 35,
• Sorin B., Scorte C. (2011), The Profit Target In a Restauration Unit, December,
• Stewart R. D., Wyskida R. M., Johannes J. D., (1995), Cost Estimator's Reference Manual

Author: Marzena Rusin