# 6.7: Income Taxes and Cost-Volume-Profit Analysis

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Skills to Develop

• Understand the effect of income taxes on cost-volume-profit analysis.

Question: Some organizations, such as not-for-profit entities and governmental agencies, are not required to pay income taxes. However, most for-profit organizations must pay income taxes on their profits. How do we find the target profit in units or sales dollars for organizations that pay income taxes?

Three steps are required:

## Step 3. Use the target profit before taxes in the appropriate formula to calculate the target profit in units or sales dollars.

Using Snowboard Company as an example, the assumptions are as follows:

 Sales price per unit $250 Variable cost per unit$150 Fixed costs per month $50,000 Target profit$30,000

## Step 2. Convert the desired target profit after taxes to the target profit before taxes.

The formula used to solve for target profit before taxes is

$$\begin{split} \text{Target profit}\; before\; \text{taxes} &= \text{Target profit}\; after\; \text{taxes} \div (1 − \text{tax rate}) \\ &= \ 50,000 \div (1 - 0.20) \\ &= \ 62,500 \end{split}$$

## Step 3. Use the target profit before taxes in the appropriate formula to calculate the target profit in units.

The formula to solve for target profit in units is

$$\frac{\text{Total fixed costs + Target profit}}{\text{Selling price per unit − Variable cost per unit}}$$

For Snowboard Company, it would read as follows:

$$\begin{split} \text{Target profit in units} &= (\ 50,000 + \ 62,500) \div (\ 250 − \ 150) \\ &= \ 112,500 \div \ 100 \\ &= 1,125\; \text{units} \end{split}$$

1. The three steps to determine how many sales dollars are required to achieve a target profit after taxes are as follows:

## Step 1. Determine the desired target profit after taxes.

Management wants a profit of \$60,000 after taxes and needs to know the sales dollars required to earn this profit.

## Step 2. Convert the desired target profit after taxes to target profit before taxes.

The formula used to solve for target profit before taxes is

$$\begin{split} \text{Target profit}\; before\; \text{taxes} &= \text{Target profit}\; after\; \text{taxes} \div (1 − \text{tax rate}) \\ &= \ 60,000 \div (1 - 0.20) \\ &= \ 75,000 \end{split}$$

## Step 3. Use the target profit before taxes in the appropriate formula to calculate the target profit in sales dollars.

The formula used to solve for target profit in sales dollars is

$$\frac{\text{Total fixed costs + Target profit}}{\text{Contribution margin ratio}}$$

$$\begin{split} \text{Target profit in sales dollars} &= (\ 50,000 + \ 75,000) \div (\ 100 \div \ 250) \\ &= \ 125,000 \div 0.40 \\ &= \ 312,500\; \text{in sales} \end{split}$$